@Stephen Sawrie
I know, and I'm about to share, a LOT about this and how it is good for you. I have more than a dozen years of experience with real estate professionals under Internal Revenue Code section 469. I spent time working at the Internal Revenue Service first as a tax examiner, then in the Criminal Investigation Division, where I learned to read and understand the tax code. Also, I am a CPA whose firm prepares hundreds of tax returns for real estate investors annually including real estate professionals. I myself am the investor/owner/operator along with my wife of residential and commercial properties in NJ and until recently, Texas, two. Anyway, here is where the benefits of being a real estate professional outweigh the risks and the labor involved:.
Before I give an example of where these rules really help, I wanted to review the rules of what you stated. You are correct in that you must work more than 750 hours a year, which is about 15 hours a week, but in addition you must spend more than 50% of your time performing real estate. For example, I had a client who worked 20 hours a week loading and unloading trucks at FedEx, and she managed eight properties full-time. She got audited, and we used her log to document that she spent more than 1092 hours a year, which is 21 hours a week for 52 weeks to year. I instructed her, like all clients in this category, to book the entire years worth of time, which ended up being closer to about 1600 hrs. She did it, but she wasn't happy about all the work until she learned why: the auditor studied the log and began to challenge some of the line items, and began to hack away at the hours to try to get it below 750. The auditor failed. She identified about 160 hours that she wanted to disqualify, but we were so way over 750. I could've spent hours arguing that they were all bona fide, but rather than run the bill up, I said, "okay, go ahead." When the auditor did that, my client was still well over the amount required.
So here is an example of where the code section 469 regulations work to the taxpayers advantage: my client, "Tom" is a full-time real estate investor. By taking advantage of the loopholes that I taught him about cost segregation and component appreciation, every year his 30 or so rental properties generate a $48,000 loss. Because he is a full-time real estate investor, is not passive, this is how he feeds his family, so the risk of gain or loss is recognized in the current year. Yes, I enter a$48,000 loss for him and I'm comfortable with it. Why? I'm glad you asked. Here's why:
There is about $60,000 of depreciation in that $40,000 loss. Remember, depreciation is a paper expense – you don't really write a check for it. So as an IRS auditor, I wonder where the money comes from to pay the bills (follow the cash, follow the cash, follow the cash). If you take that $48,000 loss, and add back to $60,000, you are at positive $12,000, or $1000 per month. It passes the smell test with flying colors.
This is just background, though. Here's the payoff. Tom slips two houses a year and makes 70 or $80,000 of taxable gain. When you take that $80,000 of gain, and offset it with the $48,000 of deductible rental losses, it leaves him with $22,000 of taxable income. His itemized deductions and his dependency exemptions for his wife and daughter and up zeroing out his tax liability completely.
Think about that for a minute: this guy makes $80,000 of cash profit for two flips and pays no income tax on it whatsoever. Not a bad lifestyle!
What if he gets audited? I know he's a target, so I showed him how to keep an investors log to document his time spent, and he books his time, day by day, property by property, 15 min. by 15 min. I suggested he buys some tax deductible speech recognition software, and as he makes his notes thru the course of the day, he later dictates them into a gigantic word document, when he gets home and at the end of the year he sends it to me along with his tax information that he e-mails up. He lives in Florida, and I am located in southern New Jersey.
And, for the record, to further tighten down the documentation and decrease his risk of negative audit outcomes, he uses a list that I provided him of 64 things that are personal property upon which we celebrate the depreciation. Each one of these things is fully substantiated by a private letter ruling, a revenue ruling, regulation section, or a court case.
Is it a lot of work for him? He hates recordkeeping, but keeps his log religiously because he knows it will save income tax on $70-80,000 every year. This will be his 11th year of filing like this with me, and there's been no audits by the IRS by correspondence or by personal visit. being prepared ahead of time? It's just one of the things that I hammer away with all the time, not just in real estate or tax planning but in all phases of my life: the 5P's of the Marines teach us "prior planning prevents poor performance"
I have other clients who are real estate professionals, and the more properties you have, the bigger the loss you can legitimately generate.Hope that helps.
Jim Kennedy
