All Forum Posts by: Jason Watson

Steven is correct.. unfortunately. 27.5 years for a $600 item is crazy. Some have argued that a water heater is simply a component of a plumbing system, and therefore could be considered a repair. Nope. US Master Depreciation Guide includes this, pre-heaters and softeners as structural.

Other taxpayers have found a friendly plumber who simply invoices him or her for plumbing repairs. This is not our tax advice of course, but we have seen it.

Thanks,
Jason

Classification of improvements versus expenses is dictated by Pub 527. Here is a snippet from our FAQ-

One sticky area is repairs versus improvements. Repairs are expensed and deducted in the current tax year, whereas improvements are capitalized and depreciated over time. Most rental property owners want to expense as much as they can to gain the immediate tax benefit. In Publication 527 the IRS defines improvements as something that “adds to the value of property, prolongs its useful life, or adapts it to new uses.” Some examples from the publication include wall to wall carpet, new roof, additions, kitchen updates, etc.

There is one caveat that you should be aware of- in the same list of examples, the IRS is quick to point out that work you do or have done to your rental property that does not add much to either the value or the life of the property, but rather keeps the property in good condition is considered a repair and not an improvement. A common example is paint, even if you completely paint the interior and exterior.

HOA dues can also be problematic since some HOAs cover the costs of roofs and other items that are typically depreciated and not expensed. This is especially true for condominiums or cooperatives. Having said that, as tax pros we usually deduct 100% of all HOA dues unless there is a strong distinction of the funds.

Having said that, improvements should not reflect poorly on your cash flow or your ability to have a reasonable expense to income ratios.

I would find a new lender. We deal with lenders all the time for our clients, and lenders run the gamut of intelligence as they relate to rentals.

Thanks,
Jason

Be careful. In Tax Court Summary 2012-94 (Wallach), the court denied these expenses on two fronts. First, the taxpayer did not do a good job on recordkeeping (imagine that). Second, these expenses were considered "investment" expenses subject to the 2% AGI rule, and not rental activities.

Read an expanded KnowledgeBase article detailing this and several other real estate professional court cases at-

http://www.watsoncpagroup.com/kb/What-are-some-of-the-tax-court-cases-for-real-estate-professionals_163.html

Thanks,
Jason

Hey Jon.. Steven is right. The IRS is making this one of their hot topics. People have been gaming the system so to speak, and while many investors are truly real estate professionals many are simply checking the box to squeak that passive loss through.

Another area are s-corps. It is very easy to see if an owner (shareholder) is not taking a W-2 salary. And while the IRS wants income taxes, they want employment taxes (SS, Medicare) much more.

Thanks,
Jason

Along with Material Participation as a Real Estate Professional, you might also want to consider grouping your activities together. So a common question that I get is-

Do I need to group my rental activities together?

Yes. Otherwise you will need to prove 750-hour rule for real estate professional for each property, including the proof of material participation in each property. That’s tough. The election is simply a statement that is attached to your tax return. And under Revenue Procedure 2010-13, you can make the election retroactively (typically requires amending a tax return just for the election).

Disallowed losses prior to grouping your rental activities together are suspended if you also claim the real estate professional designation with material participation. Unbundling is required during a sale of a property to deduct the disallowed and suspended losses.

Grouping also helps taxpayers obtain the 10% interest requirement in the activity for active participation.

Lastly, with the new Medicare surcharges being attached to passive incomes, grouping your activities into one activity while materially participating as a real estate professional allows you to minmize the tax consequences.

Are there downsides to the real estate professional designation?

Yes. But the downsides are obscure.

If you have other passive income you might want to keep your rental losses passive to offset this income. For example, you are an investor in an investment partnership that loses money and you have rental properties which make good money. If you consider yourself a real estate professional for your rentals, that income is no longer passive and will now be considered earned income. Your tax deduction from your investment partnership losses will be limited according to passive loss limits when deducted against earned income.

Typically most real estate professionals group their rentals together to eliminate the hourly requirement per property. However, if you had disallowed losses in prior years, you need to unbundle your grouping if you want to deduct those losses in the year of sale or disposal. This is a minor issue, and it requires a bit of mental gymnastics, but it should not dissuade you from electing real estate professional status and grouping your rentals.

Happy Investing!

Thanks,
Jason

What activities count and don’t count?

In general, any work you do in connection with an activity in which you own an interest is treated as participation in the activity. Some of the activities that count towards your hourly requirements include collecting rent, bookkeeping, advertising, maintaining legal compliance, safety reviews, inspections, decorating, tenant approval, contractor supervision, procuring insurance, paying taxes, and actual hands-on maintenance.

There are some activities that do not count.

Travel: While you can deduct mileage and expenses for your travels to and from your rentals, the time spent traveling is considering commuting and therefore does not count towards your hourly thresholds. However, there is an IRS position asserted in Tax Court Memo 2012-83 (Trzeciak) allowing you to count the time spent traveling if you are also claiming a home office that is used regularly and exclusively for your real estate activities.

