Introduction
If you have a rental property, whether it's a small
strip center, a home you inherited from your parents, or just a vacation
home that you rent during the off season, your rental losses are
generally limited through the passive activity rules. The passive
activity rules only allow losses from passive activities to offset
income from passive activities. Some activities, like real estate
rentals, are inherently passive. Other activities, such as a LLC or S
corporation that operates a retail business isn't passive per se, but to
the member or shareholder it's passive unless that individual
materially participates in the activity. (For a definition of material
participation, go to our article Material Participation.)
There's
a special exception for rental real estate. If you can show you
actively participate in the activity, losses of up to $25,000 a year can
be used to offset ordinary income as long as your adjusted gross income
(AGI) is $100,000 or less. For every $1 of AGI over $100,000, the
$25,000 exemption is reduced by $0.50. Thus, if your AGI exceeds
$150,000, none of the losses come under the exemption. Instead, the
losses can only be used to offset passive income from rental real estate
or carried forward to be used under the same rules in subsequent years.
Any accumulated losses can also be deducted on the disposition of the
property.
The $25,000 exemption may be cold comfort for many
taxpayers. It's pretty easy to broach the $100,000 AGI threshold (which
hasn't changed since it was put in the law in 1986). And, as a result,
the limitation allows the losses to be used only when you're in a lower
bracket.
Real Estate Professionals
Some investors have
another option. "Qualifying taxpayers" also known as "real estate
professionals" can deduct rental property losses without the limitations
discussed above. For example, you've got three rental properties where
the net losses from the properties total $75,000. If you qualify, the
entire $75,000 can be deducted. A taxpayer is a real estate professional
if:
The taxpayer owns at least one interest in rental real
estate, more than one-half of the personal services the taxpayer
performs in trades or businesses during the tax year are performed in
real property trades or businesses in which the taxpayer materially
participates, and the taxpayer performs more than 750 hours of service
during the tax year in real property trades or businesses in which the
taxpayer materially participates.
Real property trade or
business, as defined here, means any real property development,
redevelopment, construction, reconstruction, acquisition, conversion,
rental, operation, management, leasing, or brokerage trade or business.
If you are an employee of the business, the work only counts if you are
at least a 5-percent owner at all times during the year. For example,
you have a 50%-interest in an LLC in the construction business.
Taxpayers
who have a number of properties may meet the 750-hour threshold by
simply working on the properties. For example, Sue owns five
single-family properties and a seven-unit strip mall. She also has at
least one property she's rehabbing at all times. She not only does
recordkeeping, banking, and administrative functions for the properties,
she oversees maintenance, renovations, gets building permits, etc. Her
time spent at these activities during the year exceeds 750 hours and,
aside from a couple of hours a week working for her husband's business,
that's her only trade or business. Sue qualifies as a real estate
professional.
Fred is in much the same situation as Sue. He has a
number of rental properties and materially participates in the
management for 800 hours during the year. However, Fred is a attorney
who spends 1,200 hours a year in his legal practice, almost all drafting
leases and purchase and sale agreements for real estate. Since he
doesn't spend more than one-half of his time performing personal
services in the real property trade or businesses (he's in the legal
profession), he doesn't meet the second part of the test above.
Some other points:
A
husband and wife can't combine their time to meet the 750-hour
requirement. One party has to meet the requirement on their own. Meeting
the material participation requirement may not be easy. There are seven
possible ways to do so, but it can still be difficult. For a complete
discussion see our article Material Participation. Only your
participation in rental real estate can be used to determine if you
materially participate in the rental real estate activity. Material
participation is much more than approving tenants, repair work, etc. and
sending a check to the management company. If you hold the property in
your own name or as the sole member of an LLC the ownership and grouping
rules are simple. However, the grouping of rental activities can get
more complicated if you have interests in pass-through entities such as
partnerships or S corporations that hold real estate. Check with your
tax advisor. Short-term rentals (where the average rental period is less
than seven days at a time) such as a vacation home, aren't part of the
rules here and participation in such an activity doesn't count toward
meeting the 750-hour requirement. That's considered a separate trade or
business.If you provide significant services to the tenants that are not
usually provided with a lease of real estate, the activity may not be a
rental. For example, you own a strip mall, and in addition to the usual
maintenance, you organize special events for the center, help with
cooperative advertising, etc.
