Professionals who charge by the hour are used to keeping track of how they spend their workdays. The tax law is making time-trackers of the rest of us. And tracking time made a five-figure difference in the tax life of a Brooklyn apartment owner who recently beat the IRS in Tax Court.
The “passive activity” rules (IRS offers free oxymorons, no extra charge) have made it worthwhile for taxpayers to keep track of hours worked since they were enacted in 1986. If your business income and loss is reported on your 1040, these rules apply to you. It matters for sole proprietorships reported on schedule C, partnerships and S corporation income reported on schedule E, and farm income reported on schedule F.
The rules keep you from deducting a loss when you are a “passive” investor in the “activity.” If your “passive losses” exceed your “passive income” for a year, you can’t deduct the net loss; the disallowed loss carries forward until you either generate passive income, or until you sell the activity in a taxable sale.
For the most part, whether you are “passive” depends on how much time you spend on an activity. You have to meet one of these tests:
500 hours worked in the activity in a tax year.
100-500 hours worked in the activity in a tax year, and when combined with other 100-500 hour activities, you get over 500 hours. This is for people running multiple businesses.
Over 100 hours, and more than anyone else.
Substantially all of the activity in the business.
You have met one of the hours tests in five of the prior 10 years.
If you rent real estate, you also must prove that you are a “real estate professional" before you can deduct rental losses. It’s a test that’s hard to meet for taxpayers who aren’t involved in the real estate industry.
If you have a business loss in a year, these tests become a big deal. They might eliminate your taxes on your other income, or even give you a tax loss that you can carry back to prior years for a refund.
The IRS can be distrustful of taxpayers claiming losses, and they may ask you to prove your time spent. You aren’t required to keep a time sheet, but then you have to prove your involvement by other means. That may be easy if you have a full-time business you show up at and run, but it is harder for part-time side businesses. The best way is to keep a calendar of your time.
A Brooklyn, New York man with a full-time real estate job (a real estate professional) had to prove the IRS that he wasn’t passive in managing the two apartments above his home. Fortunately, he did keep a calendar of his time, and the Tax Court ruled that he showed that he spent over 500 hours managing his business. the record keeping saved the taxpayer $25,174.60 in taxes and penalties that the Tax Court overturned.
Many other taxpayers who weren’t so careful have lost their deductions, sometimes into six figures. And don’t count on preparing a time log retroactively if the IRS ever comes calling. The results can be embarassing.
So when it comes to your business losses, time really is money. Keep track of it. And get your tax professional involved to make sure your recordkeeping and reporting will get you through an IRS exam.