Investors are limited in their ability to offset income with passive losses, and even real estate investors who “actively participate” in their rentals (through management, capital improvements, selection of tenants, negotiation of leases, etc.) have a maximum $25,000 offset. However, 26 U.S. Code § 469(c)(7) provides special rules for real estate professionals – if you qualify, all real estate losses may be applied without limitation.
How do you qualify as a “real estate professional”?
Taxpayers generally have the burden to prove that they are entitled to a deduction that they have claimed, and 26 CFR 1.469-5T(f)(4) lists the types of evidence that is admissible. To qualify as a real estate professional under 26 U.S. Code § 469(c)(7)(B) and to receive your full deduction, you must prove that material participation in your real estate ventures (1) constitutes more than half of your activities during the year and (2) the total time spent during the year exceeds 750 hours.
A new U.S. Tax Court summary opinion provides an excellent example of how to qualify as a real estate professional for tax purposes. The case involved an architect, Jose Franco, who also owned two rental properties. On his 2013 tax return, Franco reported gross rental income of $101,950 from his properties, offset by expenses of $169,832, for a net loss of $67,882. The IRS issued a notice of deficiency, acknowledging that Franco was entitled to deduct $25,000 of his $67,882 loss per 26 U.S. Code § 469(i), but disallowed the rest.
Franco succeeded in proving to the court that he qualified as a real estate professional by presenting extensive records detailing his real estate activities:
- Activity log. Mr. Franco’s activity log detailed all of his actions managing his rental properties in 2013, including time spent on each of those activities. The total came to 1,137 hours in personal services managing his rental properties during the year at issue (as opposed to 649 hours on his architectural services).
- Receipts and email records. Mr. Franco also produced records of email exchanges with tenants and mortgage brokers, and numerous receipts for property repairs and other management expenses.
The court noted that other reasonable means of proof include, but are not limited to submission of appointment books, calendars, and narrative summaries. It unequivocally accepted Mr. Franco’s evidence – since his rental real estate activities were “regular, continuous, and substantial within the meaning of section 469(h)(1)” the court held that Franco qualified as a real estate professional for purposes of his 2013 tax return and allowed the entire loss deduction.