Grouping Election
Generally,
you have to meet the 750-hour and more than half of your personal
services in the real estate activity for each property. However, you can
make an election to group all your properties for purposes of meeting
the requirement and deducting the losses. You can do this by filing a
statement with your original return for the tax year for which the
election is to first apply. Simply grouping the properties, deducting
the net losses and checking the box on the second page of Schedule E
won't meet the requirement. While there is no set wording, you must
state the election is made under IRC Sec. 469(c)(7)(A) and that you want
to group all your interests in rental real estate as a single rental
real estate activity. The election, once made is irrevocable unless
there's a material change in the your circumstances. Talk to your tax
advisor.
In a recent revenue procedure (Rev. Proc. 2011-34, IRB
2011-24) the IRS recognized that many taxpayers were not aware of the
requirement to file a statement to group the properties. The revenue
procedure provides a means for taxpayers to make a late election that
will be considered as timely filed. In order to meet the requirements of
the procedure, you must have filed consistently with having made an
election on any return that would have been affected if you had timely
made the election. You must have filed all required federal income tax
returns consistent with the requested aggregation to be effective. You
must also have timely filed the returns. A return will be treated as
timely filed if the return is filed within 6 months after its due date,
including extensions. You must also have a reasonable cause for failure
to file the statement.
If you can't comply with the requirements
of Rev. Proc. 2011-34, you may still be able to correct a late filed
election, but you'll have to apply for a letter ruling.
Audit Issues
If
you're audited you can expect the agent to scrutinize the facts to make
sure you qualify as a real estate professional. If you have a regular
job, meeting the more than one-half requirement will be difficult, and
the IRS knows it. Meeting the 750-hour requirement is not easy, nor is
the material participation requirement. The best approach is to keep a
log or diary of your activities, detailing work performed, hours, etc.
It'll help if you can substantiate your entry with receipts, invoices,
etc. For example, a trip to the hardware store on 6/11 can be
substantiated with a receipt for plumbing supplies. While there are
other ways to substantiate your time, a well-kept, contemporaneous log
or diary should forestall any questions by the agent.
Documentation is More Than Invoice and Canceled Check
Tax
Court cases are often good guides to what happens in practice. In one
recent case (C. Michael and Gwendolyn E. Willcock, T.C. Memo. 2010-75)
the taxpayer lost several deductions. If some of the facts below sound
familiar, you should be taking a look at your recordkeeping.
Car and Truck Expenses
The
IRS denied the taxpayers' claimed deductions for car and truck expenses
for tax years 2002 and 2003, respectively. In 2002 the taxpayers drove
an Audi and a Land Rover, both of which were claimed to have been driven
solely for business purposes. The taxpayer's wife had veneers (cosmetic
dental applications) applied to her teeth by petitioner husband. The
taxpayers claimed that any time petitioner wife drove anywhere in one of
the vehicles she was "a walking, talking billboard for the dental
office" because of the veneer work the husband had performed.
Additionally, each vehicle had a license plate holder that displayed the
name of the dental practice. The husband used the vehicles to perform
various tasks for the dental practice, such as purchasing office
supplies. During 2002 and 2003, the taxpayers owned four vehicles: a GMC
Envoy, an Audi, a Land Rover, and a Chevy Tahoe. The wife testified
that she drove the Audi until the lease expired, after which she drove
the Land Rover.
The taxpayers started leasing the Land Rover on
May 1, 2002, and the dental practice claimed deductions for lease
payments with respect to both the Land Rover and the Audi during 2002.
They leased the Audi until February 10, 2003. During 2002 and 2003 the
taxpayers also reported a $750 monthly expense for "GMAC", which is
reflected in their car and truck expenses for 2002 and 2003. It was
unclear which vehicle these payments were for. The vehicles were owned
or leased by the taxpayers individually, not by the dental practice;
however, the dental practice claimed the deductions.
