Avoid the Latest IRS Audit Trap: Real Estate Investors

Many of my medical practitioner clients have invested in real estate over the years. When it works, there are great benefits of passive income and appreciation over time. And with good management, it can be a fairly hands off investment, which is probably the best benefit of all for a busy practitioner.

Sometimes the tax benefits look very tempting as well. You can invest in real estate to create a paper loss, all the while putting money in your pocket. That’s possible by making smart use of depreciation and especially depreciation valuation for shorter lived personal property items within the property itself, including heating units, air conditioners, cabinets, and even the cost of paving in a parking lot or driveway.

But that’s where it gets a little troublesome for your tax return. If you make less than $100,000 per year, you can take a loss of up to $25,000 in real estate losses against your other income. If you make more than $150,000, you can’t take any of the loss. The loss amount phases out between $100,000 and $150,000.

There is one big loophole: the real estate professional status. Over the past boom years of real estate, a lot of people took advantage of this loophole to be able to take the loss on their otherwise high income tax return.

And with the downturn in the real estate market, it looks like real estate investors have another, perhaps bigger, problem to worry about. IRS audits are on the rise for real estate investors. Currently they are hunting two primary candidates: anyone who owned their property within a Limited Partnership and anyone who claimed the Real Estate Professional status on their tax return to allow a real estate loss against high income.

If you are concerned that you might fall into one of these two categories, here are some tips to prepare you for an IRS audit that might be coming your way.

IRS Survival Tip #1: If you had property within a Limited Partnership in which you held a limited partnership interest, did you have a loss? If so, was this loss taken on your personal Form 1040? This will be disallowed in an audit. One of the other rules to take a real estate loss against your income is that you have to have “material participation” in the property. In other words, you were actively doing something with the property. A limited partner, by definition, can not fulfill this requirement, so the loss will not be allowed.

IRS Survival Tip #2: If you had multiple properties, you will be required to materially participate in each of them to the tune of 500 hours each per year. There is one huge exception: your CPA can file an election with your return to aggregate the properties so that you only have to meet one requirement. Check with your CPA to see if this was done.

IRS Survival Tip #3: If you (or your spouse) are claiming real estate professional status, remember that there are two tests. First, you have to have at least 750 hours per year. Secondly, you must have more hours in active real estate activities than you do in any other business activity. That means you’ll need to produce two logs: (1) Real Estate Activities and (2) Other Business Activity. Be prepared for the IRS to disallow a lot of the real estate activities. Don’t plan to go into an audit with 751 hours and think all is well.

Probably the best advice of all is to not go it alone. If you do get called for one of the thousands of audits happening right now, call your CPA or tax attorney and get expert advice right from the start.

My website, www.TaxLoopholes.com, features strategies to prepare for an audit and what to do if you get the audit notice. If you have real estate investments, make sure you’re prepared.

Diane Kennedy, CPA is the author of the best-selling Loophole of the Rich and Real Estate Loopholes, along with 5 other books. For more tax-saving information, see her website www.LessTaxForDocs.com.