Many real estate agents work only part time, or work at real estate for a while and then leave the field. If this is you, 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 deductions.
Real Estate Agent Tax Tip: How to Prove You Are in Business
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 show that you were working to make money by trying to get listings or close sales.
It’s also not necessary to show a profit every year to qualify as a business. You only need to be able to prove that your primary purpose is to make money.
Many businesses have losses in their first year. 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. 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.
Yet, the IRS may find consider this a hobby if your primary purpose for being a real estate agent isn’t making a profit. If this happens, you’ll face some potentially disastrous tax consequences.
How This Impacts Real Estate Agent Tax Deductions
Example:J. Thomas Orr, a Los Angeles schoolteacher, obtained a real estate broker’s license. His goal was to work part-time at the activity.
Unfortunately, he was not successful. For two years, he obtained no listings and sold no real estate. His only income from real estate was $150 for doing an appraisal.
He claimed he had over $5,600 in deductible business expenses from his real estate activity. The IRS and tax court concluded that Orr’s real estate activity was not a business because there was no evidence he engaged in it in an organized, businesslike manner to earn a profit. The tax court disallowed all his business expense deductions. (Orr v. Comm’r, 64 TCM 882 (1992).)
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.
Three-of-Five Year Profit Test
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.
What the IRS Considers
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.
- Whether you act like a business. Among other things, acting like a business means you keep good books and other records and carry on your activities in a professional manner.
- Your expertise. People who are trying to make money usually have some knowledge and skill in the field of their endeavor.
- The time and effort you spend. People who want to make profits work regularly and continuously. You don’t have to work full time, but you must work regularly.
Other Factors The IRS Considers for Real Estate Agents
- Your track record. Having a track record of success in other businesses—whether or not they are related to your current business—helps show that you are trying to make money in your most recent venture.
- Your history of profit and losses. Even if you can’t satisfy the profit test described above, earning a profit in at least some years helps show that you have a profit motive. This is especially true for real estate sales, which tend to be cyclical.
- Your profits. Earning a substantial profit, even after years of losses, can help show that you are trying to make a go of it. On the other hand, earning only small or occasional yearly profits when you have years of large losses in the activity tends to show that you aren’t in it for the money.
- Your personal wealth. The IRS figures that you probably have a profit motive if you don’t have substantial income from other sources. After all, you’ll need to earn money from your real estate activity to survive. The IRS may be suspicious if you have substantial income from other sources. This is true particularly if the real-estate losses generate substantial tax deductions.
- The nature of your activity. Activities that are inherently fun or recreational are particularly likely to be found to be hobbies by the IRS. Obviously, this doesn’t pose a problem for a real estate agent. No one would claim that selling real estate is a “fun” activity—in the same category as art, photography, writing, antique or stamp collecting, or training and showing dogs or horses (for example).
How to Pass the Behavior Test
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).
- Keep good business records. Keeping good records of your expenses and income from your real estate activity is the single most important thing you can do to show that you want to earn a profit. Without good records, you’ll never have an accurate idea of where you stand financially. Lack of records shows that you don’t really care whether you make money or not—and it is almost always fatal in an IRS audit.
- Keep a separate checking account. Open up a separate checking account for your real estate business. This will help you keep your personal and business expenses separate—another factor that shows you want to make money.
- Create a business plan. Draw up a business plan with a realistic profit and loss forecast—a projection of how much money your business will bring in, your expenses and how much profit you expect to make. The forecast should cover the next five or ten years. It should show you earning a profit sometime in the future. Both the IRS and courts are usually impressed by good business plans.
- Market yourself. Real estate agents who are trying to earn a profit ordinarily take steps to market themselves and their services. At a minimum, you should have a business card and letterhead. Having your own real estate sales website or blog also shows you are serious about earning a profit. Engaging in advertising also shows you’re trying hard to get business.
- Obtain all necessary business licenses and permits. Getting the required licenses and permits for your activities will show that you are acting like a business. Obviously, you must have a real estate license. You should also have any other license or permits required to operate a business in your locality, such as a city business license.
- Join professional organizations and associations. Taking part in professional groups and organizations will help you make valuable contacts and obtain useful advice and expertise. This helps to show that you’re motivated to earn a profit. There are many professional organizations real estate agents can join, such as the National Association of Realtors.
If you’re already a real estate expert, you’re a step ahead of the game. 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. Yet, you must work regularly and continuously rather than sporadically. You may establish any schedule you want, as long as you work regularly.
If you work less than five or ten hours a week, it’s tough to convince the IRS of a profit motive. 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.
MileIQ’s blog does not constitute professional tax advice. You should contact your own tax professional to discuss your situation.