For those real estate professionals who want to deduct their passive rental losses against ordinary
income, in addition to substantiating rental income and expenses reported on their return, they will need to prove that they are “real estate professionals” who “materially participate” in their rental operations. While this appears simple, I assure you it is not.
IRC § 469 provides the definitions for “real estate professional” and “materially participation”, and the Treasury has provided additional regulations to assist the taxpayer in interpreting this section of the Code. However, during an examination the IRS Agent will follow a predetermined script designed to re-classify the taxpayer to a passive investor, rather than a “real estate professional” and will try to re-classify “material participation” time to investor activity.
Taxpayers should consider representation in any Federal or state tax examination. Real estate investors are well advised to meet with a qualified tax professional to determine if they qualify as a “real estate professional” under the Code and to develop strategies to counter the IRS’s re-classification tactics.