Home Office Red Flag,
Make Rental Property Losses Tax Deductible &
Tax Deductions for Business Entertainment Meals!
Myth: Home-Office Tax Deduction Is a Red Flag for IRS
man-on-the-street interview will tell you that claiming a
home-office deduction is a red flag for IRS audit. Of course,
we know that the man on the street who did the interview is
But what about all the publications that say the home-office
tax deduction is a red flag for audit? For example, if you put
“home office” and “red flag” in Google with quotes as you see
here, you find 157,000 results.
What’s interesting in the Google search is that many of the
published articles now say that the homeoffice tax deduction
is not a red flag. The problem is that lots of the other
articles say that it is a red flag. Who’s right? Why?
Facts: The IRS does
not publish its audit flags. That’s a shame. So how do tax
professionals, newspapers, magazines, and newsletters know if
the home-office tax deduction is a red flag or not? Good
question. The people who say that the home office is, or is
not, a red flag don’t cite any authorities to back their
What We Know: Last
October a group conducted a two-hour continuing education
webinar for CPAs and enrolled agents. During the webinar they
asked the following polling question—a question that
participants have to answer to prove attendance and attention:
Question G from the webinar for CPAs and enrolled agents: Do
this: Think of yourself and how many clients you have who have
claimed the home-office deduction for each of the last three
years. Now with that number of clients in mind, what
percentage have been audited by the IRS in the last three
- No audits at all—73 percent
- Fewer than 5 percent audited—22 percent
- Five to 10 percent—5 percent
During live seminars given to one-owner and husband-and-wife
owned businesses we found that the rate of audit for those who
claimed the home-office deduction was no greater than the rate
of audit for those who did not claim the deduction.
In fact, we found hundreds of instances where the business
owner claimed the home-office deduction and experienced an
audit, but he was never asked about the home office during the
Obviously, the IRS examiners conducting these audits did not
carry in their audit bags any home-office tax deduction red
Conclusion: Based on
surveys and the answers to questions during the seminars, the
home-office deduction is not a red flag.
What Is a Red Flag?
As you know, the IRS does not publish its audit flags.
Further, the flags are secrets that have not been exposed.
Make Your Rental Property Losses Tax Deductible
do not like your rental property. The IRS does not like
your rental property. If you want to deduct your rental
property losses, you need to run and survive the passive-loss
gauntlet. This article will give you safe passage.
Tax law allows you to qualify to deduct your rental property
One way to qualify (albeit for a limited deduction) is by
Qualifying for Rental Real Estate’s Tax-Favored $25,000
Test 1: Real Estate Professional
The second way to qualify is by (1) materially participating
as a (2) tax law-defined real estate professional. That’s what
this article is about.
The test for real estate professional status is an
hours-worked test. You pass this test when in real property
trades or businesses in which you and/or your spouse
1) you OR your spouse individually work
more than 750 hours, and that more-than-750-hour-work effort
by you OR your spouse individually is more than half of that
individual’s total work effort for the year.
2) Example. You own and materially participate in five rental
properties and also operate an unrelated business. You spend
900 hours on the
rental properties and 800 hours on your unrelated business.
You are a tax law-defined real estate professional for
purposes of deducting your rental property losses because you
1) materially participated in the
properties (more on this later),
2) worked more than 750 hours on the
properties (or in tax law-approved real estate activities
3) spent more time on your rental
properties than you spent on your unrelated business.
Test 2: Material Participation
If you are married, you can count your spouse for purposes of
materially participating in the individual rental properties
or in a group
of rental properties, but you may not count your spouse for
purposes of the 750 hours or the more than 50 percent tests.
Passing test 1 is only part 1. You next need to pass the
material participation test as shown in the listing below:
As a tax law-defined real estate professional, you may
deduct rental losses for
Each rental property in which the combined efforts of
you and your spouse result in material participation (if
you did not elect to group the properties), or
If you elected to group the properties, the combined
efforts of you and your spouse result in material
participation in the property group.
As a tax law-defined real estate professional, you may deduct
rental losses for
Each rental property in which the combined efforts of you and
your spouse result in material participation (if you did not
elect to group the properties), or
If you elected to group the properties, the combined efforts
of you and your spouse result in material participation in the
For the real estate professional test, either you or your
spouse individually had to pass the test.
For the material participation test, the law allows the
combined efforts of husband and wife.
Group or Not
In the two tests above, note the words “materially
- To be a real estate professional, either you or your spouse
individually must pass the time tests for the real property
trades or businesses (including rental properties) in which
you and/or your spouse “materially participate.”
