Cost Segregation for Real Estate Professionals

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Real estate is a fascinating asset class. It shares characteristics with a variety of assets like gold, private equity, stocks, and bonds. It can be owned by individuals, in a partnership, on paper, in physical form, and even publicly traded. Not to mention there are many forms of real estate such as residential, commercial, industrial, and raw land. It’s no wonder why so many people own or have owned real estate in their lifetime. 

For those who have owned real estate, they know that it has its challenges. This white paper is designed to address one of those challenges. In particular, we are attempting to clarify the selection of “real estate professional” as it pertains to IRS Form 8582 and the passive activities in which they materially participate. The “real estate professional” selection can be used with a cost segregation study to help offset active income from wages or business income with real estate losses.

The framework of this paper starts with pulling direct quotes from the IRS Audit Guide on Passive Activities. The IRS decides who will be audited and who will not, but it can be a good practice to refer to the audit guide when making tax planning decisions. 

The areas that we have pulled directly from the audit guide have been highlighted/italicized/indented to indicate the exact text from the IRS. We begin in section 2-4 of the audit guide.

Real Estate Professional In A Nutshell 

Beginning in 1994, a real estate professional may treat rental real estate activities as non-passive if the taxpayer materially participates in the rental activities. [2] The material participation requirement applies separately to each rental activity (unless the taxpayer made a timely election to group all his rentals as a single activity). These rules apply to individual taxpayers and closely held C Corporations. 

There is a lot to unpack in this paragraph. What is the definition of a “real estate professional?” How do you “materially participate” in a rental activity? What is the election to “group” as a single activity? What are the benefits and drawbacks to “grouping” activities? We will address each of these questions below. 

  • To qualify as a real estate professional, the taxpayer must spend:

  1. more than 50 percent of his/her time in real estate activities; AND,

  2. more than 750 hours in real estate activities.

  • A real estate professional must materially participate in each rental activity for the loss to be deductible. [3] 

To be considered a real estate professional there are two rules. First, you must spend more than half of your time on real estate activities. Second, you have to spend more than 750 hours in real estate activities. Neither of these are high hurdles. One way to think about the first rule is that you cannot be a “real estate professional” if you have another primary profession. For the second rule, 750 hours per year averages to only about 15 hours a week. The last bullet point states that as a real estate professional you must spend 750 hours per activity that you are claiming.  This means if you have three rental properties, you would have to spend 750 hours on each property, or a total of 2,250 hours in real estate activities. This leads to several more questions that need to be answered. What counts as a “real estate activity?” How would you prove that you spent 750 hours in said activities? What about real estate professionals that own 10, 20 or 100 real estate properties? Isn’t it counterintuitive that the more property you own, the harder it is to be considered a real estate professional?

Exception: A real estate professional may file a written election to group all rental real estate activities as one activity. As a practical matter, most elections were filed in 1995. However, the taxpayer may file the election in any year, and it will bind future years from that point. [4]

The ATG gives an exception and answers our last question. This exception allows the taxpayer to group all the activities as one activity. This changes the passive gains (losses) to active gains (losses) that can only be deducted from other active gains. Grouping all the activities has a potential downside, however. Once the election has been made, it is binding in future years barring certain exceptions. This can be problematic for those taxpayers that have other forms of passive income that they may want to take a tax deduction in the future. With that said, the grouping activities election allows a real estate professional to meet the 750 hours only once for the entire group. It also helps in situations where you have a real estate broker that owns several real estate properties. That person could offset some of the active income from the brokerage with some of the losses from the rental properties.

Issue Identification

  • Check to see if all Schedule E rental real estate losses have been deducted as non-passive, possibly not considering the fact that the taxpayer must materially participate in each rental activity.

  • Look at the taxpayer’s occupation next to the signature block and Schedule E line 43. To be a real estate professional, the taxpayer must spend the majority of time[5] in real property businesses and/or rental real estate.

  • Review the Schedule E activities, Schedule K-1s for Form 1065 and Form 1120S returns, and W-2s for other indications regarding the nature of the taxpayer’s activities.

This part of the ATG starts to get into the examination of the taxpayer. The auditor is going to check the past and current tax returns to see if the taxpayer has identified as a real estate professional. It’s a good idea for the taxpayer to start identifying as a “real estate professional” as soon as they meet the above conditions. That way, there is an established paper trail of identifying as a real estate professional.

