Real Estate Professional Status: The IRS Has Read Sun Tzu


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.

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. 

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  1. Whenever I’ve written on this subject, many comments wonder if my stance is far too conservative. Hardly, since the stakes are high on both sides of all coins involved. Seems the IRS agrees. You’ve no doubt save lots a folks much grief, anxiety, and money. Frankly, either BE a professional investor, or shy away from being a pretender. The IRS doesn’t play well with others.

    • More than 1000 hours per month makes one the real deal, not a pretender (your comment is offensive). The Baileys seem to have been trying to play by the rules. They clearly are REAL real estate investors, whether judging by portfolio size or time spent. I’ve known plenty of Realtors and property managers who worked less than that amount. The IRS chooses to pick on people, and generally, they have the resources to succeed (right or wrong). Real estate professionals like Mrs. Bailey are working to stimulate the economy. Her and her husband work & produce, and our government would rather give to those who don’t work & don’t produce.

  2. Dave Toelkes on


    As far as I am aware, us rental property owners have always had to issue 1099s to any individual or partnership that was paid $600 or more during the year for services related to our rental property activity. This requirement was in play long before the Health Care Reform Act. It would appear that the Health Care Reform Act has added the requirement to 1099 corporations, whereas it was only individuals and partnerships before. Under the new rules beginning in 2011, I will have to issue 1099s to each of my corporate property managers for the property management fees I pay throughout the year. If the Republicans are able to repeal any portion of the Health Care Reform Act, I hope it is this requirement.

    I welcome the increased scrutiny the IRS is giving to those claiming Real Estate Professional status. I believe many improperly claim the status, perhaps some even know they don’t really qualify.

  3. I have to agree with Clint, I think. The 1099 thing is pretty straight-forward, and increased scrutiny can either result in greater education/awareness on the part of investors, or greater awareness on the IRS’s part of what investors are really up against.

  4. Maybe some of the real estate investor misses some issue regarding the taxes. Just like the government, it need those taxes, and investors should start taking advantages with their investment.

  5. “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.”

    Why did you find the ruling perverse? take a look at these:—-Chapter-2,-Rental-Losses-

    • stan pace

      It was absolutely a “perverse ruling”. When looking at one snippet of the rules, it appears it would not be counted toward the hours, however look closer. A person does not even have to own real estate to meet the 2 quantitative requirements. Of course there would be no value, however it is still not necessary. Reg 1-469-4 allows that aggregation of different activities in separate groupings. Even though the hours were non rentals, they could have been grouped into a single unit of “management and operation of real-estate”, which are activities of real estate trade or business. As long as she met material participation in the activity, they hours would count. That reg is known as “slice and dice”.

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