Donna earns about $300,000 in W-2 wages. Her new short-term rental generated a $120,000 loss after a cost segregation study front-loaded depreciation. She wants that loss to offset her wages.
She’s read IRS publications and blog posts, listened to podcasts, and consulted AI. She’s convinced. Now you have to decide whether her position belongs on the return.
In Tax in Action, Jeremy Wells, EA, CPA, uses Donna’s case to explain what makes a tax position defensible. The answer depends on verified facts and recognized authority rather than the client’s confidence or the odds of an audit.
Useful research isn’t necessarily authority
A source can explain tax law accurately without establishing substantial authority. Jeremy points to Treasury Regulation § 1.6662-4(d)(3)(iii), which provides a closed list of recognized authorities:
- Enacted statutes and proposed, temporary, and final Treasury regulations
- Tax treaties and court opinions
- Revenue rulings and revenue procedures, as well as IRS notices and announcements published in the Internal Revenue Bulletin
- Congressional committee reports and certain other legislative history
- Joint Committee on Taxation Blue Books, which explain tax legislation after enactment
By contrast, IRS publications, form instructions, articles, research services, professional advice, podcasts, and AI output are research aids. They may help you find authority, but they do not establish it themselves.
Jeremy applies that rule to his own show: follow the citations and read the underlying sources. That matters especially when AI supplies the summary.
Finding a recognized source is only the start. Next, decide how much it supports your client’s position.
Weigh the authority instead of counting citations
Jeremy distinguishes three standards:
- More likely than not: Greater than a 50% likelihood that the position would be upheld
- Substantial authority: Supporting authority is substantial relative to contrary authority
- Reasonable basis: A lower standard than substantial authority that generally requires sound support from one or more recognized authorities.
“We’re weighing authority. We’re not necessarily counting them,” Jeremy says.
Weight depends on relevance to the facts, persuasive reasoning, the type of authority, and whether it remains good law. You cannot cherry-pick favorable cases and ignore similar cases where taxpayers lost.
These standards measure legal merits, not audit risk. That distinction is crucial because the level of support affects the substantial-understatement penalty.
Disclosure helps, but it has limits
For individuals, an understatement is substantial when it exceeds the greater of $5,000 or 10% of the tax required to be shown. The percentage drops to 5% if the taxpayer claims the section 199A qualified business income deduction.
If the understatement exceeds the applicable threshold, the penalty is generally 20% of the portion of the underpayment attributable to the substantial understatement.
For most positions, two routes can exclude the tax attributable to a disputed item from the understatement calculation:
- Substantial authority, without disclosure for this purpose
- Reasonable basis plus adequate disclosure of the relevant facts
These rules apply to the substantial understatement penalty. Other grounds for an accuracy-related penalty, such as negligence, are evaluated separately.
Disclosure generally uses Form 8275, or Form 8275-R for positions contrary to Treasury regulations. The IRS also specifies when reporting an item on the return itself is adequate disclosure. For tax years beginning in 2025 and filed on 2025 forms, see Rev. Proc. 2026-12. Tax shelters and certain reportable transactions face stricter rules.
Return preparers face a separate standard under § 6694(a). For most positions, the preparer needs substantial authority if the position is undisclosed, or reasonable basis if it is adequately disclosed. For tax shelters and reportable transactions subject to § 6662A, the preparer must reasonably believe the position is more likely than not to be sustained on its merits.
But disclosure has limits. As Jeremy puts it, “Disclosure can never cure inadequate legal support or substantiation for a position.”
Attaching a form doesn’t replace missing participation evidence or make an unsupported position defensible. Donna’s hours show why.
Donna’s claim turns on 35 hours
Donna’s 15 customer stays averaged six days. Under Temp. Reg. § 1.469-1T(e)(3)(ii)(A), an activity with an average period of customer use of seven days or less falls outside the definition of a rental activity for § 469 purposes. She therefore doesn’t need real estate professional status to potentially treat this loss as nonpassive.
But she still needs to establish material participation.
Under Temp. Reg. § 1.469-5T(a)(3), Donna meets this test if she participates for more than 100 hours during the tax year and participates at least as much as any other individual, including nonowners such as her property manager. Donna reports 145 hours; her property manager reports 115.
At first glance, she passes. Then we examine what she actually did. Her total includes 35 hours reviewing financial reports, analyzing investment returns, and researching tax benefits. Those are investor hours.
Under the rule Jeremy explains, work Donna performs in her capacity as an investor counts toward material participation only if she is directly involved in the activity’s day-to-day management or operations. In this example, Donna isn’t involved in those daily activities. Excluding the 35 hours leaves 110 qualifying hours, which is five fewer than her manager’s 115.
The key fact is her lack of day-to-day involvement, not simply that she hired a manager.
Jeremy already ruled out the other six material participation tests. He concludes that counting those investor hours lacks substantial authority and, in his view, even a reasonable basis. Disclosure can’t solve that problem.
On these facts, Donna’s short-term rental loss is passive and cannot offset her W-2 wages. Any portion of the loss disallowed under § 469 this year generally carries forward to the next tax year.
The research answered the question. Now the practitioner must explain and document the answer.
Build a file that explains your conclusion
Jeremy draws on Circular 230’s diligence framework. Practitioners can generally rely in good faith on information clients provide. If that information appears incorrect, inconsistent with an important fact or assumption, or incomplete, practitioners must make reasonable inquiries.
Use that approach to build a repeatable process:
- Establish the relevant facts. Define the issue before researching. In Donna’s case, ask what she did during the 145 hours she reported and what records support the time she spent on each task.
- Find the controlling law. Start with the Code and regulations; use research tools to locate relevant rulings and cases.
- Read both sides. Compare supporting and contrary authorities with the client’s facts.
- Assess support and evidence. Determine whether substantial authority exists or whether reasonable basis and disclosure are available.
- Document and advise. Record sources, reasoning, conclusions, and uncertainty. Explain the treatment and potential penalties to the client.
For Donna, that means explaining why the 35 hours don’t count and why the loss can’t receive the proposed nonpassive treatment. Offer to prepare the return using the passive-loss treatment. If Donna insists on treating the loss as nonpassive on these facts, decline to prepare or sign a return that takes that position.
Your answer should rest on the law and facts, not on whether you expect an audit.
Listen to Tax in Action, episode 39 to hear Jeremy work through Donna’s case and explain how to weigh the authorities that support and cut against a return position.