Do your clients qualify for the real estate professional (REP) status, even if they own just one rental property? If so, their activity rises to the level of trade or business, and losses can be used against ordinary income like wages. If they don’t qualify, they will be treated as investors in a passive activity with income limited by passive loss rules.

Lower tax bill in three ways

To be classified as a REP, the taxpayer must satisfy specific criteria, or tests, outlined in §469. Those who pass the IRS’s criteria and materially participate in the business can use rental losses to offset ordinary income like wages rather than be limited by passive loss rules. They may also avoid the net investment income tax (NIIT) of 3.8% levied on investments since the activity is considered a trade or business. Finally, the qualified business income deduction (QBID) of 20% may be available if the income further meets the standards for qualified business income.

Statutory requirements and material participation

REPs must meet two statutory participation tests: the more-than-50% and the 750-hour tests. They must also pass one of seven material participation tests for each property unless they are aggregated with other holdings.

The two statutory participation tests are:

1) More than half of the personal services the taxpayer performs during that year are performed in real property trades or businesses in which the taxpayer materially participates (see below).

2) The taxpayer performs more than 750 hours of services during that year in real property trades or businesses in which they materially participate.

  All seven material participation tests are listed in the [IRS Publication 925, *Passive Activities and At-Risk Rules*.](https://www.irs.gov/pub/irs-pdf/p525.pdf) However, one test stands out: clients must participate in the activity for __more than 500 hours during the year__. A different test can be used for each separate property. 

Personal services defined

The regulations define personal services as “any work performed by an individual in connection with a trade or business.” [Treas. Reg. §1.469-9(b)(4)] Work must be done by the individual taxpayer rather than employees or contractors unless the taxpayer materially participates in their employees’ work.

Real property trades or businesses defined (partial list)

1. Development and construction/reconstruction: Planning and improving land or buildings for future use or sale
2. Rental: Direct real estate rental operations, including managing leases and tenants
3. Operation: Day-to-day hands-on real property management, such as maintenance and tenant relations or supervising the same

Participation

To meet the participation standard, the taxpayer must perform nearly all the work in the activity for the year, including that done by non-owners. Documentation of hours spent, where and when, is crucial to proving exactly where the client spent time to qualify for the REP status.

Documentation best practices

Court cases reflect the IRS’s insistence on detailed, contemporaneous logs or lists substantiating the taxpayer’s time, rather than estimates or anecdotal proof of participation (Bailey v. Commissioner, T.C. Memo 2001-2).

To substantiate real estate professional status, taxpayers should maintain:

• Contemporaneous logs or time records detailing hours, dates, and descriptions of tasks
• Evidence of material participation includes decision-making records, correspondence or contracts

You can learn more in-depth information about this topic in an upcoming NATP on-demand webinar, Tax Considerations for Real Estate Professionals.

Question: Frankie is a U.S. citizen who lives and works in Greece. He meets the bona fide residence test and, under §911(d)(1), he elects to exclude his foreign earned income of $125,000 from U.S. taxation on Form 2555, Foreign Earned Income. Can he also claim the foreign tax credit on Form 1116, Foreign Tax Credit, for income taxes he paid to Greece?

Answer: No, he cannot double-dip on the same income. Because Frankie is using Form 2555 to exclude his foreign-earned income, he cannot use Form 1116 to claim the credit on the same income. Once Frankie elects to exclude his foreign-earned income, he cannot take a foreign tax credit for taxes on income he excluded or could have excluded. If he does, one or both choices may be considered revoked §911(a), Reg. § 1.911-7(b) (2).

Working with clients doesn’t always end once a return is filed. When they bring updated documents or corrected info, you must know when to file Form 1040-X and when to let the IRS handle it. Understanding this distinction helps you avoid unnecessary amendments and better serve your clients.

Below, you’ll find a few of the top questions from a recent webinar on the topic and their corresponding answers. If you choose to attend the on-demand version of this webinar, you can access the full recording and the entire list of Q&As.   

Q: What is the difference between a superseding return and an amended return?

A: A superseding return is a complete replacement of the original return filed before the original return’s due date (including extensions). A Form 1040-X is used for an amended return, which is filed after the due date or to correct issues not resolved by a superseding return. Superseding returns are not filed on Form 1040-X [Treas. Reg. §1.6011-1(a)].

Q: How can taxpayers repay a refund received in error in a future tax year?

A: If a taxpayer received a larger refund than they were entitled to and an amended return reduces the refund amount, they must repay the excess. This can be done by sending a check to the IRS with a detailed explanation or waiting for the IRS to issue a notice of adjustment. See: https://www.irs.gov/taxtopics/tc202.

Q: Should tax preparers pay penalties and interest due to their own error?

A: While not required by law, some tax professionals may choose to voluntarily reimburse clients for penalties and interest resulting from their own mistakes. This is a professional and ethical decision and may vary by firm policy.

Q: Should a Form 1040-X be filed to correct an error on a 1098-T for the American opportunity tax credit?

A: Yes. If the wrong dependent’s name or SSN was listed on a Form 1098-T, and this affects the American opportunity tax credit, a Form 1040-X should be filed with corrected information. If not corrected, it could impact eligibility for others trying to claim the credit for that dependent.

To learn more about filing amended returns for individual taxpayers, you can watch our on-demand webinar. NATP members can attend for free, depending on membership level! If you’re not an NATP member and want to learn more, join our completely free 30-day trial.