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Tax Audits for Real Estate Professionals
On Wednesday, September 9, 2015, the U.S. Attorney’s Office for the District of Minnesota posted the following headline on its website:
Former Minnesota Real Estate Developer Sentenced To 78 Months in Prison And $1.5 Million Special Assessment For Tax Evasion, Mail And Wire Fraud
The evidence presented at trial proved that from 2009 until January 2012, the real estate developer willfully evaded the payment of employment and excise taxes owed by him and the three businesses he controlled. One of the ways he avoided paying taxes was by transferring over $1.1 million into a bank account in the name of a shell company with no legitimate business purpose but used by him to pay personal expenses. The developer evaded payment of more than $700,000 in taxes.
He had also filed a fraudulent financial statement, making numerous misrepresentations to the IRS to avoid paying the taxes he owed. For example, he failed to disclose multiple personal vehicles that he owned, and he denied the existence of the shell company’s bank account, which he was using to receive monthly compensation of $50,000 from two of his companies. The developer also falsely claimed to be living in Bayport, Minnesota, when, in truth, he had already moved into a $1.4 million house he was purchasing in Knoxville, Tennessee.
Read on to know how you can save yourself from becoming a similar cautionary tale.
Who is a Real Estate Professional?
To be a real estate professional, an individual must spend the majority of his or her time in real property businesses:
- Development or redevelopment
- Construction or reconstruction
- Acquisition or conversion
- Management or operation
Furthermore, to qualify as a real estate professional, the taxpayer must spend:
- more than 50 percent of his/her time in real estate activities; AND,
- more than 750 hours in real estate activities.
From our experience, we know that your examiner will give serious attention to the fact whether you are able to satisfy him that you materially participate in one or more of the specific real estate trades or businesses listed above. The examiner will try to determine who is the real estate professional, husband or wife. The auditor will request and closely examine your documentation regarding time. You are required under the law to provide proof of services performed and the hours attributable to those services.
We advise you to seek legal guidance from a dually California licensed Tax Attorney and CPA immediately if you or your business entity (S Corp, C Corp, LLC, Partnership, etc.) have received an audit notice from the IRS or a California Taxing Authority, such as Franchise Tax Board (FTB), the California Department of Tax and Fee Administration (CDTFA) and the Employment Development Department (EDD) concerning a tax audit. Depending on what the federal or California auditor finds, an examination of your business and personal tax filings could lead to devastating outcomes, including an unexpected tax assessment, costly accumulated interest, and/or substantial civil penalties—none of which even begins to approach the danger involved in an IRS or California criminal tax investigation. If the government believes that there is strong enough evidence to prosecute you for tax evasion or related offenses successfully, you will be at risk of jail time, in addition to much higher financial fines and criminal restitution.
A taxpayer materially participates in an activity if he or she works on a regular, continuous, and substantial basis in operations. If a taxpayer does not materially participate, losses are passive, which means they generally are not deductible in the absence of passive income. Material participation is time sensitive.
Under an audit, you shall be required to identify the amount of your participation in a trade or business activity for each year. The type and quantity of time documented shall determine whether an activity should be treated by you as passive or non-passive. Please note that you can have a significant financial interest in a business and yet not materially participate. Real estate investing is generally passive under the tax code but can rise to the level of trade or business depending on the individual facts and circumstances of your case.
Material participation is a year-by-year determination. Consequently, it is conceivable you could be passive in one year and non-passive (in other words, materially participating) in the subsequent year. An examiner will try to determine if reported losses are classified properly on your given return. Losses from businesses, whether conducted as a Schedule C, Schedule Form, partnership, or S Corporation, are passive if the taxpayer does not materially participate.
Material participation does not apply to the following activities:
- Rentals are generally passive, whether or not the taxpayer materially participates. However, rental real estate interests of real estate professionals are subject to the material participation tests.
- Working interests in oil and gas activities are excepted from the passive loss limitations. If liability is not limited, the taxpayer has a “working interest.”
