Under audit the IRS will often insist upon the taxpayer producing contemporaneous time logs to substantiate the time put into the rental activity. However, the regulations state that a taxpayer’s participation in an activity may be established by any reasonable means. Moreover, contemporaneous daily time reports, logs, or similar documents are not required if the extent of the taxpayer’s participation may be established by other reasonable means. Other reasonable means include the identification of services performed over a period of time and the approximate number of hours spent performing the services during that period based on appointment books, calendars or narrative summaries.
Auditors are known to skew participation testing by parsing out activities that case law has shown do not qualify as participation in the activity from the taxpayer’s time substantiation. The following activities can be attacked in this manner:
- Time claimed for work that is not customarily performed by the owner of a rental activity is not treated as participation in the rental activity if one of the principal purposes of performing the work is to avoid the disallowance of a loss from the rental activity.
- Time claimed for work done by a real estate investor in his capacity as a real estate investor is not treated as active participation in the activity unless the investor is involved in the day-to-day management or operations of the rental activity. Work that auditors will attempt to parse out as non-qualifying includes studying and reviewing financial statements or reports on operations of the activity, preparing or compiling summaries or analyses of the finances or operations of the activity for the taxpayer’s own use, preparing budgets, phone calls or visits to monitor operations, writing checks, trips to post offices and banks, preparing schedule E of the tax return, organizing records, reading journals and monitoring the finances or operations of the activity in a non-managerial capacity. It is very interesting to note the activities listed above are fully recognizable for material testing purposes where a rental activity rises to the level of a trade or business but are routinely disallowed and thus treated as non-countable where the activity only rises to the level of investment activity.
- If a rental activity has on-site management it takes the position that it is hard for a taxpayer to materially participate because rental activities by nature do not require significant day-to-day involvement and therefore are not time intensive. They take the position that of the five tests above, only the 500-hour test is applicable because of the on-site management. They will look at the taxpayer’s other activities to see if 500 hours a year is even possible such as the manner in which the taxpayer earns his or her living. Auditors are known to equate on-site management with the activities of an off- site management company. It is important to note that property management companies often offer services on an a la cart basis and can be used for nothing more than to collect and remit the rent, which leaves plenty of activities necessary for the owner to perform. The auditors are trained to look for indications of on-site or off- site management companies by scanning for commissions, management fees, expenses for cleaning apartments, maintenance, repairs, etc. Each activity that is paid for that an owner could have done for himself is an indication of a lack of material participation.
Another common attack under audit is where the auditor takes the position that for purposes of applying the real estate professional exception, each interest that a real estate professional owns in a rental real estate activity is tested as a separate activity. In practice the auditor will often disallow the losses from a particular rental activity unless both the real estate professional exception rules delineated above are met and it can be shown that at least 100 hours of material participation can be substantiated per rental property. To mitigate against this 100-hour requirement, a real estate professional should consider electing to treat all his or her interests in rental real estate activities as one activity. This election is made by attaching a statement to the original income tax return for the year that declares that the taxpayer is a real estate professional and that he is making the election under Code Sec. 469(c)(7)(A).
Auditors routinely determine if the taxpayer is an employee early on in an audit. Case law has held that personal services performed by a taxpayer as an employee are not treated as personal services performed in real estate trades or businesses unless the taxpayer owns more than five percent of the employer. What this means is that a taxpayer who is an employee must meet the 750-hour requirement to be a real estate professional strictly from time devoted to his rental real estate activities. Auditors take the position that being an employee takes a minimum of 2050 hours a year, which leaves little time to devote 750 hours a year to being a real estate professional. It is important to note that this hurtle is not impossible to meet but is often treated by the IRS under audit as impossible to meet.