Real Estate Professional 

To be a real estate professional, an individual must spend the majority of his or her time in real property businesses:

  • Development or redevelopment

  • Construction or reconstruction

  • Acquisition or conversion

  • Rental

  • Management or operation

  • Leasing

  • Brokerage

This highlighted section answers another one of our questions. What “activities” count for a real estate professional? They are clearly listed above, but as always there are more questions. If you are acquiring a property, the actual transaction would not involve 750 hours of work. What about research and planning? Does searching online for potential properties in your bathrobe count? How would you prove that you looked up properties in bed for hours? We will address this more in a later section. As a rule, however, it’s not the location of or time spent on the activity that is important, but the ability to prove that the activity was actually completed. A receipt from Starbucks in not proof real estate activities were completed. 

The taxpayer must meet each of the following two-time requirements:

  • More than 50 percent of his/her time working in real property businesses; AND,

  • More than 750 hours of service during the year. [6]

One spouse alone must meet both tests. In addition, services performed as an employee do not count unless the employee is at least a 5 percent owner. 

Finally, before rental losses are deductible without being limited by the passive losses rules, the taxpayer must materially participate in each rental. [7]

This part of the ATG repeats the previously stated rules but adds an interesting twist. Only one spouse needs to meet both tests. Consider the following situation. One spouse has wages of $500,000. The other spouse is considered unemployed but spends a majority of their time managing several rental properties that due to depreciation schedules are running at a loss. In this situation it is possible to have the second spouse, assuming they meet the above hurdles, become a real estate professional. This would create a situation where real estate losses could offset wage income. What if you had a lot of real estate losses? We’ll come back to that. 

Examination Techniques:

  • Determine whether the taxpayer materially participates in one or more of the specific real estate trades or businesses listed above.

  • Determine who is the real estate professional, husband or wife.

  • Request and closely examine the taxpayer’s documentation regarding time. The taxpayer is required under Reg. § 1.469-5T(f)(4) to provide proof of services performed and the hours attributable to those services. See Chapter 4 for more on methods of proof.

  • Scrutinize other activities the taxpayer is engaged in to determine whether time claimed makes sense.

Here are more audit techniques provided by the ATG. Any auditor will look for clear documentation to demonstrate that the 750 hours have been met.  In Reg. § 1.469-5T(f)(4), it specifically states that the taxpayer does not have to keep a log of their time. However, it does say that you have to prove your activities. So, how would you prove your activities without keeping a log? Our answer is, keep a log. We provide sample logs for taxpayers aspiring to be real estate professionals in the eyes of the IRS.

  • Qualification as a real estate professional is a determination, not an election. A taxpayer may attempt to manipulate the passive activity rules by inappropriately claiming to be a real estate professional, or conversely, by not claiming to be one (for instance, if certain activities are generating net income).

This is an interesting definition of being considered a real estate professional. We are often asked, “Do I need a license to be a real estate professional?” or “I have a real estate license. Does that make me a real estate professional?” This paragraph states that the taxpayer is a real estate professional due to their work activities, not by simply having a license or choosing a profession. Our estimation is that this guideline is to differentiate between grouping activities (an election) and being considered a real estate professional (a determination).

Material Participation for Real Estate Pros 

A real estate professional may deduct rental real estate losses only to the extent he or she materially participates in each rental activity. Unless the taxpayer elected to group his rentals as a single activity, each rental is treated as a separate activity. Under the material participation rules, the time of both spouses is counted. [8] The material participation test [9] then applies separately to each individual rental real estate activity. If the taxpayer materially participates in an activity, net income or loss from that activity is non-passive. If the taxpayer does not materially participate, despite being a real estate professional, the rental is passive and losses (or income) go on Form 8582. 

A taxpayer, who does most of the work in a rental, meets Test 2 for material participation in Reg. § 1.469-5T(a)(2). 

This seems a bit redundant, but there is a clear distinction from our discussion above. The IRS stresses that rental income is non-passive if the taxpayer does not materially participate.

At this point, let’s take a deeper look at some rules for PALs or Passive Activity Losses. It appears that some of the rules are written to prevent a taxpayer from turning a passive activity into an active one. However, there are also rules that appear to prevent active activities from becoming passive. Why the discrepancy? Well, keep in mind that the IRS isn’t for or against passive activities or active ones. They simply want to prevent abuse. For example, there are certain circumstances where passive activities are more advantageous for the taxpayer. A taxpayer many want to turn an active income into a passive income in order to avoid payroll taxes. However, taxpayers cannot simply decide that an activity is passive in order to avoid taxation. They need to follow the IRS rules. We point this out because the IRS is not trying to keep your activities passive or active. Again, they are trying to prevent abuse.

However, if there is on-site management, it may be difficult for the taxpayer to materially participate because:

  1. Rental activities, by nature, normally do not require significant day-to-day involvement, i.e. they are not time intensive.

  2. For many taxpayers using any kind of outside management, the only material participation test available is the 500-hour test. In many situations, the other tests will not apply.