- Income from a partnership or S Corporation that trades in stocks, bonds, or securities for the accounts of the partners or shareholders is non-passive. Income or losses, even from a limited partnership interest, may be deducted as non-passive.
You should know that The IRS and California taxing authorities, such as the Franchise Tax Board (FTB), the California Department of Tax and Fee Administration (CDTFA), and the Employment Development Department (EDD), have been aggressive in auditing real estate professionals. To survive the audit and prove that the statutory requirements have been met, it is critical that taxpayers establish credibility by maintaining detailed, accurate records. Let us discuss some of the common issues faced by taxpayers involved in the real estate industry.
Passive Active Loss
Prior to 1986, a taxpayer could generally deduct losses in full from rental activities and trades or businesses regardless of his or her level of participation. This gave rise to significant numbers of tax shelters that allowed taxpayers to deduct non-economic losses against wages and investment income. The Tax Reform Act of 1986 added IRC § 469, which limits the taxpayer’s ability to deduct losses from businesses in which he or she does not materially participate and from rental activities.
Federal tax law disallows any deduction for a taxpayer’s net loss from passive activities for the year. Passive activities include, by definition, any rental activity, including any rental activity conducted through the means of a separate entity, such as a partnership or limited liability company. An exception to this disallowance rule prevails if the taxpayer is deemed a “real estate professional.” Passing muster as a real estate professional requires the taxpayer to meet certain statutory tests (see above). Difficulties can arise in meeting these tests, especially if taxpayers are nonchalant about keeping good records.
Section 469(a) of the Internal Revenue Code provides that no tax deduction is allowed for the taxpayer’s net passive loss for the year. The passive loss rule applies to all taxpayers other than taxable corporations, so called C corporations. Losses from one passive activity are allowed only to the extent that there are other passive activities that generate a net profit. Passive activities can include more than rental operations. For example, allocations of income and loss from limited partnerships, no matter what the business purpose of the partnership, are generally considered passive in nature.
Any excess passive loss not deductible in the current year is suspended and can be carried forward indefinitely into future years and can be deducted if there are net profits from passive activities. Alternatively, if a passive activity is sold, the taxpayer can deduct all suspended losses at that time. There is no expiration of the suspended losses as long as the taxpayer still owns the property in question. Rental activities are passive activities by definition.
The passive loss rules are extraordinarily complex and obtuse. Let’s use some examples to depict the basics of the passive loss rules as they apply to rental activities.
Julia is a full-time attorney who leases a single-family residence to tenants. This is her only passive activity. Her adjusted gross income (AGI) for the current year, Year 1, is $200,000 before considering any rental loss. For Year 1, the rental had a loss of $(15,000). Julia is not allowed to deduct any of this loss for the current year. Rather, the loss is suspended and carried forward into future tax years, starting with Year 2, when it can offset future profits generated by the rental residence or profits generated by any other passive activity.
Continuing with Example 1, assume that during the following year, Year 2, the rental residence shows a net loss of $(5,000) through July 1, at which time Julia sells the residence. Julia can now deduct all $20,000 of the losses from the rental, as she has disposed of her entire interest in this passive activity. She is allowed to deduct all these losses in Year 2 even if the rental residence had been sold at a loss.
The foregoing examples included a mention of adjusted gross income (AGI) for the taxpayers. AGI is basically the taxpayer’s gross taxable income for the year, less business deductions, rental losses, and contributions to retirement accounts. Readers may know this as the so-called “bottom line” on page 1 of Form 1040. From AGI, various other deductions, such as home mortgage interest, property taxes, and charitable contributions, are deducted in deriving taxable income.
How are Real Estate Professionals Audited?
You must understand that your examiner will scrutinize your situation thoroughly. Expect to be asked: What are your real property trades or businesses? Where do you materially participate? Are you or is your spouse the real estate professional?
You will be requested to provide documentation of your timekeeping; the auditor is likely to closely examine your log. The examiner will scrutinize all activities you are involved in—even if they are not related to real estate and even if you are not getting paid.
