In the near future the IRS will likely be performing more examinations of individual income tax returns reporting rental real estate activity. On March 9, 2011, the Treasury Inspector General for Tax Administration (TIGTA) published the results of an internal audit to identify ways to improve enforcement activity in the area of rental real estate income. The audit was undertaken in response to an August 2008 Government Accountability Office (GAO) report that found, “at least 53 percent 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.”
The TIGTA report demonstrates with a convincing degree of certainty that increased examination of individual returns with rental real estate activity, particularly those reporting losses, could increase the efficiency of IRS agents and help to close the tax gap.
In their review of the results of examinations from various selection sources, TIGTA discovered the “no-change rate” for rental real estate examinations was generally lower than for randomly selected returns. This resulted in a greater likelihood of tax assessments coming from rental real estate examinations. In addition, the average time to complete an examination of these rental real estate returns was lower. This combination of factors results in higher dollars per hour from IRS agent time directed in the area of rental real estate income and losses.
What makes rental real estate income and losses different?
The complexity in reporting the results of rental real estate activity for individuals typically centers on the application of the passive activity rules. For most individuals, losses generated by rental real estate activities are considered passive losses. Under the tax code, losses from passive activities cannot reduce taxable income from “non-passive” sources such as salary, self-employment income, interest or dividends. Net passive losses are suspended and carried forward to future years until the taxpayer has passive income or until they completely dispose of their interest in the activity generating the losses.
There are limited exceptions to the passive activity rules. Taxpayers with adjusted gross income of less than $100,000 may be allowed to deduct up to $25,000 of passive losses in a given tax year. Likewise, certain qualified real estate professionals may be allowed to deduct rental real estate losses against income from non-passive sources.
The tax rules related to the rental of vacation homes or other property used for non-business purposes also requires special attention in determining taxable income. Generally, expenses deductible in determining net rental income must be allocated between the personal and business use based on the relative time the property is occupied for each type of activity. If personal use exceeds certain limits (the greater of 14 days or 10 percent of the days of rental use) then expenses are deductible only to the extent of rental income.
How is the IRS responding to these issues?
Prior to this TIGTA audit, the IRS had already begun to address compliance weaknesses in the reporting of rental real estate activities. Proposed revisions to the form used to report rental real estate activities (Schedule E) will implement the use of common standardized descriptions of rental real estate property in order to aid the IRS in making meaningful analysis and comparisons of the reported activity. Also, taxpayers will be required to provide the actual number of days the rental property was occupied and the number of days the property was used for personal purposes.
These changes are planned to be implemented beginning with Tax Year 2011.
As a result of their audit, The TIGTA put forth three recommendations for the IRS:
- The entities within the IRS responsible for determining examination policy should analyze the population of tax returns with rental real estate activity to identify tax returns with questionable issues, and if warranted, develop and execute a plan for increasing the volume of tax return examinations on returns with rental real estate activity.
- The form instructions relating to reporting passive activity losses should be changed to require more detailed reporting of passive activity losses carried forward from prior years.
- The net amount of income earned or losses incurred from being a “qualified real estate professional” should be captured and transcribed into IRS systems.
How should taxpayers with rental real estate activities respond to increased IRS scrutiny?
The tax code is written to provide taxpayers with allowable deductions and rules for determining their taxable income. Structuring your affairs to take advantage of benefits provided under the law is NOT tax evasion; it is simply sound business practice. By minimizing your total tax liability you further maximize your overall financial return. That being said, an IRS audit is just one more potential risk that property owners face in conducting their business affairs. Just as you insure against the risk of fire, flood or theft, you should take steps to be prepared in the event this “disaster” strikes.
If you own rental real estate you have to be sure to properly account for, document, and report the income and expenses related to your investment. If you choose to prepare your own tax returns you must work to educate yourself completely and comply with the tax law. For most people, hiring a knowledgeable and qualified tax preparer is a worthwhile investment.
Even if you use a CPA or other professional remember that you are still responsible for your own tax return. Be sure to keep through and accurate records of income and expense. Communicate with your tax preparer to insure they are fully informed and engage them to assist you in proactively preparing for the risk of IRS audit. Complete, well-organized records and supporting documentation are without a doubt the keys to quickly and efficiently resolving an IRS examination in your favor.
If you are selected for audit, it is probably worthwhile to consider having a qualified CPA or enrolled agent represent you before the IRS. Not only can they help you identify and manage any errors or potential exposure on your return, but they can also help you organize and present the necessary documents to the IRS in the best possible way. Most importantly, they can communicate with the agent conducting the examination without the anxiety and fear that accompanies most taxpayers on a trip to the IRS.
If you have any questions or concerns pertaining to an audit or your real estate, fill in the form below and one of our specialists will be in touch.
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