When it comes to taxes, real estate professionals have one thing going for them that no one else has: They can qualify for a special exemption from the IRS passive loss rules. This is an exemption that nobody else can get. If you qualify, you may deduct any amount of rental losses you have for the year from your non-rental income-such as real estate commission income. Everybody else is limited to deducting a maximum of $25,000 in rental losses each year from their non-rental income.
The catch? You must be able to prove you are a “real estate professional.” This requires solid and detailed record keeping.
Raymond Vandergrift owned nine real estate rentals on which he lost over $25,000. Raymond earned $120,000 working as a real estate salesperson, so he tried to deduct his rental loss from his sales commissions.
Vandergrift argued to both the IRS and tax court that he qualified as a real estate professional because he spent over one-half of his time, and over 751 hours, on his real estate activities during the year. Unfortunately, he had no records showing how he spent his time.
Although the tax court found Raymond to be generally honest and forthright, it refused to accept his after-the-fact “ballpark guesstimate” of the amount of time he spent on his real estate activities. As a result, he was not allowed to deduct his $25,000 loss.
IRS rules require that you keep reasonable records of how you spent your work time to qualify as a the real estate professional. These do not have to be fancy daily time reports or logs. Any reasonable record can be used, including appointment books, calendars, or even narrative summaries.
Thus all poor Raymond would have had to do to qualify as a real estate pro was mark on his calendar the days he spent working as a real estate salesperson and on his rentals–this might have taken 30 seconds each day. He lost a $25,000 tax exemption because he couldn’t be bothered.
Here are some general guidelines on good record keeping:
- Keeping good records will help you understand how well your business is doing, prepare your tax return and financial statements, support tax your deductions and credits and quantify how much you have invested in your business and assets, not to mention save you hours when you need to pull together your financial information
- There are numerous guidelines on how far back your records should go, but generally the rule of thumb is three years. You should refer to the IRS for additional information to see if you need to keep records for more than three years (i.e. you own property, you fail to file a return, you do not report all of your revenue, etc.).
- Your records should include a summary of your revenues and expenses (general ledger, accounting journal, accounting software, etc.) and underlying support. Underlying support can include but is not limited to invoices, Form 1099-MISC’s, credit card and bank statements, petty cash slips, deposit slips, receipts, cancelled checks and real estate closing statements. You can keep your records hard copy or electronically (keep in mind that sometimes paper receipts can fade in a matter of months), what is most important is that you have them.
- Keep in mind that if you travel for business you may need to adhere to some additional record keeping requirements. For example, a hotel receipt from a business trip would need to be itemized (room, meals, and incidental expenses stated separately), include the name and location of the hotel and the dates you stayed there; A meal receipt would need to include the name and location of the restaurant, the number of people served, the date and the amount you spent; A trip log to substantiate your mileage deduction would need to include including the date, destination, and miles driven; Further, for all travel, meal, and entertainment expenses you must also provide a brief written summary of the business purpose of an expense.
- Remember, it is your responsibility to be able to support the revenues and expenses you report on your tax return. The IRS refers to this as the “burden of proof”.