The Court
noted a taxpayer is entitled to deduct transportation expenses incurred
in carrying on a trade or business. Commuting expenses, however,
incurred in going from a taxpayer's residence to his or her place of
business and returning are nondeductible personal expenses. When a
taxpayer uses a car for personal as well as for business purposes, he or
she must allocate expenses between personal and business use. The
taxpayers did not allocate their expenses.
The law requires that
sufficient records be maintained to establish the amount of any
deduction claimed. A taxpayer must indicate mileage, including total
business, commuting, and other personal mileage, percentage of business
use, date placed in service, use of other vehicles, after-work use,
whether the taxpayer has evidence supporting claimed business use, and
whether or not the evidence is written. The taxpayers did not provide
this information.
Section 274(d)(4) provides that no deduction is
allowed for listed property (e.g., cars, trucks) as defined by Section
280F(d)(4) unless the taxpayer substantiates by adequate records or
corroborative evidence (1) the amount of such expense, (2) the time and
place of use, (3) the business purpose of the expense, and (4) the
business relationship of the taxpayer to the persons using the property.
Pursuant to Section 280F(d)(4) listed property includes, with certain
exceptions, "any passenger automobile" or "other property used as a
means of transportation".
The IRS denied these deductions,
claiming that the taxpayers failed to adequately substantiate the
expenses or provide information that the amounts were incurred as
ordinary and necessary business expenses. In order to substantiate the
expenses the taxpayers offered canceled checks and credit card bills for
various items such as repairs and gas. Additionally, the taxpayers
offered a series of handwritten calendars that detail their daily work
schedules, but not the particular use of the vehicles for which expenses
were claimed. They used their cars for personal as well as business
purposes; however, the taxpayers claimed all use was business related
because each vehicle had a license plate holder that displayed the name
of the dental practice. They contended that even when the vehicles were
being used for personal reasons they provided a valuable advertising
service to the dental practice. They did not maintain records allocating
personal and business use of their cars. They also commuted to the
dental practice from their home daily, but did not make an allocation
for any commuting to and from the dental practice.
The taxpayers
failed to prove that the vehicles were used in the conduct of a trade or
business as defined under section 162. In addition, they failed to
maintain adequate records to substantiate the use of their vehicles
under Section 274. The Court disallowed the deductions in full.
Section 179 Expense Deduction
The
dental practice claimed Section 179 expense deductions for tax year
2003 for $38,630. The IRS partially disallowed the section 179 expense
deduction for 2003 claimed in regard to the GMC Envoy. On the dental
practice's return, the taxpayers reported that the GMC Envoy was placed
in service on November 18, 2003, and that it was used solely for
business purposes. They purchased the GMC Envoy after the lease for the
Land Rover expired. The lease on the Land Rover ended sometime after
2003, i.e., in 2004. The Court noted it appeared that the taxpayers
retained the Land Rover lease through 2003, and purchased the GMC Envoy
after 2003. The GMC Envoy bore a license plate holder with the name of
the dental practice. The GMC Envoy was titled in the taxpayers' names
rather than in the name of the dental practice, which claimed the
deductions.
Subject to certain restrictions, a taxpayer may elect
to deduct as a current expense the cost of any Section 179 property,
that is acquired by purchase, used in the active conduct of a trade or
business and placed in service during the taxable year.
The
dental practice claimed Section 179 deductions for tax year 2003 of
$38,630. The IRS disallowed the Section 179 deduction claimed in 2003
for the GMC Envoy the taxpayers claimed was used solely for business
purposes. The Court noted it was unclear whether the taxpayers placed
the item in service in 2003 or in 2004 after the lease on the Land Rover
expired. They offered no other evidence to corroborate their claimed
placed-in-service date. The Court sided with the IRS in denying the
deduction.
Travel Expenses
The IRS disallowed travel
expenses of $5,082 for 2002, which the taxpayers claim they incurred
during a business trip to Hawaii for a dental conference. They were in
Hawaii from May 3 through 12, 2002. They testified that the dental
conference was held from May 7 through 10, 2002. The taxpayers presented
the Court an invoice for the purchase of dental equipment which they
claim they purchased in Hawaii during the conference. The invoice,
however, states only when the equipment was purchased, not where it was
purchased.
