How Not to Document Your Qualification for ‘Real Estate Professional’ Status on Your Federal Income Tax Return

In the market that has existed since the housing crash of the last decade, there are an increased number of people who are landlords of small numbers of rental properties. The Internal Revenue Code declares that only a fraction of these landlords can deduct their losses on their properties from their income taxes. One of the keys to qualifying for this deduction is ensuring that the documentation supporting these claims appear plausible and contemporaneously prepared. One taxpayer found this out the hard way when the US Tax Court rejected her appeal of an IRS determination of deficiency.

The case involved Sherry Hudzik, who held a full-time professional position with an insurance company, but also owned two rental properties. The taxpayer allegedly lost several thousand dollars on these rental properties in 2006-08. The problem she faced is that such losses are generally considered “passive activity” losses, which are not deductible from federal income taxes.

One way that such losses may be deductible is if the taxpayer qualifies as a “real estate professional.” Hudzik decided she qualified and took the deductions for the losses. The IRS ultimately disagreed with her conclusion and assessed a deficiency and accuracy-related penalties. The Tax Court largely agreed with the IRS. A key part of the reason the taxpayer’s claim failed was that the court found her evidence less than credible. The taxpayer’s time logs for her real estate work were not dated, so they contained no proof that the taxpayer contemporaneously prepared them, which is one requirement for such logs.

Also, and perhaps more damagingly, the taxpayer claimed that, each year, she spent more hours on her two rental properties than she did working at her full-time insurance position. The court declared the logs “implausible,” noting that, if they were correct, it would mean that Hudzik spent nearly every waking moment outside her insurance job working on her rental properties. In short, the logs failed to pass the “smell test.” The absence of any documents other than the implausible, undated logs also undercut the taxpayer’s position.

The court did offer a bit of good news to Hudzik, from which other rental property owners can learn. Even if an owner is not a real estate professional, Section 469(i) of the tax code permits a deduction of up to $25,000 per year of losses if the taxpayer actively participated in the rental real estate business. This deduction, however, is subject to a gradual income phase-out, with a full phase-out at $150,000. Hudzik’s income was large enough that she was ineligible in 2007 and 2008, but could claim a partially phased-out deduction for 2006.

The evolution of the economy in the US in the 21st Century has placed more taxpayers in more complex tax situations than just receiving one Form W-2 and filing a Form 1040-A federal return. As your federal income tax return becomes more complex, more opportunities exist to maximize credits and deductions, but more opportunities also exist to claim those credits and deductions erroneously, and face severe consequences. To make sure you get all the deductions for which you qualify, while minimizing the risk of incurring problems with the IRS, contact the tax attorneys at Samuel C. Berger, P.C. and the CPAs at S.C. Berger, P.C. Our tax attorneys and CPAs are here to help you maximize the potential benefits accorded under the tax code, when ensuring your returns comply with the law. Reach us online or call (201) 587-1500 or (212) 380-8117.

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