There is also some case law saying No. In Tax Court Summary 2003-130 (Truskowsky) unless a taxpayer can prove day-to-day managerial involvement, then travel time is considered commuting, which is personal in nature, and therefore does not qualify. This is a fairly grey area and more discussion is required.

If you did not claim a home office, you should assert that position on your tax returns right away. Home office suggests regular and exclusive use, and coupled with proof and day-to-day participation, travel time can be successfully argued.

Research: A lot of investors claiming real estate professional status attempt to fill in the holes of their hourly requirements and day-to-day involvement by suggesting research into other investment properties. While this sounds legitimate, the IRS and Tax Court has denied this position as investor activities and not real estate activities. Find something else to put on your time sheet- cut some grass, hunt and peck your QuickBooks entries, but don’t log Zillow hours.

Investor: You do not treat the work you do in your capacity as an investor in an activity as participation unless you are directly involved in the day-to-day management or operations of the activity. Work you do as an investor includes:

- Studying and reviewing financial statements or reports on operations of the activity,

- Preparing or compiling summaries or analyses of the finances or operations of the activity for your own use, and

- Monitoring the finances or operations of the activity in a non- managerial capacity.

Note that these activities are acceptable as long as you can demonstrate a day-to-day involvement with the activity. This is critical since it is presumptuous of the IRS to consider rental activities not requiring day-to-day involvement.

Spouse Participation: Remember, your material participation in an activity includes your spouse's material participation. This applies even if your spouse did not own any interest in the activity and you and your spouse do not file a joint return for the year. Note the word material- you will need to demonstrate that your spouse’s time was material to the rental activity or operation.

There are several other horror stories, if you will, about investors and real estate professionals being denied time spent on various activities that seem real estate related. Some of those stories appear to hinge on the auditor, how they interact with the auditor, and simply bad information.

Thanks, Jason Watson

What are the general tests for material participation? This question comes up all the time. As tax professionals, we want to get the word out for those considering a real estate professional designation.

Ok. Here we go. This is where the IRS is starting to crack down on what they deem gaming the system by self-determined real estate professionals.

There are several requirements for material participation, and satisfaction of any one test will allow you to be considered materially participating. We’ll discuss each one in turn, and refer to notes from the IRS Audit Techniques Guide (ATG) for each test including case law when applicable.

1. You participated in the activity for more than 500 hours.

ATG Notes: If the taxpayer participates more than 500 hours during the year in a business, income or loss from the activity will be non-passive. Participation of both spouses is counted, but not participation of the children or employees. Participation in operations must be regular, continuous, and substantial. The examiner should determine whether the quantity of time documented is reasonable in light of other obligations.

ATG Notes Specific to Real Estate Pros: Rental activities, by nature, normally do not require significant day-to-day involvement, i.e. they are not time intensive. For many taxpayers using any kind of outside management, the only material participation test available is the 500 hour test- the other tests will not apply. In many circumstances, an individual rental activity will not require 500 hours of participation, nor will the taxpayer have sufficient time available to spend 500 hours on each individual rental real estate activity.

Examination Techniques: Review W-2s and other non-passive activities. Does it seem likely that the taxpayer could spend 500 hours on the activity in light of other employment obligations? Ask questions on taxpayer material participation activity time early in the examination. Establish time the taxpayer spends on all activities during the initial interview if possible. Determine the location of each activity. If located far from the taxpayer’s residence, how likely is the taxpayer to have spent substantial time on the activity?

Tax Court: Despite the IRS’s ATG notes, the Court in Tax Court Memo 1998-17 (Pohoksi) implied that they would entertain proof that the taxpayer substantially participated as compared to the participation of a property management company. This is a satisfaction of test #2.

2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.

ATG Notes: Stated simply, if the taxpayer does most of the work, income or loss will be non-passive. The involvement in the activity of an employee or non-owner could cause the taxpayer to fail this test. There is no specific number of hours associated with this test. In addition, the term “substantially” is not defined in the regulations.

Tax Court: Noted that the taxpayer did not introduce evidence of the hours spent by a property management company. The Court implied that they would entertain proof that the taxpayer substantially participated as compared to the participation of a third party (in this case a management company). Tax Court Memo 1998-17 (Pohoski) stated the second test was not satisfied when taxpayers failed “to put forth some indication of the actual time spent by” third-party non-owners in activities on the property.

3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.

ATG Notes: If a taxpayer participates in an activity for more than 100 hours and no other individual participates more than the taxpayer (including any employee or non-owner), income or losses from the activity are non-passive.

Examination Techniques: Be alert to employees who are managing the activity, indicating the taxpayer deducting the losses may not be materially participating (particularly on Form 1040 Schedules C and F). When reviewing taxpayer hours, watch for “investor” activities (Income Tax Regs Section 1.469-5T(f)(2)(ii)). The taxpayer must be involved in the activity’s day-to-day management or operations. Hours spent toward reviewing financial statements, preparing analysis for personal use, and monitoring the activity in a non-managerial capacity do not count.

4. The activity is a significant participation activity (SPA), and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test.

