Qualifying as a real estate professional is very helpful at tax time. It releases you from the restrictions of passive activity rules, which prevent investors from using losses on rental real estate to offset passive income.
Many taxpayers cannot avoid passive activity rules if they do not materially participate. There is an exception for a real estate professional, defined as a taxpayer involved in a regular, continuous, ongoing basis in the operation of a real estate business and:
- Spends more than half the personal services he performs during the year in real estate business activities in which he materially participates and
- Performs over 750 hours of services in those activities.
Real estate professionals are not limited to a $25,000 loss allowance available to some taxpayers who have a modified adjusted gross income of $100,000 or less (with exceptions) and have actively participated in the real estate activity: participated in management decisions and exercised independent judgment. There is no specific hour requirement.
But the Tax Court has shown once again how difficult it is for a real estate investor to qualify as a real estate professional – particularly if they have another, non-real estate, job.
In the case of John Kutney, an aeronautical engineer, engaged in independent engineering consulting work in addition to managing his rental real estate properties (John T. Kutney, et. ux. v. Commissioner, TC Summary Opinion 2012-120, Dec. 17, 2012), Kutney kept no log or other contemporaneous documentation of the number of hours he spent working on his rental properties.
The court was not convinced that Kutney performed more than half of his personal services in real property business activities, despite the fact that he seemed to have spent relatively little time on his engineering consulting activities. His testimony regarding the time he spent on consulting and rental activities was vague and indefinite.
The court also refused to accept Kutney’s contention that management of the rental properties was a full-day activity requiring him to be available all day, every day and that these on-call hours should count toward the 750-hour requirement. The court found that merely being on call to perform services was not the same as actually working in the activity.
Although the tax law does not require you to keep contemporaneous daily time reports, logs or similar documents, if you are expected to be able to prove that you spend a particular amount of time in a specific activity, this case shows that you will have to provide more than what the court called “a post-event ballpark guesstimate” to win the day.