How to Handle an IRS Real Estate Professional Audit

The Real Estate Professional (REP) status is a tax designation from the Internal Revenue Service that allows individuals involved in real estate to treat their rental activities as non-passive. This allows for the deduction of rental losses against other income, such as wages or business profits, which can lead to tax savings.

This tax treatment is why the IRS scrutinizes REP claims. An audit can reclassify losses back to passive, leading to back taxes, penalties, and interest. The burden of proof is on the taxpayer to demonstrate they meet the requirements, and understanding these rules is the first step in defending the position.

Qualifying as a Real Estate Professional

To be recognized as a real estate professional, a taxpayer must satisfy two quantitative tests each year. Failing either test means the individual cannot claim REP status for that tax year, and any rental losses will be subject to passive activity loss limitations.

The first requirement is the “more than one-half personal services” test, which mandates that more than 50% of the total personal services a taxpayer performs in all trades or businesses during the year must be in real property trades or businesses. The second is the “750-hour” test, which requires the taxpayer to perform more than 750 hours of service during the tax year in real property trades or businesses where they materially participate. Qualifying activities include:

• Development or redevelopment
• Construction or acquisition
• Conversion
• Rental, operation, or management
• Leasing or brokerage

For an individual to count hours from working for a real estate company, they must own at least 5% of that business. Time spent as a W-2 employee for a real estate firm where the taxpayer has a minimal ownership stake does not count toward the 750-hour requirement. This prevents employees in the real estate industry from qualifying without a significant ownership role.

Proving Material Participation in Rental Activities

After meeting the two initial tests, the taxpayer must prove they “materially participated” in their rental activities. This is a separate hurdle the IRS examines closely. If material participation is not established, the rental activities remain passive, and the losses cannot be deducted against non-passive income, even if the taxpayer qualifies as a real estate professional.

The IRS provides seven tests to determine material participation, but only one needs to be met. For real estate activities, taxpayers most commonly rely on three of these tests.

• The 500-hour test is met if the individual participates in the activity for more than 500 hours during the year.
• The “substantially all participation” test is met if the taxpayer’s participation constitutes almost all of the total participation from all individuals.
• The 100-hour test requires the individual to participate for more than 100 hours, and that participation must not be less than the participation of any other single individual.

The remaining tests are less common for rental real estate. They include situations where the activity is a “significant participation activity” or where the taxpayer materially participated in prior years.

Making the Aggregation Election

For a real estate professional with multiple rental properties, proving material participation for each one can be a challenge, as the IRS views each property as a distinct activity by default. This would require meeting a material participation test independently for each property.

The tax code allows a real estate professional to make an aggregation election under Internal Revenue Code Section 469. This election permits the taxpayer to group all their interests in rental real estate and treat them as a single activity for the material participation tests. Combining the hours spent across an entire portfolio makes it more feasible to meet the 500-hour test or other standards.

The aggregation election must be made by attaching a statement to a timely filed original tax return for the year the election is to become effective. The statement must declare that the taxpayer is a real estate professional and is making the election to aggregate their rental activities. Once made, the election is binding for all future years and can only be revoked if there is a material change in the taxpayer’s facts and circumstances.

Required Documentation for an Audit

Success in an audit depends on the quality of the taxpayer’s documentation. The burden of proof is on the individual to substantiate the hours claimed for both REP qualification and material participation. The IRS requires detailed records, as vague estimates are insufficient.

Under Treasury Regulation 1.469, a taxpayer can establish their hours by any “reasonable means.” The most reliable proof is a contemporaneous time log, calendar, or appointment book. Records created at or near the time the service was performed carry the most weight with the IRS, while post-event reconstructions are viewed with more skepticism.

A detailed time log should include the date, the specific property address, a precise description of the service provided, and the time spent. For example, an entry stating “Worked on rental – 8 hours” is inadequate. A strong entry would be: “3/15/2025, 123 Main St: 2 hours – met with plumber to fix leak; 3 hours – painted bedroom; 1 hour – screened new tenant applications.”

Taxpayers should also keep supporting evidence that corroborates their activities. This can include emails with tenants and contractors, invoices and receipts for materials, and bank statements or contracts related to property management. This documentation helps create a comprehensive picture of the taxpayer’s involvement.

Auditors look for inconsistencies. If a taxpayer claims significant hours managing a property but their tax return shows large payments for property management fees, this will raise a red flag. The documentation must present a credible and consistent narrative of the taxpayer’s role.

The IRS Audit Process

The audit begins with a formal Information Document Request (IDR), notifying the taxpayer that their return is under examination. This notice will specify the tax year in question and outline the information the examiner needs to see. The primary document requested is the taxpayer’s time log or other proof of hours worked.

The examiner will scrutinize the log for detail, consistency, and credibility. They will cross-reference the log with other information on the tax return, such as expenses for repairs, management fees, and travel, to see if the narrative holds together.

Following the document review, the IRS examiner may conduct an interview with the taxpayer. The agent will ask specific questions about the taxpayer’s real estate activities and other professional commitments to gauge their true level of involvement.

The examiner will review the submitted documents and may ask for additional supporting information. Providing clear, organized, and prompt responses is important. If the examiner finds the documentation insufficient, they will issue a report proposing changes to the tax liability, which may include disallowing the rental losses and assessing additional tax, penalties, and interest.