Keeping Down with the Joneses

Is our general inability to delay gratification part of a larger societal issue, or are real estate investors just naturally impatient? Either way, nothing seems to get a rental property owner hopping mad faster than having suspended passive losses. 

• Never mind that the only exception in the tax code allowing passive losses to be deducted against other forms of income was made for real estate investors. 
• Never mind that the only thing preventing you from being able to deduct up to $25,000 of passive income is having a high income. 
• Never mind that suspended passive losses are merely delayed, not forfeited. 

When a real estate investor has passive real estate losses, they want to be able to take them in the year they occurred. We don’t like to wait.

What’s that you say? Real estate professionals can deduct all their losses without any pesky limitations? That's sweet music to many real estate investors' ears. It gets their thoughts rolling...

I work very hard on my real estate investments. Surely that makes me a real estate professional. 

This convenient rationalization leads many real estate investors to do what Alvin Jones did. Alvin had passive losses on his real estate properties greater than $25,000, so Alvin claimed he was a real estate professional. That way he could take all the losses in the years they occurred. The IRS didn’t agree with Alvin’s assessment of the situation. They made a ‘redetermination’ of Alvin’s taxes and sent him a tax bill. (A redetermination is when the IRS changes your tax return and tells you what they think you really owed in taxes for the year.) Alvin didn’t much care for the IRS’s redetermination, and petitioned the tax court for relief from his new tax bill.

(Picture provided in case you thought the tax court was full of tax geeks, and were unaware it is actually a powerful symbol of American justice and freedom.)

Just the Facts.

• In 2011 and 2012 Alvin owned and operated an insurance business.
• In 2011 Alvin (and his wife) also owned and operated 12 rental properties. In 2012 they owned and operated 11 rental properties.
• In 2011 Alvin deducted $32,790 in passive losses from his real estate business. In 2012 he deducted $54,959 in losses. Both years he claimed to be a real estate professional.
• In 2011 Alvin claimed to have worked 520 hours in his insurance business and 951 hours on his real estate business. In 2012 Alvin claimed to have worked 173 hours in his insurance business and 1,040 hours on his real estate business.
• The IRS determined Alvin was not a real estate professional and limited his passive losses in accordance with Internal Revenue Code Section 469.
• The IRS (re)determined The Joneses owed additional tax of $4,636 for 2011 and $16,457 for 2012.
• Alvin disagreed and took the IRS to tax court.

Was Alvin a Real Estate Pro?

The issue at hand is whether Alvin met the standard in the Internal Revenue Code to qualify as a real estate professional. It is a 2-part test:

• Alvin must have worked at least 750 hours each year on his real estate business.
• Alvin must have worked more on his real estate business than he worked in another trade or profession.

Alvin claims to have met both tests, and the numbers he provided seem to back that up. The IRS disagreed. The IRS did not believe Alvin worked as much in real estate as he claimed or as little in his insurance business as he claimed. The IRS pointed out that Alvin claimed driving mileage for his insurance business of 17,742 miles in 2011 and 19,777 miles in 2012. This time spent driving was clearly not reflected in Alvin’s statement of the amount of time he spent working for his insurance business.

When the IRS makes a redetermination of a taxpayer’s tax liability they are generally presumed to be correct. That’s a big deal. This presumption places the burden of proof on the tax payer to prove the IRS erred when it made the redetermination. Let me rephrase that so it sinks in: the IRS does not have to prove the numbers Alvin provided for the time he worked on his businesses are wrong. Alvin has to prove they are right.

Alvin lacked sufficient records to show the actual hours he worked in his insurance business in 2011 or 2012. Without these records Alvin was unable to conclusively establish how many hours he worked in his insurance business.

Because Alvin couldn’t prove how many hours he worked in his insurance business it was impossible for the court to know if his real estate work exceeded his insurance work. Unable to prove to the court he qualified as a real estate professional, the tax redetermination by the IRS was upheld. Alvin’s excess passive losses were disallowed, and he owed tax of $4,636 for 2011 and $16,457 for 2012.

$21,093. That’s a painful way to find out you haven’t been keeping sufficient records.

How many of us keep great records? Records so airtight we could prove in Tax Court how many hours we spent on real estate. Or how many miles we spent on the road. Or the business-related purpose of every dinner we write off as an expense. I'd venture a guess that not many of us would fare well during an audit.

We call ourselves real estate investors, but we frequently forget that thing we’re investing in is a real estate business. Businesses require paperwork. The reason why is no great mystery - the starting point in the tax code is that you pay taxes on every nickel you earn from any source. Deductions, exemptions, exclusions, adjustments, and credits are not a constitutionally-protected right. They are exceptions to the rule provided through legislative grace. If you want to claim a deduction, exemption, exclusion, adjustment, or credit then you must be able to substantiate it.

I don’t like it. You don’t have to like it. But if we want our tax breaks we have to do it.

If you nerd out and read tax court decisions you will find quite a few of them pertain to tax payers having deductions disallowed because they lack sufficient documentation to support the deduction. Tax professionals are constantly reminding their clients (and anyone else who will listen) to keep good records. We aren’t just nagging for the sake of nagging. Alvin Jones got handed 21,093 reasons to improve his record keeping. Learn from other people’s mistakes. Life is too short to make them all yourself.