You will be interviewed. You will be asked questions about your personal life, business, civic activities, philanthropy, family obligations, and hobbies. Be mindful that the examiner is building a case around all of your time spent in all activities to determine the remaining time available for real estate. The examiner is going to assess your credibility.
Knowing what to say and, more importantly, what not to say is the key to the entire process. Therefore, it is absolutely crucial that you are thoroughly prepared for an audit. While representing you, we strive not to be surprised by anything raised by the IRS or a California taxing authority conducting the audit or disclosed by you during the course of the audit. That is where our years of experience comes in. Once we determine that you might be facing potential criminal tax liabilities, your primary goal becomes the prevention of initiation of a criminal tax investigation, and we do whatever we can to achieve that.
Our Approach to Dealing with Audits
During an eggshell audit, the IRS or a California taxing authority is looking for the possibility that you, as a subject of a civil audit, will make a mistake and provide information leading to the initiation of a criminal tax investigation. As your attorney representing you in an eggshell audit, our goal is extremely clear: the resolution of the audit without a referral by the civil examiner to the IRS’s criminal investigation division (CID). However, as simple as that goal is, reaching it is cumbersome and perilous. That is where we come in!
Using our decades of experience, we have distilled our approach to four key aspects while we represent you as you undergo an eggshell audit:
- Understanding deeply how civil audits arise and the steps that need to be taken as your counsel to prepare you for the audit;
- Recognizing when you are facing an eggshell audit and recognizing whether you might have committed criminal tax fraud;
- Key techniques to employ when representing a real estate entity going through an eggshell audit and the signals to look for when evaluating whether a civil investigation has turned criminal; and
- Steps to take after a criminal investigation has started to lessen the possibility of referral for prosecution.
The IRS is very thorough in its approach and has a deep understanding of all vulnerable areas related to the tax filings of those in the real estate industry. The IRS audits real estate entities so frequently that it has even developed a Passive Activity Loss Audit Technique Guide to assist its IRS Revenue Agents during audits by providing insight into the issues, accounting practices, and methods unique to the real estate industry. In general, the guide identifies issues unique to the real estate industry of which the Revenue Agents should be aware. It directs Revenue Agents to look for certain vital sources of information and outlines steps and techniques to be taken in conducting effective and focused audits/investigations of real estate entities. However, using our extensive experience, we use the same tools to the advantage of our clients. In other words, we know what weapons and strategies the other side might deploy, making us ready to defend every blow that might come our way.
If you know you cheated on your tax returns, the biggest mistake you can make is to consult the original preparer. The reason is that they are likely to become the primary witness against you if the government decides to initiate criminal tax proceedings. They would have absolutely no incentive to protect you and are likely to reveal everything, including the information that you thought was confidential. A CPA, EA, or CTEC certified preparer generates most of his income from tax accounting and preparation; thus, they are strongly motivated to protect their reputation with the taxing authorities at the expense of your reputation. As uniquely qualified and extensively experienced Criminal Tax Defense Tax Attorneys, KovelCPAs our firm provides a unique platform to efficiently achieve the optimal and predictable results that simultaneously protect your liberty and your net worth.
If you have failed to file a tax return for one or more years or have taken a position on a tax return that could not be supported upon an IRS or state tax authority audit, eggshell audit, reverse eggshell audit, or criminal tax investigation, consider hiring the Tax Law Offices of David W. Klasing. Hiring our firm can make all the difference between paying the proper amount of income taxes due, as opposed to doing jail time, paying a hefty penalty, and paying for the cost of a long and agonizing prosecution.
Defending Audits Challenging Taxpayers’ Status as Real Estate Professionals
Investing in rental real estate is often pitched to taxpayers by various financial advisors, often out of their own self-interest by the way, as a viable investment option because of the propensity of rental real estate to throw off tax losses that are commonly perceived to be fully available to offset other income generating activities while simultaneously producing positive cash flow largely because of depreciation expense, which is a non-cash deduction. Also genuinely attractive from a tax planning perspective is the liberal use of section 1031 of the Internal Revenue Code to defer tax gains in a subsequent piece of rental real estate by tax free exchanging into the next property rather than by selling and then purchasing another property. With over 20 years of focused rental real estate tax experience I have developed a distinct set of skills that allows me to identify and resolve rental real estate tax issues in a comprehensive manner.