ATG Notes: The term significant participation activity is unique to Income Tax Regs Section 1.469-5T. If the sum of the taxpayer’s time in all SPAs is more than 500 hours for the year, then income or losses from the businesses are non-passive. For each SPA, the regulations require: The taxpayer to participate more than 100 hours during the year. The activity must be a business, i.e. it cannot be a rental or investment activity. The business must be a passive activity. Thus, if the taxpayer works more than 500 hours in the business, it is not a SPA as 500 hours is one of the qualifying tests for material participation. Similarly, if the taxpayer does most of the work in the business, it cannot be a SPA as Income Tax Regs Section 1.469-5T(a)(2) holds that performing substantially all the work qualifies for material participation.

5. You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.

ATG Notes: An activity is non-passive if the taxpayer would have been treated as materially participating in any 5 of the previous 10 years (whether or not consecutive). This test usually applies when a taxpayer “retires from material participation” but maintains an ownership interest in the activity.

Examination Techniques: Even if the taxpayer performs no services for a business currently, the examiner should inquire about involvement in prior years and review the returns to see if income or losses were treated as non-passive.

6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.

ATG Notes: None.

Examination Techniques: None.

Tax Court: As far as we can tell, this test has not been used in tax court involving real estate professionals and rental properties.

Some real estate investors and tax strategists have argued that operating rental properties is a personal service. We disagree. The personal services listed in this test are traditional service professions where you would have clients. Of course an argument could be made that tenants are clients, but the one hiccup is the rental property itself. The personal service would not exist if it wasn’t for the building, therefore capital is a material income-producing factor (income comes from rents, rents come from tenants, tenants live in buildings, buildings require capital for acquisition).

7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

ATG Notes: The facts and circumstances test may apply if none of the other tests are met. This test does not apply unless the taxpayer worked more than 100 hours a year. Furthermore, the taxpayer’s time spent managing will not count if: Any person received compensation for managing the activity and any person spent more hours than the taxpayer managing the activity.

Examination Techniques: Taxpayers may argue the facts and circumstances test when they fail the others. However, due to the stringent limitations, few taxpayers can meet the facts and circumstances standard. If there is paid on-site management, the facts and circumstances test cannot be used.

If you owned an activity as a limited partner, you generally are not treated as materially participating in the activity. However, you are treated as materially participating in the activity if you met test #1, #5 or #6 described above. You can also see Tax Court Summary 2012-91 (Chambers) for some real snoozer material.

Posted by Jason Watson, Watson CPA Group, 719-387-9800

Originally posted by Jason Watson

Rental depreciation first- an asset has a useful life, and while there are exceptions (Section 179, Bonus Depreciation) with computers, machinery, etc., the IRS requires an amortization schedule where only a portion of the asset's cost is deducted each year.

Section 179 depreciation is not allowed for a residential rental property.

I was giving a broad example of depreciation. I stated "asset" as a generic term.

Originally posted by Jason Watson

So, you could have a rental that breaks even from a cash perspective, yet offers a tax loss (and therefore a tax shelter) because of the depreciation. Calculating and deducting depreciation is not automatic- a taxpayer can choose to not depreciate their investment rental (more on that later), but it is generally a bad idea.

It is true that the depreciation expense is optional, BUT, the IRS always expects you to take it, and even penalizes you if you don't. Failing to take allowable depreciation is always a bad idea, IMHO.

Isn't that what I said? BTW, the IRS does not have expectations. They process. However, you might be thinking of the allowed versus allowable rule, and Yes, they assume you to have taken it when computing recapture gains.

Thanks,

Jason (Watson CPA Group)

http://www.irs.gov/publications/p523/ar02.html#en_US_2010_publink1000200747

No proration unless you have-

A change in place of employment.

Health.

Unforeseen circumstances.

Previous posts are correct.

How much are we talking about here? If it makes sense, "move back in", claim it as your primary residence, receive mail there, receive voter card there, register your cars there, get a license there, yet vacation in your second home until the primary home sells.

Thanks,

Jason

To be a tax shelter the investment has to lose money. When it comes to rentals, it is easy to lose money especially if the rental income does not cover the mortgage, you have several repair bills, among other things. These are cash losses; in other words, you are having to put money into the investment to keep it floating.

Another way for your investment to lose money is through non-cash expenses, such as depreciation and mileage. Rental depreciation first- an asset has a useful life, and while there are exceptions (Section 179, Bonus Depreciation) with computers, machinery, etc., the IRS requires an amortization schedule where only a portion of the asset’s cost is deducted each year. Generally speaking, a rental property is depreciated over 27.5 years, and only that portion attributed to the dwelling itself and not the land is depreciated. Separating the land from the overall asset value can be challenging, especially on townhomes and condos.

So, you could have a rental that breaks even from a cash perspective, yet offers a tax loss (and therefore a tax shelter) because of the depreciation. Calculating and deducting depreciation is not automatic- a taxpayer can choose to not depreciate their investment rental (more on that later), but it is generally a bad idea.

Mileage associated with your rental is another non-cash deduction since most vehicles operate for less than the standard mileage rate, but this is typically a small amount relative to everything else.

Thanks,

Watson CPA Group