The Court noted the taxpayers offered no probative
evidence to substantiate their attendance at the seminar, nor did they
offer any probative evidence to support the business purpose of the
trip. The taxpayers produced no evidence supporting any of the expenses
claimed, which included meals, first-class airline tickets, and taxi
fees. The Court held the taxpayers failed to substantiate that their
claimed expenses were in any way related to their dental practice. The
Court allowed only the travel expenses allowed by the IRS.
Professional Fees
The
taxpayers deducted professional fees of $10,080.50 for tax year 2002,
which amount they claimed was paid to the pastor of the taxpayers'
church. The taxpayers hired the pastor to instruct the wife in the areas
of networking and marketing so that she could be a more effective
salesperson and marketer for the dental practice. These instructional
sessions purportedly occurred in the taxpayers' home and, for a brief
period of time, over the telephone. They presented copies of Forms
1099-MISC, Miscellaneous Income, in support of these claimed expenses
for consulting. No Social Security number is listed for the pastor on
either form, and no evidence was offered to confirm that the tax forms
were actually delivered to the pastor. The pastor did not testify at
trial. The taxpayer wife's testimony was contradictory. The Court held
the taxpayers did not meet their burden of substantiating the
expenditures and denied the deduction.
Janitorial Services Expense
The
IRS reduced the dental practice's claimed janitorial expenses for both
2002 and 2003. With respect to 2002, the dental practice claimed
janitorial expenses of $20,226. The only expenses in dispute were
certain expenses of $12,208 in connection with payments claimed to have
been made to the "Sotelos", a landscaping service. The taxpayers
testified that these expenses were reported on their 2002 income tax
return, and represented expenses incurred for landscaping services
provided to the dental practice. All of the invoices from the Sotelos
were addressed to petitioners at their home address, and were not
addressed to the dental practice, or sent to the dental practice
address.
Of the disallowed amount, $1,500 represents an amount
the taxpayers claim to have paid to their son on behalf of the
condominium association where the dental office is located. The
taxpayers claimed that they paid their son to provide landscaping
upgrades to the dental practice. However, they presented no
documentation supporting this claimed expense. The remaining $6,074
reflected a payment to their son, as evidenced by a Form W-2 petitioners
generated. The taxpayers provided no evidence of the services which
their son purportedly provided for this amount.
The Court found
the taxpayers failed to substantiate that these claimed expenses had a
business purpose or that the services were even provided to their
business, rather than to them personally. The Court disallowed the
expenses.
Loan to Son
The IRS used the bank deposits
method of proof to reconstruct the taxpayers income and determined
unexplained deposits of $8,500 should be included in income. Deposits in
a taxpayer's bank account are prima facie evidence of income, and the
taxpayer bears the burden of showing that the deposits were not taxable
income but were derived from a nontaxable source. The bank deposits
method assumes that all money deposited in a taxpayer's bank account
during a given period constitutes taxable income, but the Government
must take into account any nontaxable source or deductible expense of
which it has knowledge. The taxpayers claimed the $8,500 was repayment
of a loan made to the taxpayers' son. The taxpayers were able to show
two checks, one for $7,200 and another for $1,300 written on their son's
account and deposited soon thereafter in their account. (The taxpayers
also were able to show payments for $8,500 out of their account for the
purchase of the car.)
Supporting Documentation
The case
discussed above is far from unique. In fact, it's the type of issues
CPAs encounter regularly. A canceled check and an invoice sometimes
isn't sufficient to completely secure the deduction. Moreover, small
businesses are particularly vulnerable to a challenge. Taxpayers often
make it worse by mixing business and personal finances. Here are some
points to keep in mind.
