[IMGCAP(1)]The IRS is conducting a sweep of real estate investors that challenges deductions investors have been taking as a routine part of business for years. The sweep is based on an IRS belief that there is a “compliance gap” in this area.

In the event that an investor client becomes the subject of an audit, CPAs should be armed with the necessary tools to counter IRS claims and, if necessary, fight audits in court.

Owning real estate is not without its costs. As you are aware, Congress allows deductions pertaining to operations, such as depreciation, and you deduct every penny without a second thought. Unfortunately, what Congress giveth on one hand, it taketh away on the other. In a 1986 tax overhaul, Section 469 of the Tax Code was given some teeth. It says that passive investors cannot take these standard deductions if they exceed the income a property generates. They are not lost; they just get deferred to when the property is sold.

But what constitutes a passive investor? The answer is easier to explain in the reverse (i.e., who is an active investor?) To be considered an active investor under provisions of Section 469, your client must: (1) be a “real estate professional” and (2) “materially participate” in the real estate operation. If your client meets both standards, then he may pass into the land of tax-reducing bliss. But wait.

The definition of “real estate professional” is not what it seems. Under the IRC, real estate professionals are individuals who spend more than 750 hours annually working on real estate, and devote more than 50 percent of working hours to real estate tasks rather than their day jobs.

Assume your client meets the first standard. Now, he must meet the second. An IRS auditor will likely say that to qualify as a material participator, an investor must spend at least 500 hours working on each of his properties. This statement is not exactly true. Let’s assume you made an election pursuant to Section 469(c)(7) on a tax return, allowing properties to be lumped together to determine material participation. Your client can show that time spent collectively on properties totals 500 hours. This avoids having to show 500 hours on individual properties. The election, once made, continues indefinitely until you revoke it.

In addition to the IRS, the Treasury Department also provides guidelines to interpret the Tax Code. Specifically, regulations under Section 1.469-5T provide seven safe harbor tests to qualify for material participation, some of which are easier to pass than others. For example, under one test, clients can qualify if they spend more than 100 hours (per property, unless you made the election discussed above), and nobody else spends more time working on their property than them.

To combat these easier tests, the IRS sometimes rules that laborers working for investors count against the hours needed for material participation. For example if your client calls a contractor to fix a leaky roof, IRS auditors sometimes believe (erroneously in my professional opinion) that the roofer’s hours constitute hours worked by “others.” I think the IRS is flat out wrong on this one, but no court has ruled on it.

It probably is a non-issue for most investors anyway. How many are going to spend less time on real estate-related activities than plumbers and gardeners? Under usual circumstances, there aren’t too many.

The reason I believe so strongly that the IRS will be proven wrong is the purpose behind Section 469. Congress wanted to limit deductions for people who collect net rental income without doing much work, and for investors in real estate syndications or investment groups.

If you have clients doing all the work on their holdings, these “investors” are not who the statute was designed to target.

Now here comes the trickiest part of all. How does your client prove how much time they’ve spent working on their property? They are not lawyers or CPAs, so they don’t keep minute-by-minute accounts of their time. Unfortunately, the IRS takes the position that if investors don’t have objective proof of their working hours; they can’t count them. What does the IRS consider objective proof? A contemporaneously created log that provides minute-by-minute details of time spent on individual activities. Is this required under the Tax Code? No. Is the IRS insisting upon it to give credit for the time spent? Yes.

From my perspective, this is hogwash. But it is also reality. If a case goes before the U.S. Tax Court, your client can provide minute-by-minute details of their material participation. Most clients, however, would rather not litigate because it’s expensive. But if an auditor is insisting upon a log that was not legally required to be kept, litigation may be the only option.

If your client goes to Tax Court, the judge will assess the credibility of your client and other witnesses. An electrician can testify that your client contacted him to do work, not some management company. Although clients are loath to bring other people into litigation, it is necessary to prove objectivity. And from a practical standpoint, who will the IRS call as a witness to refute testimony from your client and witnesses? Unless your client has a bitter ex-partner, the answer is nobody. Nor will the IRS get your client to crack under vigorous cross-examination.

It should be noted that Tax Court judges do not appreciate mere “guesstimates” of hours worked. So if your client testifies that he spent 10 hours changing light bulbs, he had better have objective proof or a photographic memory. For example, he knows to a reasonable certainty that he can change 10 light bulbs in an hour. And has the receipts for 100 light bulbs.

Philip Garrett Panitz is a national tax litigator and a certified tax specialist with the California law firm of Panitz & Kossoff, LLP (pgp@pktaxlaw.com or 877-Fed-TAXS).

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