Qualifying as a real estate professional is going to become even more important in 2013 than it ever was. The IRS is pretty tough about it and as the recent decision in the case of Sherry Hudzik shows the Tax Court tends to back them up. Up till now, the issue has been important to people who have real estate rental losses they don’t want suspended. The 3.8% Obamacare tax on net investment income will make it relevant to a much larger group.
The Big Picture
The Tax Reform Act of 1986 gave us the seemingly oxymoronic concept of “passive activities”. Collecting interest and dividends is not a “passive activity” even though interest and dividends are considered “passive income” in other areas of tax law, such as the sting tax on S Corporations. There has to be an activity, such as a trade or business, for you to not materially participate in, in order for you to have passive income or losses under Code Section 469. If you have net passive losses, they are suspended to be released if you have passive income in the future or when the associated activities are entirely disposed of. Rental activities are “per se” passive. This seemed to be a hardship for people who were generally active in real estate, so an exception to the “per se” passive rule was carved out for them.
A lot of trade or business income is subject to self-employment tax. Not all of it though. Flow-through income from an S Corporation is not subject to self-employment income, although the IRS will get on you if your salary is unreasonably low (As a practical matter it seems that the lowness has to be extermely unreasonable.) Whether the trade or business income flowed through to a limited partner or an LLC member is subject to self-employment tax is a really sticky issue. Real estate rental income is specifically excluded from the self-employment base. Trade or business income that is not subject to self-employment tax will be subject to the tax on net investment income.
There is a very big exception, though. Income that is considered non-passive under Code Section 469 will not be subject to net investment income tax. This means that the income from rental real estate, including gain on disposition, might be exempt from the 3.8% tax in the case of real estate professionals. Someone who is below the AGI threshold for net investment income tax might not think this is all that exciting until they reflect on how high AGI might be in the year that their ship comes in and they sell the property. If somebody decides then that they want to establish themselves as a real estate professional, it will be very challenging, which is why cases like that of Sherry Hudzik are worth watching.
It Is Not Easy
Before we get into the really hard part, there is an easy thing that people often miss. Getting the real estate pro status just relieves you of the “per se” passive rule. You still have to materially participate in each of the activities. If you have several properties this can be virtually impossible. You are allowed to elect to aggregate all your properties together, but many people miss that election, as did Ms. Hudzik, although she did not get far enough for that to matter.
In order to qualify as a real estate professional you must spend at least 750 hours on your real estate trades or businesses in which you are an owner. As an accidental landlord of one condo, I would never get there. On the other hand, if I actually found the experience rewarding, I can see how getting just a couple more and not relying on somebody else to deal with the tenants would turn the activity into a time sink nearly as catastrophic as tax blogging. 750 hours is not the sole requirement. You also have to spend more time on the real estate activities than you do on anything else. This generally proves to be an insurmountable obstacle for amateur landlords with day jobs, particularly since there is a much harder unstated requirement.
You Have To Be Able To Prove It
How much time you spend on your day job is generally not that controversial. There was no argument that Ms. Hudzik spent 1,650 hours each year as a “treaty manager” for Swiss Reinsurance America Corp. You might envy those short hours, but you sure would not envy her commute. Watchung, NJ to Armonk, NY. According to Mapquest it is about an hour and a half each way, but it involves crossing the Hudson River either at the George Washington Bridge or the Tappan Zee. Yikes. So she needed to show that she spent quite a bit of time on her real estate. Here is what she had:
To substantiate her claim that she was a real estate professional, petitioner introduced three logs reflecting the amount of time she purportedly spent on rental real estate activities during each of the years at issue. ……..Of those hours, petitioner contends that she worked 1,270.25 hours on real estate activities related to the Florida[property and 660 hours related to the New Jersey property and the Florida property combined. For 2007 petitioner contends that she spent a total of 1,790 hours on real estate activities. Of those hours, petitioner contends that she worked 1,525 hours on real estate activities related to the Florida property and 265 hours related to the New Jersey property and the Florida property combined. For 2008 petitioner contends that she spent a total of 1,680.75 hours on real estate activities. Of those hours, petitioner contends that she worked 1,511.25 hours on real estate activities related to the Florida[ property and 169.5 hours related to the New Jersey property and the Florida property combined.
I thought the hours were kind of odd given that she owns a four unit building in New Jersey] and a condominium in Florida. It made a little more sense when I realized Clearwater was the type of place where you might be doing a lot of short-term rentals. You should note that she would have had a material participation problem with the the ]New Jersey property due to her failure to make the election. The reason it never got there was simple. The Tax Court just did not believe her.
Petitioner alleges that most of her real estate activity consisted of searching for prospective tenants for the New Jersey property and the Florida property on Craigslist. In addition to her Craigslist activity, petitioner asserts that her rental activity also included renting and managing the New Jersey property and the Florida property, paying bills, and doing whatever else was required by the State and the town. Petitioner did not specify any of these activities in the logs.
The logs that petitioner provided, however, are suspect. Petitioner attempted to establish the hours she purportedly devoted to the rental properties with the logs and her testimony at trial. The logs list totals of 1,942.25 hours, 1,790 hours, and 1,680.75 hours that petitioner spent during taxable years 2006, 2007, and 2008, respectively, working on the rental properties. We consider the hours reflected in the logs implausible, given that petitioner already worked 1,650 hours per year at Swiss Re and would have had to spend almost all of her remaining time working on the rental properties.
As these cases go it was pretty big money, nearly $60,000 in deficiencies plus accuracy related penalties. I find this case a little troubling. The Tax Court is more or less saying that people with day jobs will never be able to meet the standard. The lesson, if you are going to try anyway, is not only to keep logs, but to be specific about what you are doing.
You can follow me on twitter @peterreillycpa.
Originally published on Forbes.com Jan 27th, 2013