Tax Audits for Real Estate Professionals
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
- What constitutes material participation?
- How are passive activity expenses and losses characterized
- What is passive activity gross income?
- What are the conditions of a passive activity deduction?
- How are rental activities defined?
- Special allowance for rental real estate activities
- What is the Real Estate Professionals exception?
- IRS challenge to Real estate Professional status
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.