- To deduct your rental losses, you and/or your spouse must
“materially participate either in the individual properties
or, if elected, in the group of rental properties."
Profits Not a Problem
For tax planning purposes, if your rental activity is showing
a taxable profit, you don’t need to think or worry about being
a real estate professional or whether or not you materially
But since most real estate rental property investments operate
in tax-shelter mode, especially in the early years of
ownership, you generally want to deduct those rental property
losses against your other income.
Before we address grouping as a possible enabler for deducting
your rental losses, let’s examine the material participation
standards that apply to an individual property.
Seven Possibilities for Material Participation
To materially participate in a rental property activity, you
must answer “yes” to one of the seven standards in this
You do this on a property-by-property basis if you did not
make the formal tax election to group your properties. With an
election to group your rentals into a single activity, you
apply the seven tests for material participation to the
The material participation tests apply to the combined efforts
of husband and wife without regard to ownership or whether or
not a joint return is filed.
1) Did you and your spouse combined
participate in the activity for more than 500 hours?
2) Was the combined participation by you and your spouse
substantially all the participation in the activity when you
consider all the
individuals who participated?
3) Are the combined hours of participation by you and your
spouse (a) more than 100 hours and (b) more hours than the
any other individual?
4) N/A (This test 4 for material participation under the
“significant participation activity” does not
apply to rentals.
5) You and/or your spouse materially participated in the
activity for any five of the 10 immediate preceding tax years.
6) N/A (This test is for material participation in a “personal
service activity” and it generally does not apply to rentals.
7) Based on all the facts and circumstances, you and your
spouse materially participated in the activity on a regular,
continuous, and substantial basis during the year. You cannot
pass this test with participation of less than 100 hours.
Further, this is likely a “last gasp” try at material
participation that’s problematic at best.
You and your spouse own five rental properties and you did not
group them. Your activities and results from the material
tests on each of the five properties are as follows:
What Participation Took Place
You did all the work on property number 1 by yourself.
It took 45 hours of your time for the year.
On property number 2, you and your spouse each spent 75
hours and that was more than 100 hours and more hours
than anyone else spent.
On property number 3, you had a total of 250 material
participation hours and that was more than any other
On property number 4, your spouse spent 100 hours and
you spent 250 hours and that 350 hours was more time
than any other individual spent.
On property number 5, you spent 280 hours and that was
more time than any other individual spent.
You spent 900 total hours and your spouse spent 175 hours.
Your 900 hours
> are in properties in which you materially participated,
> exceed 750 hours, and
> exceed more than half of your total work hours in all trades
or businesses in which you materially participated.
You are a tax law-defined real estate professional and you may
deduct the losses on all five properties above.
Let’s say that you failed to materially participate on one or
more of the properties above. If that were the case and you
had tax losses that you wanted to deduct, you would group the
five properties into one activity.
Now you apply the seven tests to the group as if the group
were one. In the above example, you would select the more than
500 hours of participation test to deduct the rental losses of
If you grouped a self-rental with your business that property
is now part of the business and not a rental property subject
to the passive loss rules.
Bad news. Under the self-rental rule, without the grouping
with the business, your income from the self-rental is
“non-passive income” whereas a loss is passive.
This gives you the worst of all worlds and makes your
self-rental useless as a helper with your rental properties.
Protect yourself. Group your self-rental with your business.
Short-Term Rentals—Careful Here
Short-term rentals can cause trouble. For example, if the
average stay over the tax year at a property is for seven days
or less, the property is a hotel that you report on Schedule C
as a business and not as a rental property.
Similarly, if the average period of customer use is 30 days or
less and you provide significant personal services, that
property is a hotel reported on Schedule C and not a rental
If the short-term rentals are not rental properties, you can’t
group them with your rental properties or count them as rental
properties for the various hourly tests.
Should the short-term rental hotels produce a loss on your tax
return, you can deduct that loss only if you materially
participate in the hotel activity.
Should you have a hotel property, keep this in mind:
A) You may not group the hotel with your rentals.
B) Time spent on the hotel does not count as “material
participation” time for the 750-hour test.
C) To deduct a loss on the hotel, you need to materially
participate in the hotel activity.
D) If you have a group of hotels, you may need to consider the
grouping election for the hotels.
Protecting Your Tax Deductions for Business Entertainment
you ever had to face these two conflicted tax laws?
1) The law that denies your deductions for personal living
2) The law that allows meals as tax-deductible entertainment.
