Fun With Passive Activity Rules
Some of you may know, rental properties are passive in nature, unless you are a real estate professional. The rule is you must spend 750 hours on the rental properties to be considered a real estate professional.
Now, with rentals you get a $25,000 deduction, regardless of the passive nature of the activity, unless your adjusted gross income (AGI) is too high. If that occurs, the suspended passive losses will be suspended until the rental is sold.
I have a client that is a doctor. She works four days a week and has two young children. On her days off she spends time with her kids. However those four days a week that she works are 12-hour days.
She has three rental properties that she manages herself, and before her daughter was born she did some side work with another S-Corporation. The question I had for myself was which of these side jobs are passive?
I’ll give this to you: 15 hours a week, which is 750 hours a year, isn’t a stretch. The client didn’t have a property management company. So when the renters had an issue, they called her. However, proving this is another thing.
The US Tax Court states that you need contemporaneous records to prove your involvement in the passive activity. Contemporaneous is a legal term, meaning continuously. So, to prove that you spent 750 hours on a real estate activity, you would literally have to write down all of the calls from tenants that you received, the time it took you to arrange the repairs, and the trips that you took to the rental property.
I understand why the US Tax Court wants these records, but let’s be honest here. Who literally keeps records like this? I’m a tax accountant and I don’t.
As I was working this out, I had an idea. My client may work four days a week, but that is 48 hours a week. She has two small children at home.
Before she got hired at this hospital, she had an S-Corporation, where she took different jobs at different hospitals. This lasted three months. She didn’t spend more than 500 hours (the bar is set lower for non-real estate) doing work. I then made the income from that business passive, and it was lowered by the passive losses from real estate.
What I figure and has been proven to me in audit and appeals, the IRS will accept that you have one full-time job. Proving an activity is passive, is far easier than proving that it isn’t.
Another client of mine owns a business, for which he spends countless hours working. At tax-time, he gave me a K-1 from a Partnership, stating that he was an active partner, and his income was subject to self-employment tax. I asked him about it, and explained the rules, along with the fact that he would have to pay 15.3% taxes, when he had a net operating loss (NOL) carrying forward. I asked him to have his K-1 changed to a limited partner.
A few years ago, one of the IRS’s Dirty Dozen was people starting fictitious home businesses and writing them off. This write off would reduce their taxable income. At any point, did the IRS question if the taxpayer materially or actively participated in the business? That would of put a stop to it.
I do not, in anyway, ask you (the reader) to play with the passive activity rules. I know too much about them because I have had to defend them in audit and appeals and learned a lot about them.
What I have learned is this: the IRS will buy that you have a full-time job. All of these side businesses should be considered passive. The horrible thing, less real estate, is that passive losses can only be taken against passive income.
The odds of most Americans having either is slim and none. For whatever reason, I’ve dealt with them over and over again.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...