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Building Success: An EisnerAmper Real Estate Blog

The Advantages and Hurdles of Being a Real Estate Professional

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August 14, 2014

By Mariana Moghadam, CPA  

Moghadam, MarianaOver the past year, qualifying as a real estate professional has become more important, and even more difficult than it ever was in the past. Since 1994, the issue has been significant, mainly to those taxpayers (including many of our clients) who have rental real estate losses that they want to offset against their earned or active or investment income.

However, beginning in 2013, being treated as a qualified real estate professional has also become critical for those individuals with rental real estate gains. After all, if the income from rental real estate (including any gains from the sale of property) is considered non-passive under IRC sec. 469, then that income is not going to be subject to the new 3.8% tax on net investment income.

Background

Since 1986, most rental activities are “per se” considered passive. Because this imposes a hardship on real estate professionals, an exception to the rule was carved out for those real estate professionals who meet the criteria of IRC sec. 469(c)(7):

  • More than one-half of the taxpayer’s personal services are performed in real property trades or businesses in which he or she materially participates; AND
  • The taxpayer works more than 750 hours in real property trades or businesses in which he or she materially participates.

In other words, the rental real estate activities will continue to be treated as passive gains and losses, unless the taxpayer materially participates in each of those rental real estate activities.

The Gragg Case

A recent court decision in California, involving husband-and-wife taxpayers, Charles and Delores Gragg, illustrates some of the hurdles in receiving the tax status of qualified real estate professionals [Gragg v. U.S., 113 AFTR 2d 2014-XXXX (N.D. Cal.)].

The Graggs owned two real estate rental properties that incurred losses in 2006 and 2007. In jointly-filed returns, the Graggs deducted those losses from their otherwise taxable income. After all, Mrs. Gragg’s full-time occupation as a real estate professional should have entitled the couple to offset their earned income with losses from rental real estate activities.

The IRS did not dispute the fact that Mrs. Gragg was a qualified real estate professional in both 2006 and 2007. However, the Service disallowed the losses based on the fact that Mrs. Gragg did not materially participate in the particular rental activities that generated those rental losses. As a result, the District Court for the Northern District of California agreed with the IRS, concluding that Mrs. Gragg’s work as a real estate agent and her ownership of rental real estate were separate and distinct activities that cannot be considered together.The Hurdles

It is not surprising that the IRS audited the Graggs’ returns. In recent years, the Service has a track record of examining the returns of would-be qualified real estate professionals.

In this case (like so many others), Mrs. Gragg provided the court with her estimates of the amount of time she spent on the couples’ rental activities. Since the hours she spent on the rental activities were “overall” estimates rather than contemporaneous time logs and calendars, the court agreed with the IRS that Mrs. Gragg’s estimates were not a “reasonable means” of documenting her material participation in the rental activities.

Adding Insult to Injury

Even if Mrs. Gragg’s participation in the rental activities had exceeded 750 hours in a year, the Graggs would have been required to make a “grouping” election under IRC sec. 469(c)(7)(A)(ii) to treat the two separate real estate rental properties as one “activity.” As a result, the court held that the two rental properties should be treated as separate activities for tax purposes.

The Bottom Line

With situations like the Graggs, it has become commonplace for the IRS to disallow the deduction of real estate rental losses. Court decisions in the past several years have upheld the Service’s insistence on contemporaneous substantiation to prove material participation in real estate rental activities.

As a result, those taxpayers who are considering treating their rental losses (or, in 2013 and forward, their rental gains) as non-passive should be certain they have appropriate records and, if necessary, have made a grouping election. As always, it makes sense to discuss these situations with your tax advisor prior to filing any tax return involving real estate rental activities.

Upcoming EisnerAmper Real Estate Private Equity Summit Featured in Real Estate Weekly

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The second annual EisnerAmper Real Estate Private Equity Summit will take place on October 1st in New York. Organizers expect more than 500 real estate investors, owners, and industry leaders to come together once again at the McGraw-Hill Conference Center to hear from real estate and private equity speakers, including Keynote Sam Zell, chairman of Equity Group Investments. Real Estate Weekly just covered the all-day event on their website. Find out more about our event here.

The (Potential) Rebirth of Bonus Depreciation

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Dmitriy Gelfand By Dmitriy Gelfand, CPA and Jonathan Sparacio, CPA

First enacted in the aftermath of 9/11, the federal bonus first-year depreciation allowance (“bonus depreciation”) has provided an incentive for businesses to accelerate their purchases. However, the provision expired, once again, as of December 31, 2013. As a result, significant tax benefits from prior years may not be available to companies for expensing the cost of this year’s business equipment purchases and leasehold improvements.

Of course, over the past dozen years, bonus depreciation has died – and been resurrected by Congress – several times, but has never been made permanent. The good news: The outlook seems outstanding that some form of bonus depreciation is likely to be extended retroactively for 2014 (and, probably, for 2015). The bad news: Despite bipartisan support from the tax-writing committees in both houses of Congress, it appears that bonus depreciation may not officially be brought back into the tax code until after the November 2014 mid-term elections.

On one hand, the House Ways and Means Committee recently approved legislation (H.R. 4718) that would make bonus depreciation a permanent part of the tax code. Specifically, the House bill would allow businesses to immediately deduct one-half of their new qualified business equipment purchases. In addition, it would enable companies to elect accelerated alternative minimum tax (AMT) credits in lieu of bonus depreciation, and it would expand the types of retail improvements that are eligible for bonus depreciation.

On the other hand, the Senate Finance Committee favors legislation (S. 2260) that would extend the existing 50% bonus depreciation only until December 31, 2015. This action, under the proposed Expiring Provisions Improvement Reform and Efficiency (EXPIRE) Act, would extend 51 of the temporary tax provisions for a two-year period.

Before any legislation is enacted, the House of Representatives and the Senate will need to agree on a final bill that reconciles both proposals and that provides revenue “offsets” for its costs. However, leaders of both political parties, in both houses of Congress, seem to agree that it is essential to provide an incentive – such as bonus depreciation – to encourage immediate capital investments by U.S. companies.

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