Real Estate Losses Become An IRS Tax Audit Target

Sorry, real estate investor, the Internal Revenue Service is coming to get you, and it won't be pretty.

The IRS is stepping up property scrutiny as a result of a 2008 Government Accountability Office finding: "At least 53% of individual taxpayers with rental real estate activity for Tax Year 2001 misreported their rental real estate activity, resulting in an estimated $12.4 billion of net misreported income."

That spurred the Treasury Inspector General for Tax Administration, an independent overseer, to evaluate how the IRS covers individual tax returns with rental real estate activity and to propose changes. These changes amount to a call to war on real estate tax cheats. The IRS is also going to require substantial additional accounting records and costs for all real estate investors.

Gaining From Losses

The Dec. 20 TIGTA report specifically recommended that the IRS boost the number of audits of tax returns showing real estate losses. Based on a study of fiscal 2008-09 data, it projected that increased tax examinations could add up to $27.3 million in tax assessments over five years.

"Taxpayers are likely to see rental-property-related audits rise starting almost immediately on all open tax years," said Audubon, N.J., CPA Joel Petchon. "As of April 15, 2011, returns filed for 2007 in April 2008 will be insulated by the three-year statute of limitations. All others will be subject to potential audit."

Real estate investors are normally in higher marginal tax brackets, so such examinations should be more productive than exams of other taxpayers.

"Harvest the crop where the yield is highest," Petchon said. "The IRS collects a whole lot more when it disallows a loss at 35% than it does at 10%."

The IRS is already revising Schedule E, the form on which real estate investments are reported, for 2011. Expect to report much more detail on rentals, starting with the type of property rented — such as whether it's a condo, single-family home, duplex or commercial property. Real estate investors will also have to list the number of days the property was occupied as well as the number of days used for personal purposes.

Under existing rules, if the property was used personally for the greater of 14 days or 10% of the days it was rented to others at a fair market price, real estate deductions will be limited to mortgage interest, real estate taxes and casualty losses. Also allowed are other expenses directly related to the use of the property as a rental, such as advertising and rental agent fees.

Other deductions such as insurance for the term rented, general repairs and depreciation will only be allowed to offset rental income. Such expenses won't be allowed to create a net rental loss. But, any amounts not deducted in 2010 can be carried over to 2011 to offset 2011 rental income.

TIGTA's report suggests passive losses are apt to be one target of scrutiny, especially when claimed by taxpayers alleging to be real estate professionals.

Pros And Tax Cons

Those claiming exemption from the passive loss limitations because they are "real estate professionals" will be subject to additional screening immediately to see if they truly do qualify. A "real estate professional" needs to spend more than 50% of her time and at least 750 hours during the year to qualify. Otherwise, the passive limitation rules apply. They limit real estate losses to a maximum of $25,000 per year.

Under the passive loss limitation rules, as a taxpayer's income (without considering potential losses) increases over $100,000, each dollar costs an investor a 50-cent reduction in potential allowable losses. So, when income exceeds $150,000, no real estate losses are allowed for the current year. These losses are suspended until either the property produces positive income or is sold. At that point, any suspended passive losses are allowed.

A qualified real estate professional who has, say, rental real estate with losses is not subject to these limitations and can deduct all of the losses immediately.

The TIGTA also recommended that the IRS require all taxpayers with unallowed passive losses in prior years to submit Form 8582, Passive Activity Loss Limitations, to improve the efficiency of the programs used to select tax returns with questionable real estate activities for further examination. Previously taxpayers didn't have to file the form if they didn't have any losses in the current year.

The new rules are designed to catch tax cheats. But they will make things a little more laborious for law-abiding citizens as well.

"It's getting real hard to land a break in this business," said Joel Berinson, president of Ultra Mortgage in Marlton, N.J. "First the real estate market crashes, and now the IRS threatens to audit you because you have losses? Where have they been the past couple of years?"

At least real estate investors may be about to dodge one big tax-reporting bullet. If not for repeal legislation now awaiting the president's signature and expected to get it, those paying for repairs of $600 or more would have soon had to start providing 1099s to their plumbers, painters, handymen and other workers, with copies to the IRS.