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 nonrental 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 nonrental income.
Unfortunately, the rules for determining who qualifies for the real estate professional are complex. Basically, you (or your spouse, if you file a joint return) must spend more than half of your working hours during the year working in one or more real property businesses. In addition, you (or your spouse, if you file a joint return) must spend more than 751 hours a year in one or more real property businesses. A real property business includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage business. (IRC Sec. 469(c)(7)(C).) It includes working as a real estate broker or self-employed salesperson.
A recent tax case shows that, if you want to qualify as a real estate professional, you need to do a little basic recordkeeping. 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.
For more information on this and other tax issues for real estate agents and brokers, refer to The Real Estate Agent's Tax Deduction Guide, by Stephen Fishman (Nolo).