In a couple of discussions last week—one with an IRS agent and one with another CPA—it became clear to me that real estate investors often struggle with counting real estate professional hours.
Counting real estate professional hours correctly is super-important, though. And here’s why…
If some investor accumulates more than 750 hours on real estate and they spend more than half their time on real estate, they get two big benefits. First, losses on the real estate (such as from depreciation) aren’t considered passive and so can be deducted as they occur. Second, gains on real estate probably won’t be subject to the 3.8% net investment income tax (also known as the Obamacare tax).
Tip: Need way more information about how to maximize your real estate tax deductions? Check out our downloadable ebook, Real Estate Tax Loopholes and Secrets.
But how should you count hours? And which hours count and don’t count toward that 750 hour threshold? This all gets tricky in practice…
Fortunately, the IRS provides some useful instructions in their Publication 925—and those rules really do spotlight both opportunities and traps.
Counting Real Estate Professional Hours
A first thing to know? You need to have a system for counting your real estate hours.
Fortunately, Publication 925 provides a taxpayer-friendly rule for this:
Proof of participation. You can use any reasonable method to prove your participation in an activity for the year. You don’t have to keep contemporaneous daily time reports, logs, or similar documents if you can establish your participation in some other way. For example, you can show the services you performed and the approximate number of hours spent by using an appointment book, calendar, or narrative summary.
In other words, you can pretty much use any reasonable approach to prove your time. You do need to identify the actual services you’ve performed. But estimates work.
Categories of Real Estate Professional Hours
Further, Publication 925 goes into detail about the types of services that count as real estate work. I reproduce the actual list from the IRS publication, in boldface, below. Note that the un-boldfaced text is me commenting on phrases in the IRS document.
“Develops or redevelops [real estate]…” So this category of work includes people who develop real estate or renovate or rehab real estate. Pretty obvious.
“Constructs or reconstructs [real estate]…” So people who build buildings and homes. Again pretty obvious.
“Acquires [real estate]…” So people doing the work of buying real estate including looking for property and then purchasing property. This is a little trickier, but the Publication 925 language says to me the hours you spend finding and then purchasing a property counts. This should be significant for new real estate professionals.
“Converts [real estate]…” Presumably this category includes people converting property from one use to another use.
“Rents or leases [real estate]…” Commercial and residential leasing agents or rental agents. Easy enough to understand.
“Operates or manages [real estate]…” Commercial or residential property managers. Again, easy to understand.
“Brokers [real estate]…” Commercial or residential real estate brokers. Again, easy, right.
In short, any hours you’d just logically consider “work” in a real estate business potentially count as real estate professional hours.
Owner Real Estate Professional Hours That Don’t Count
Predictably, however, the IRS has identified some real-estate-y work that doesn’t count.
First, you can’t count hours for work that’s not usually performed by an owner if (and here I quote the publication) “One of your main reasons for doing the work is to avoid the disallowance of any loss or credit from the activity under the passive activity rules.”
For example, if you own a skyscraper but for some crazy reason you don’t accumulate enough hours? You can’t join the janitorial staff simply in order to rack up the hours. You can’t, in other words, do work a skyscraper owner would never do simply to pass the 750 hour test or the more than 50% of your time test.
But notice the dual requirement here—this is significant: Can you intentionally boost your hours doing something that owners would do? Can you rack up the hours learning more and more about real estate investment? And merely to pass the 750 hour or more than 50% test?
I think the answer is “yes.” The IRS’s own rules say work doesn’t count if two conditions apply: The work isn’t owner work, and your reason is to sidestep the passive loss limitations. Note that they could have written this requirement to have a single condition where you can’t artificially bump hours…
Investor Real Estate Professional Hours That Don’t Count
The IRS also says that you can’t relabel work any old investor would do with any investment as real estate professional hours—unless (and I’m going to quote the publication again) “… you’re directly involved in the day-to-day management or operations of the activity…”
This sort of investor work is exactly what you’d expect: Pouring over financial statements or reports, analyzing financial and operations data for your own use, and monitoring the finances or operations of the investment.
This all makes sense. If you’re not “into” the day-to-day operational details of your real estate, you’re really just an investor who could be investing in just about anything. Your “anything” just happens real estate. But you could be investing in anything and doing this stuff.
But again, look closely at the rule… you could be doing any of this stuff and count the hours if you’re “…directly involved in the day-to-day management or operations…” That is okay…
If you’re investing in real estate, you want to know how count up your hours and qualify as a “real estate professional.” And for two reasons…
First reason: Qualifying as a real estate professional will let you save big on your taxes.
And the second reason: Understanding how you count real estate professional hours means you’ll be able to defend your status to anyone (like an IRS auditor) who questions you.