  3. In many circumstances, an individual rental activity will not require 500 hours of participation, nor will the taxpayer have sufficient time available to spend 500 hours on each individual rental real estate activity.

This paragraph is specific, but it may apply to some taxpayers. Simply stated, it’s hard to get the work hours if you are paying someone to manage your properties. (On a side note, you may have noticed that the number of hours referenced in the paragraph above is 500 rather than 750. That’s because the IRS audit guide covers more than just the real estate professional qualification and the 500-hour test applies to circumstances outside the scope of this paper. For the purposes of the real estate professional qualification, we are working with the 750-hour test.)

Examination Techniques:

  • During the initial interview, question the taxpayer regarding time spent in all activities (personal, business, civic, family, hobbies, etc.).

  • Request and closely examine the taxpayer’s documentation of time utilized for material participation in each activity. See the log-Chapter 5.

  • Look for time spent by others in the activity. Indicators: commissions, management fees, expenses for cleaning, maintenance, repairs, etc.

Here are even more audit examination techniques. Notice that they will try to determine what is a hobby as opposed to what is a profession. If the taxpayer doesn’t have time to spend 750 hours in a profession, that may lead the IRS to question the hours logged. Although they will examine the log, they will also take a look at supporting documentation such as receipts, calendars, and commissions in order to help them determine if the 750 hours have been met.

Election to Group Rental Real Estate 

A real estate professional may make an election to group all rental real estate activities as one single activity. In order to make a valid election, Treasury Regulation § 1.469-9(g) requires a taxpayer to file a written statement and attach it to an original return. This election cannot be made on an amended return or during an audit! 

The most important part of this paragraph is that the grouping activity election cannot be made during an audit. Tax professionals will be familiar with this, but it bears repeating. The election to group activities must be made when you file your taxes. An election in an audit will not be allowed and penalties will be assessed. As always, planning ahead is the best course of action.

Examination Techniques:

  • Question the taxpayer in the initial interview whether an election was made, grouping rental real estate interests as a single activity.

  • Request a copy of the return with the election. Request the original Form 1040, U.S. Individual Income Tax Return, from the IRS Center if doubts exist as to the documents furnished.

  • Review prior and subsequent year’s returns for consistency.

  • Closely scrutinize any passive income on Form 8582 line 1a. If the taxpayer is a real estate professional and did most of the work on the rental, gain on disposition does not belong on Form 8582.

As part of the audit, the IRS will look for consistency.  They want to see that once an election has been made to group activities, it stays consistent in future years. Also, once the property is grouped into an active group, the sale will not go on Form 8582. Form 8582 is used for the sale of passive activities.

Identifying as a real estate professional and electing to group your real estate activities are some potential tax strategies with incredible benefits. They also are underutilized. Either taxpayers are unaware of these tax strategies, or they don’t understand it enough to take advantage of them. We hope that this white paper helps with both of these barriers.

At RCG Valuation & Monetization, we want you and your clients to take full advantage of tax laws that can benefit you. We can show you how once you are a real estate professional with grouped activities, you can use a cost segregation study to reduce your active income by a significant amount. A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for tax purposes. This reclassification reduces current income tax obligations and increases current cash flow.

Let’s use an example to drive home our point. One spouse has $500,000 in wages and the other spouse is a real estate professional with grouped activities. Up until this point, the four properties they own have been depreciating over 27.5 years. The couple has been running these properties at a break-even level once you count expenses and depreciation. This year, they have cost segregation studies done on the four properties, creating a loss of $275,000 due to the large depreciation write-off. The couple now offsets the $500,000 in wages with the $275,000 loss. This reduces their active income to $225,000. In this example, cost segregation in combination with being a real estate professional with grouped activities, saves approximately $110,000 in taxes (assuming a 40% tax rate).

Would you or your client benefit from the tax strategies discussed in this white paper? Contact us for a free estimate to see if we can help. As always, be sure to consult with your tax professionals.

For more information on Cost Segregation, IRC 469, and Business Valuation, contact:

RCG Valuation & Monetization, Inc.
O: (480) 404-7521
T: (833) 851-8045
E: info@rcgvaluation.com


Sources:

IRC § 469(c)(7): Real estate professional defined (special rules for taxpayers in real property trades or businesses.

IRC § 469(c)(7)(A)(ii) and Reg. 1.469-9(e)(3): Each interest in a rental real estate activity is a separate activity for purposes of meeting the material participation tests.

Reg. § 1.469-9(g): Election available to group all rental real estate as one activity. Must be a written statement filed on an original return.

IRC § 469(c)(7)(D)(i): Application of real estate professional rules to closely held C Corporations.