For Real Estate Investors: What Does the IRS Look for During an ...

It wasn?t raining when Noah built the ark. Likewise, you shouldn?t be waiting until you get an audit notice to get your paperwork together, gather receipts, dot your i?s and cross your t?s.

Understand that the federal government is hungry for money just now. For all the talk of recovery (how many ?recovery summers? are we at just now?), tax revenues are nowhere near where planners hoped they would be. The massive federal spending effort known as the ?stimulus? yielded bupkis. More than 8 million people have been driven from the workforce over the past four years, and the middle class ? the engine that drives both recessions and recoveries ? has been clobbered both by significant real pay cuts and a massive loss of wealth since the recession.

And we?ve got the Affordable Care Act to fund. And Medicaid. And Medicare. And an expansive mission for the Navy. Put it all together, and the heat is on the IRS to pump up the revenue.

That revenue is going to come from you.

So how can you defend yourself, and legitimately minimize your tax burden? Well, a big part of it is investing time in keeping careful records. But you also should understand and anticipate the specific things the IRS trains its people to look for when conducting an audit of someone who claims to be a real estate professional.

Caveat

Don?t go into the process thinking you are going to hide wealth or income from the IRS. This isn?t just criminal ? it?s poor planning. The best planning enables you to open your books to the IRS completely, show them everything, and still not owe them any money. Any technique that relies on secrecy and the IRS not finding out is flawed. As Sun Tzu advised, first make yourself invincible.

Dealer and Real Estate Professional Rules

If the IRS audits a real estate investor, one of the first things they look for is whether the investor is a dealer or a buy-and-hold renter. This is a critical designation for them because the answer determines which set of rules you fall under. Most buy-and-hold investors are subject to passive activity loss rules that limit the amount of losses from cash-flow-negative real estate interests you can write off against your other non-real-estate income. You have Section 469 of the Tax Reform Act of 1986 to thank for that. The average Joe is limited to $25,000 per year in passive activity write-offs against non-passive forms of income, unless the IRS designates you as a real estate professional. If you are a real estate professional, according to IRS rules, you get to write off unlimited losses against income.

So what does the IRS look for to make that determination? It?s not just a matter of looking at your wealth and income. The IRS is interested in determining whether you materially participated in managing your properties or whether you acted as a silent partner. That means the IRS wants to know how you spend your time.

Document your hours. Specifically, the IRS needs to believe you have been spent at least 750 hours each year actively working in your real estate investments ? the so-called 750 hours rule. You must also pass what the IRS calls the ?half-personal services test.? The best way is to keep a detailed appointment book, logbook or calendar documenting your activities each day, and how much time you spend on your real estate business versus other sources of income. Per the IRS, ?If the taxpayer has a full-time job working 2,080 hours a year in a non-real property business, he must work 2,081 on his real property businesses to meet half-personal services test.?

Furthermore, don?t try the ?my wife and I both work the real estate business, and between the two of us, we put over a thousand hours into the real estate business? dodge. The IRS is very specific: The 750 hour test must be met by one spouse alone.

You combine your income on a joint tax return. But you cannot combine your hours to claim status as a real estate professional on your individual/couple income tax return.

Note: The IRS trains its agents to ask about who actually manages the property. They are also trained to reality-check what you tell them against your Schedule E. If you are claiming you are actively involved in every aspect of your property ? but simultaneously claim a lot of management fees on your tax return via Schedule E, and deduct them from rental income, that gives the IRS a thread to pull that could unravel a whole sweater.

Also, you can?t ?pad? your hours by doing work that real estate investors normally contract out. The IRS has been known to refuse to count those hours towards the 750 hours and the half-personal service test, according to David W. Klasing, a tax attorney and CPA with offices in Irvine and Los Angeles, Calif.

Document Your Hours by Property

It?s not enough to document your overall time spent on your real estate investing practice. You must also break out your hours spent working by property. The standard is to be able to document 100 hours per real estate activity.

This is different than ?per property.? It is possible to have the IRS treat multiple properties as a single real estate activity, though, but you must plan ahead, writes Klasing: Attach a memo to your return stating that you?re a real estate professional and that you are making the election under Code Sec. 469(c)(7)(A).

If you are a marginal case, this memo could make a big difference when it comes to audit time.

An amusing note: Most of us in the private sector and parts of the military are quite accustomed to 20-hour workdays and more. You and I know very well it is quite possible to work another 750 hours per year on top of a 9-to-5 job. But IRS employees are government workers, and the kinds of hours that real estate pros can log trying to create success from nothing would make their little heads explode.

The IRS often assumes that it is impossible ? and occasionally disallows claims of 750 plus hours spent actively managing your real estate activities, on top of a 2,080-hour part-time job.

Red Flags

Here are some of the items the IRS coaches its auditors to look for:

• If you have a corporation, did you document a shareholders? meeting this year? Are there minutes prepared?
• If you have an LLC, do you have an operating agreement? Expect IRS auditors to ask to see them.
• Document your ownership in these entities. The IRS does not recognize material participation in a real estate activity if it?s done in the capacity of an employee. You will have to demonstrate that you own at least 5 percent of the company.
• Are you a limited partner in a partnership? If so, you can?t claim the $25,000 special allowance. The same applies if you have less than 10 percent interest in ownership.
• If you?re not a real estate professional, did you try to deduct real estate losses over $25,000? The IRS will scrutinize that.
• Did you deduct rental losses while showing an AGI of greater than $150,000?
• Did you group all your real estate investments together as a single activity? Be prepared to produce other years? returns showing the same election. The IRS expects consistency. The election is binding on future years.

Traps

Be guarded with idle chit-chat with an auditor. You may think you?re building a rapport with them. But skilled investigators are always collecting information ? even if you don?t realize it. The IRS trains its agents to question you about your overall lifestyle ? your job, hobbies, and other time commitments. Part of the reason is to set a trap: If you tell them you play golf almost every weekend, you will then have a harder time claiming you spend weekends on your real estate business when you try to qualify as a real estate professional based on the hours test.

Tagged as: audit, audited, dealer, investing, investor, its, property, real estate, tax, taxes

Source: http://www.realestate.com/advice/for-real-estate-investors-what-does-the-irs-look-for-in-an-audit-62824/

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