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:
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.