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
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.
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.
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.
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.
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.)
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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