December 13 2016
Many real estate agents work only part time, or work at real estate for a while and then leave the field. If you're in this situation and you don't earn a profit from your real estate activity, the IRS could claim that you are not really in business. Let's go over how to handle this, as well as some other important real estate tax tips.
For tax purposes, a business is an activity you regularly and continuously engage in primarily to earn a profit. You can't get a real estate license, sit back and do nothing and then claim you had a profit motive. This won't pass the "smell" test. You need to be able to show that you were actively working to make money by trying to obtain listings or close sales or something else.
It's also not necessary to show a profit every year to qualify as a business. You just need to be able to prove that your primary purpose is to make money. Many businesses have losses in their first year—and some may continue to have losses on and off for years afterwards. That's okay as long as you can establish that your intent was to earn a profit.
Your real estate business can be conducted from home, full time or part time, as long as you work at it regularly and continuously. And you can have more than one business at the same time—many real estate agents work part time and have other businesses or jobs. However, if your primary purpose for being a real estate agent is something other than making a profit—for example, to incur deductible expenses—the IRS may find that your activity is a hobby and not a business. If this happens, you'll face some potentially disastrous tax consequences.
The IRS has established two tests to determine whether someone has a profit motive. One is a simple mechanical test that looks at whether you have earned a profit in three of the last five years. The other is a more complex test designed to determine whether you act like you want to earn a profit.
If your real estate sales venture earns a profit in three of five consecutive years, the IRS will presume that you have a profit motive. The IRS and courts look at your tax returns for each year you claim to be in business to see whether you turned a profit. Any legitimate profit qualifies; you don't have to earn a particular amount or percentage. However, if your annual profits are very small, while your annual losses are very large, the IRS may claim you can't pass the test.
Careful year-end planning can help your business show a profit for the year. For example, you can reduce your expenditures (and increase your profit) by putting off paying some expenses or buying new equipment until the following tax year.
Even if you meet the three-of-five test, the IRS can still try to claim that your activity is a hobby, but it will have to prove that you don't have a profit motive. In practice, the IRS usually doesn't attack ventures that pass the profit test unless the numbers have clearly been manipulated just to meet the standard.
The presumption that you are in business applies to your third profitable year and extends to all later years within the five-year period beginning with your first profitable year.
If you can't satisfy the three-out-of-five-year profit test, don't panic. Many real estate agents are in the same boat. This was particularly true during the last few years when real estate sales were in a terrible slump. The sad fact is that many agents don't earn profits every year or even for years in a row, especially when they're first starting out; yet the IRS does not categorize all of these agents as hobbyists.
You can continue to treat your real estate activity as a business and fully deduct your losses, even if you have yet to earn a profit. However, you must take steps to demonstrate that your business isn't a hobby, in case you ever face an audit. You must be able to convince the IRS that earning a profit—not accumulating tax deductions—is your primary motive for doing what you do. This will require some time and effort on your part.
How does the IRS figure out whether you really want to earn a profit? IRS auditors can't read your mind to establish your motives, and they certainly aren't going to take your word for it. Instead, they look at whether you behave as though you want to make money.
The IRS looks at the following "objective" factors on to determine whether you are behaving like a person who wants to earn a profit (and therefore, should be classified as a business). You don't have to satisfy all of these factors to pass the test—the first three listed below (acting like a business, expertise and time and effort expended) are the most important by far. Studies demonstrate that taxpayers who meet these three factors are always found to be in business, regardless of how they do on the rest of the criteria.
Any real estate agent can pass the behavior test, but it takes time, effort and careful planning. Focus your efforts on the first three factors listed above. As noted earlier, a venture that can meet these three criteria will always be classified as a business. Here are some tips that will help you satisfy these crucial factors—and ultimately ace the behavior test.
Act like a businessperson
First and foremost, you must show that you carry on your real estate activity in a businesslike manner. Doing the things outlined below will not only help you with the IRS, but will also help you actually earn a profit someday (or at least help you figure out that your business will not be profitable).
If you're already a real estate expert, you're a step ahead of the game. But if you lack the necessary expertise, you can develop it by attending educational seminars and similar activities and consulting with other experts. Keep records of your efforts (for example, a certificate for completing a real estate sales training course or your notes documenting your attendance at a seminar or convention).
You don't have to work full time to show that you want to earn a profit. It's fine to hold a full-time job and work part time at real estate sales. However, you must work regularly and continuously rather than sporadically. You may establish any schedule you want, as long as you work regularly.
Although there is no minimum amount of time you must work, you'll have a hard time convincing the IRS that you want to make money if you work less than five or ten hours a week. Keep a log showing how much time you spend working. Your log doesn't have to be fancy—you can just mark down your hours and a summary of your activities each day on your calendar or appointment book.
To view the original article, visit the MileIQ blog.