With the current real estate crisis, taxpayers who have taken the position that they are real estate professional routinely find themselves under attack by the IRS which is refusing to share in the collapse of the real estate markets. California does not recognize the real estate professional exception so exposure is usually solely a federal matter. Few attorneys are competent to handle the multiple taxation complexities that arise during audits where challenges to Real Estate Professional status or post 1031 basis are encountered. The cold hard reality of the situation for taxpayers who feel that they were treated unfairly during an audit is that there is only a few recourse options available. The options generally are 1) to seek audit reconsideration on the issue, 2) file an appeal, and 3) if the appeal is unsatisfactory go to tax court.
To get the most of these limited opportunities it is vital to have a zealous advocate. It is sometimes said that while the focus of an accountant is accuracy, the focus of an attorney is advocacy. Our Office’s expertise and training combines both fields. As a certified public accountant (CPA) and tax attorney, I have comprehensive knowledge of federal and state tax codes, regulations and case law.
Audits for Those Claiming Rental Real Estate Passive Activity Loss
To curtail the tax perceived tax planning opportunities detailed above, Congress legislated that rental activities are by definition passive activities under Internal Revenue Code Sec. 469 regardless of whether or not a taxpayer materially participates in the rental activities or not. As a general rule passive activity expenses are limited by tax code to the amount of passive activity income making it impossible to throw of a loss from the activity without meeting an exception to the passive loss limitations rule. A taxpayer has a passive activity loss for the tax year if his or her losses from passive activities are greater than his or her income from passive activities for a given tax year.
Because of the passive activity rules, ordinarily rental passive activity losses are at worst non-deductible and at best partially deductible by congressional design. This harshness is somewhat mitigated by code sections that allow suspended passive losses to be carried forward and treated as deductions from passive activities in the following year, subject to the application of the passive activity limitations that are applicable in the following tax year. Moreover, suspended passive losses from a specific activity generally are allowed in full when a taxpayer disposes of his entire interest in the specific passive activity.
Tax law offers two exceptions to the rental real estate passive activity loss rules. The first is a deduction of up to $25,000 which phases out between $100,000 and $150,000 of Adjusted Gross Income generally available to all taxpayers. The second very limited exception is found under Code Sec. 469(c)(7), which in general dictates that rental real estate activity in which the taxpayer materially participates as a real estate professional is not treated as a passive activity and thus, losses from such activities are not subjected to the passive activity loss limitations. The IRS being shrewd has realized that the collapse of the real estate market has caused rents to decline and thus rental real estate losses to rapidly increase. In an effort to raise tax revenue they are zealously going after taxpayers claiming real estate professional status in order to prevent real estate losses from offsetting other taxable sources of income and thus raising tax revenue.
The internal revenue manual provides step by step instructions to the service’s revenue agents designed to deny real estate professional status that in my opinion are overzealous and often not in compliance with the underlying body of applicable tax law. Unfortunately, in my experience, IRS Appeals Officers and the Tax Court will often rubber stamp the IRS in this area of law.
To overcome these hurdles I will zealously apply my background as a Tax Lawyer and as a Certified Public Accountant (CPA) with a Master’s Degree in Taxation to your benefit.
Questions and Answers About Rental Real Estate Passive Activity Loss
Experienced Real Estate Audit Attorney
Our Office has developed a national practice pertaining to federal income tax issues administered by the IRS. Thus, no matter what state you are from, if you are presently under audit or will be shortly, we can provide legal services by simply moving the audit to an IRS field office locally.
I know it can be intimidating to deal with the Internal Revenue Service and I will keep you informed throughout the process to help you reduce your stress. As a Orange County and Los Angeles County real estate tax audit lawyer, I have extensive experience in every facet of this process and am ready, willing, and able to assist you should you find yourself in this situation. Contact my tax law office online or call 949-681-3502 or toll free 800.681.1295 to schedule a reduced-rate consultation.
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