Have you ever made or heard a fellow real estate agent make any of the following statements?
“I’m just working enough to pay my MLS dues.”
“Not selling right now - keeping my license active in case a listing falls in my lap.”
“Taking a break. At least I can still deduct my MLS fees and continuing education.”
As a tax professional who specializes in helping real estate agents legally minimize their taxes, statements like these flash a red light of warning.
Stop! Do not take the deduction. A loss might bring the IRS knocking.
Working just enough to keep your license active (worse yet, not working at all) while deducting a loss on your tax return can be dangerous - a danger over looked by many real estate agents and covered extensively in our Real Estate Agent Comprehensive Tax-Cut Library.
How can deducting expenses be dangerous? After all, you have to pay the bills to keep your real estate license! According to the IRS, when a taxpayer’s primary motive for incurring expenses is anything other than earning a profit, they’re not in business – they’re dabbling and own a real hobby, not a business. The danger lies in the fact that losses generated by a hobby are NOT deductible on your tax return.
A Hobby, What? The IRS definition of a hobby is simple: A hobby is an activity that generates revenue but lacks a genuine profit motive. Businesses exist for one reason – to earn more money than it spends, to make a profit! Hobbies exist for a multitude of other reasons, including those expressed in the statements above. If your real estate agent activity lacks a demonstrable profit motive, the activity is a hobby, not a business. Making matters worse, if the IRS decides your motivation is less than business-like, it’s your responsibility to prove them wrong.
IRS Profit Presumption
There is, however, a silver lining for new agents or those experiencing downturns in the market. The IRS will generally presume an activity has a profit motive if it generates a profit three of five consecutive years. When an activity results in losses for three or more consecutive years, the IRS presumption switches to your real estate agent biz being a hobby, a presumption you can only counter by proving a profit motive. Failing to show a profit motive will result in your real estate agent activity’s reclassification as a hobby. The outcome: A costly tax problem.
The taxation of hobbies is pretty simple. All hobby revenue is taxed as ordinary income on the front of the tax return, meaning most states with an income tax also tax it. Before 2018, the only way to deduct expenses related to hobby income was as a miscellaneous itemized deduction on Schedule A, subject to 2% of adjusted gross income. The deduction was only allowed to the extent of income and could not create a loss. The point – All hobby income is taxed, all of it. Hobby expenses, for all practical purposes, are not deductible.
Worse yet – The passage of the Tax Cuts and Jobs Act (TCJA) removed even the hope of offsetting hobby income with expenses by eliminating all 2% miscellaneous itemized deductions. Starting in 2018 hobby expenses are not deductible anywhere on your tax return!
Consequences of IRS Reclassification
If the IRS determines that you’re working as a real estate agent lacks a profit motive (and you cannot convince them otherwise) it will likely reclassify the activity as a hobby and retroactively tax it as such. Hobby income will be moved from schedule C and listed directly on Form 1040 (Line 21 on Schedule 1 in 2018 and later years). All expenses will become hobby expenses and subject to the treatment described earlier.
Back taxes, late payment penalties, and interest will all be assessed. If the addition to income is large enough, the IRS may also assess an additional 20% Substantially Understating of Income penalty.
Avoiding the Real Estate Agent Hobby Tax-Trap
If your real estate agent business has sustained losses for the past few years, you can prevent this reclassification by making sure the facts and circumstances are on your side – meaning the side of proving a profit motive.
Here are a few tips on showing a profit motive:
- Proper licensing
- Separate business bank accounts and credit cards for your business
- Payment of all business taxes
- Good accounting records
- Applicable insurance and separate business phone line
- A log showing that substantial time is devoted to the activity
- Documented actions you have taken to achieve a profit.
The methods listed above are general and not specific to real estate agents. For real estate agents proving profit motive will often boil down to convincing the IRS of your hustle to generate leads, gather listings, show properties, and, of course, sell real estate. For part-time agents, it’s demonstrating your hustle that matters, not necessarily the time spent selling real estate.
The ability to prove profit motive will avoid falling into the hobby tax-trap and ensure your ability to deduct losses as you incur them in the future. After all, it’s not earning a profit makes one a business owner, it’s the earnest attempt to earn that profit that proves business ownership.
We hope this article has helped you better understand real estate agents and the hobby tax-trap. Our Real Estate Agent: Comprehensive Tax-Cut Library covers every possible deduction a real estate agent can take on their tax return as well as tax planning strategies to minimize your tax obligations without complying with the tax code. We also invite you to browse our Course Listing page to view a variety of courses designed to help you navigate the tax laws and minimize your tax liability.
Need More Help?
Brett Hersh is an instructor and author for Overnight Accountant. He is also a tax professional who specializes in helping real estate agents, brokers, professionals, investors, and businesses in related industries. If you would like to schedule a consult with Brett or inquire about his services, please feel free to email him.