Real estate is a tricky part of the tax code. And if you don’t follow the rules, the IRS can be quick to disallow some or all of your rental real estate expenses.

Background. By default, the IRS assumes real estate investments are passive activities. As a passive activity, generally passive losses are matched against passive gains and any excess losses are carried over into future years. There is a $25,000 loss exception if your income is below $150,000 (joint filer) and you actively participate in the rental activity.

If you want to take full advantage, you must meet professional real estate rules with material participation standards. But it can get tricky. In the 2023 court case of Gregory F. Teague and Rachel S. Teague v. Commissioner, the taxpayer’s real estate professional qualification came into play.

The Facts. Gregory and Rachel Teague own two rental properties: (1) a duplex in New Hampshire, and (2) three cabins in Maine. In 2017, they renovated their Maine cabins but failed to keep detailed records of the time they spent on renovations. That year, they reported nearly $6,000 of net income from their New Hampshire duplex and a nearly $30,000 loss from their Maine cabins. The taxpayers fully deducted the loss from their Maine cabins, which—when netted with their New Hampshire duplex—showed a rental real estate loss on Schedule E of nearly $24,000. The tax court sought to determine if Gregory qualified as a real estate professional. If he did not, their losses would be limited due to income limitations.

Gregory obtained his real estate license in 2013. To qualify as a real estate professional in the eyes of the IRS, he must show that (1) he spent more than 750 hours on a real estate business in which he materially participated, and (2) more than half of the personal services he performed in any trade or business that year were performed in real estate businesses in which he materially participated. Because Gregory failed to keep records of his time spent renovating the Maine cabins, and because the time estimates he provided did not seem fully credible, the tax court ruled that he did not qualify as a real estate professional. The Teagues’ real estate losses were not fully deductible.

The lesson. Qualifying as a real estate professional isn’t simple or easy. If you don’t qualify, your losses will likely be limited. Keep good records of time you spend on real estate activities. Please call if you have questions about your rental property activity.

And understand your standing with passive income rules. They can get complicated, especially if you are active in short-term rental sites like VRBO, Airbnb, and Booking.com.