It would appear the IRS has read Sun Tzu’s “The Art of War” and is applying his strategy of “avoiding what is strong to strike at what is weak.” Albeit compared to four years ago the real estate market is weak even if it is beginning to show signs of stability. So who better than to attack then embattled real estate investors who have seen their fortunes and cash flow shrink dramatically? The first assault began with the Health Care Reform Act and its requirement that real estate investors 1099 any person who is paid more than $600 during the year for service on their property. Now we find the Treasury General issuing a report encouraging the IRS to perform more audits of individual tax returns that report losses from rental real estate activity. The report can be found here. Want more articles like this? Create an account today to get BiggerPocket's best blog articles delivered to your inbox Sign up for free According to the recent report, at least 53% of real estate investors misreported their activity in 2001 resulting in $12.4 billion in misreported income. Why all the attention? Taxes. The government needs money and who better to extract a pound of flesh from than cash strapped investors. Unfortunately this comes as no surprise given the recent tax court decision that found a real estate investor didn’t qualify as a real estate professional despite over 1000 hours of real estate activities. As many of you already know a real estate investor can qualify as a real estate professional, i.e., material participation, if he spends more than 50% of his time in a real estate activity and more than 750 hours of service in such activity. Basically you do not have another full time job outside of your investing and your spend 750 documented hours on real estate activities. One key factor in meeting this test is to treat all of your real estate activities as one by making an aggregation election on your individual tax return. If such an election is made then you may group all of your activities together in order to satisfy the 750-hour test. Lest you make this election the IRS will apply the 750-hour test on a per property basis. The benefit of real estate professional status is the ability to deduct all of your real estate losses regardless of income. (You are not subject to the Passive Activity Loss Rules.) Unfortunately the rules are not what they appear when you have an aggressive IRS and a sympathetic court. Consider the recent decision of Bailey v. CIR. In this case Pamela Bailey operated a number of rental properties that she owned jointly with her husband, Todd, an emergency room physician. She wasn’t engaged in any other activity besides running the rental properties. For 2004, Pamela spent a total of 1,003 hours on the properties. 324 of those hours were spent running a property called “the Inn” that was offered on a short-term rental basis to overnight lodgers, usually for about three days at a time. The Baileys incurred losses on their real estate properties and this loss offset Mr. Bailey’s income. The IRS successfully argued that Pamela’s 324 hours spent on the Inn should be counted for purposes of the 750-hour real estate professional test. In a perverse ruling the court accepted the IRS’s position based not on the Internal Revenue Code but on its regulations to find that the short-term rental use of the Inn did not count toward the 750-hour requirement. Thus, Pamela’s hours of participation dropped to 679 which is short of her 750-hour requirement. Lessons to be learned from this case and recent governmental activity – if you are down and seen as an easy target the IRS will take a bite. Your best defense is to adequately document all of your real estate activities, however minor, and make the proper aggregation election on your tax return.