Keep it all business. You'll reduce
questions from the IRS (and make your accountant's job easier) if you
keep your business account all business. For many small business owners
that's tough to do. Many owners are perpetually short of cash to pay
their personal expenses. If you must, you may be better off writing one
large check (e.g., the annual real estate tax for your home and don't
try to deduct it) rather than a bunch of small ones. The one large one
will be easier to trace and it won't look like you're trying to deduct
personal expenses.
Keep good deposit records. If you're paid by
check or cash, be able to match deposits with invoices. Try to deposit
funds daily. That's especially important if you have a significant
number of transactions each day. Document deposits from non-sale
sources. For example, the business needs a cash infusion; you loan it
$5,000. Document the loan and make sure the check is deposited at or
about the same time. Keep a copy of the check and the bank statement
showing the amount so you can trace the funds from your personal (or
other business, etc.) account to the business account. Keep records of
asset sales, repayment of loans to shareholders or employees, etc.
Expenses
paid personally. Instead of getting that cell phone in the business
name, you do it personally because you can save $6 per month. Great, but
now you've made your accounting more complicated. You should probably
pay the expense personally and put in an expense report for the amount.
Make sure you can show the business use. Talk to your accountant for his
suggestions. Unless there's some compelling reason to pay it
personally, do it through the business.
Travel and entertainment.
Always an IRS hot point. You should know what you need--time, place,
amount, person entertained, business discussed, etc. But you may want to
take it further. If there's any chance of it looking like pleasure,
keep a detailed diary. For example, business trip to Plattsburgh, NY in
January? No one is going to suspect a pleasure motive (unless you have
family there). You can probably get away with the normal IRS
requirements. Business trip to Fort Lauderdale the next week? Keep a
diary. Obvious you were on business? To you maybe, but not to an IRS
agent. Be even more careful if you're actually combining business and
pleasure on the same trip. Seminars? Use the diary and keep the
workbooks, notes, etc. from the lectures.
Details of work
performed. The plumber you called to install a new sink in the office
could just as easily put a new tub in your home. The auto repair shop
could work on the business truck or your personal auto. Get a detailed
invoice showing the work performed, the location, vehicle
identification, etc. And make sure you send out 1099s (if applicable) at
the end of the year. Have invoices mailed to the appropriate
address--business or personal.
Items purchased with dual purpose.
Some businesses use items that could be used personally. In some cases,
that could be "listed property" such as cameras, computers, audio
equipment, etc. You need to keep a diary of business vs. personal usage.
(There are exceptions; check with your accountant.) But there are other
items that don't show up on the IRS list where you could be questioned.
Be sure you can document the business use. Gas purchases for the
business vehicle--record in a diary and keep with the vehicle.
Consider
standard mileage method. In some cases you might come out ahead using
the standard mileage method (see our article Standard Mileage or Actual
Expenses?). Even if you don't, the IRS can't challenge your expenses,
only your business mileage if you use the standard mileage method.
Document
confusing issues. You've got two car loans from the Chatham National
Bank--one for your personal vehicle, one for the business. You
diligently write a personal check for your car and a business check for
the business truck. But if you're audited could you prove which was
which? Keep a copy of the loan documentation along with details of the
purchases. Same thing for business credit card payments. Make sure you
can match the monthly statement to the check or withdrawal amount for
the business card.
Conflicting documentation. If you keep
contemporaneous records, chances are you won't have this problem. But on
more than one occasion we've seen court cases where the court looks
beyond the plane ticket and credit card statement, etc. In one case the
court looked at the taxpayer's car log showing he drove 500 miles to a
distant city on the same day a plane ticket showed he flew there. Or a
trip to the bank on a Sunday. Reconstructing records later often results
in these problems. And it won't be just that one 500-mile car trip
that's disallowed. The court threw out his log, finding it unreliable.
More information. For more information on documentation, see our article Expense Documentation.
Kenneth
Hoffman counsels Entrepreneurs, Professionals and Select Individuals in
taking control of their taxes, and businesses. Discover how I can help
you overcome your tax and business challenges. To start the conversation
or to become a client, call Kenneth Hoffman at (954) 591-8290 Monday -
Friday from 8:30 a.m. to 1:00 p.m. for a no cost consultation, or drop
me a note.
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