IRS Challenges to the Real Estate Professional Status

The IRS has been stepping up their audits of anyone who takes a real estate loss on their tax returns. Some of their arguments against the taxpayers are valid and a lot of them are not.
Here are some of the recent challenges to the real estate professional status by the IRS and what you can do about it.

IRS Argument:  A real estate agent is not a real estate professional

One of the allowed real estate professional activities is “brokering  a deal.”  In some cases, the IRS has taken the position that a real estate agent doesn’t qualify because he or she is a not a broker. There have been at least three Tax Court rulings against the IRS when they have taken that position.
Bottom Line:  Real estate agent hours do count as real estate professional hours.

IRS Argument:  Material participation is 750 hours, not 500 hours

In earlier articles in this series, we talked about the need for material participation in order to claim the real estate professional deduction.  The amount needed is 500 hours per property, unless you aggregate properties in which case it is 500 hours total.
However, the IRS Audit Technique Guide (ATG) for real estate professionals has a mistake. In one place it says that the material participation is 750 hours. In another place, it correctly states that it is 500 hours.
Bottom Line: This mistake can mislead auditors, but it is wrong.

IRS Argument:  A limited partner in a limited partnership automatically does not qualify as a real estate professional

I need help with the IRS

The IRS seems to be rewriting the rules...


The IRS issued Proposed Regulations for Code Section 469 in December 2011. These clearly explain the situations under which a limited partner CAN have material participation.
Unfortunately, the IRS didn’t update their ATGs that they give auditors. The auditors are still trained to immediately deny any limited partners the benefit of real estate professionals.
There are also some IRS positions that aren’t clearly valid or invalid. For example, if you use a property manager, the IRS will likely deny that you are actively participating.
They began a massive audit offensive in June 2012, targeting most property managers in Arizona. During the audit, they are compiling lists of their real estate investor clients. At this point, we’re not certain exactly what they will be doing, but a best guess is that they will select these investors for audit.

Rewriting the Rules?

The IRS is checking on anyone who has received a Form 1099-A showing a foreclosure or deed-in-lieu-of foreclosure  If the property is in a state which is considered non-recourse, then the lender cannot pursue additional claims against the borrower. At that point, normally the lender will calculate how much the debt forgiveness is and issue a Form 1099-C.
Now the IRS says that as soon as you have a Form 1099-A, you have debt forgiveness income if you’re in a state where loans are non-recourse.
Although this last one doesn’t have anything to do with the real estate professional status, it demonstrates how the IRS is rewriting the rules or at the very least, sending out inexperienced auditors with incomplete and sometimes inaccurate handbooks.
It’s never been more important to make sure you have an experienced tax strategist and tax preparer helping you. It’s not enough to hire someone with some tax experience. If you have real estate, you need someone with real estate tax experience.