Tax professionals know this conflict as the “Sutter rule”
named after Dr. Sutter, who had a bad experience with the Tax
Court. When the IRS and/or the courts invoke the Sutter rule,
you lose your business meal deductions to the extent they
don’t exceed your personal meal costs.
Example. Your Dutch treat meal
deductions for business entertainment for the year are
$12,000. Had you had the meals at home, your cost would have
been $2,000. Under the Sutter rule, the IRS could reduce your
meal deductions by $2,000 to $10,000—the business amount in
excess of the personal cost that you proved.
But it is unlikely that you could prove your personal cost of
meals. If that’s the case, then the IRS disallows $12,000—the
usual result suffered by the victim of a Sutter attack.
This article explains the Sutter rule, gives you the triggers
that can make you a target for a Sutter attack, and shows you
how to keep your deductions if you are attacked.
In Dr. Sutter’s case, he lost the lunch deductions he claimed
for attending St. Louis Chamber of Commerce and Hospital
Council of St. Louis luncheon meetings. The court ruled that
he did not spend any more money for those lunches than he
spent for his personal lunches.
In a general comment to all taxpayers, the Sutter court stated
that you can overcome tax law’s nodeduction-for-personal-expenses
rule only by clear and detailed evidence that the expenditure
in question was different from or in excess of that which you
would have made for personal purposes
Whimsical. The IRS invokes the Sutter rule at its whim. No
standards exist, other than abuse in the eyes of the IRS.
The targets are “the wrong type and/or too many meals deducted
as business entertainment.” The problem: no definition of too
In Revenue Ruling 63-144, the IRS says that it applies this
no-deduction for the personal cost of a meal (e.g., the Sutter
rule) largely to abuse cases where taxpayers claim deductions
for substantial amounts of personal living expenses.
The Sutter rule does not apply to the cost of meals consumed
in travel status. It applies to meals deducted as
In Fenstermaker, the court ruled that the IRS policy of abuse
cases was too liberal and it applied the
no-deduction-for-personal-meals—period rule. In this case, the
court denied 68 business lunches in one year and 49 business
lunches in a second year because the cost of the business
lunches was no greater than the cost of the personal lunches.
In this case, Mr. Fenstermaker had both business and personal
lunches at the Fort Hayes Hotel. Thus, the business lunch cost
no more than a personal lunch and accordingly the court ruled
that Mr. Fenstermaker’s business lunches were not deductible.
Your legitimate entertainment expenses have been under attack
almost since inception of the income tax. Today is no
exception. But here you will learn how to build a good defense
against attacks. Your defense comes in two forms: logic
Under Sutter, in order for personal living expenses to qualify
as a deductible ordinary and necessary business expense, you
must demonstrate that the expenses were different from, or in
excess of, what you would have spent for personal purposes.
If you have a number of deductible
business meals with the same folks, you need
A) to ensure good future business benefit reasons for the
B) have proof that because of
the entertainment you spent more than you would on a personal
You need this same proof if you are having a good number of
Dutch treat business meals. The fact that you pick up the tab
for only yourself at tax-deductible entertainment does nothing
to hurt your business reason for the entertainment, but it can
raise a suspicion that you are absorbing personal and family
expenses. The ability to show that when you go on a Dutch
treat entertainment you spend more than you would personally
adds proof to your cause.
Put business first. Use the conduct of your business as
your first rule of thumb. Every business is different. Every
individual is different. You might entertain often; the next
person not at all. It doesn’t matter. What matters is your
Let’s turn to the legislation that’s on your side. First, you
have the Tax Reform Act of 1986, where lawmakers stated that
the cut from a 100 to 80 percent business meal deduction
simply reflects “that all meals and entertainment involve an
element of personal living expenses.” Thus, you already have
lawmakers saying that you absorbed the personal part of a
business meal with the cut to 80 percent.
In 1993, lawmakers reduced the 80 percent to 50 percent
believing this additional 30 percent reduction an appropriate
contribution on your part to deficit reduction and a proxy for
the personal consumption element of your meals and
But let’s not kid ourselves; there was only one reason for the
cut from 80 to 50 percent: deficit reduction. The
personal consumption side was addressed in the 80 percent.
That being true is sad. On the positive side, the now personal
consumption element of 50 percent gives you a lot more defense
against Sutter and Fenstermaker should the IRS try to impose
them against you.
To read this & my other articles online go to
and click on the Newsletter section.
always you can call me at 714-619-0667 if you have any
questions about investing, retirement or any other tax &
accounting related issues.
Regards, Monica Rebella, CPA/IAR
President, Rebella Accountancy