Many real estate investors aren’t aware of WHAT allows expenses to be tax deductible. The answer is: a business purpose and profit motive. If you lack one or both, an IRS audit on your rentals will not turn out well, because expenses you thought were deductible are disallowed.
The IRS calls these “not-for-profit” activities. Your “rentals” may appear to be “not-for-profit” rentals when you:
- Charge less than fair-market-rents.
- Are slow to collect back rents.
- Fail to take legal actions for arrearages or damages.
- Allow your rentals to remain vacant for periods of time, etc.
The tax consequences of “not-for-profit” rentals. The following example will illustrate what happens in this type of audit. When the IRS reclassifies rentals as “not-for-profits”, the rental income and expenses must be reported differently than ordinary rentals, resulting in a severe loss of tax benefits.
For example, let’s say, you collected $800 per month from a tenant, but incurred $1,000 per month in expenses for your rental. In the audit, the IRS determined that the fair-market-rent should have been $1100 and you weren’t able to justify a business purpose for the lower rent.
As a result, IRS reclassified your rental as a “not-for-profit” activity, disallowing your Schedule E reporting of the rental income and expenses. The $9,600 rental income was moved to line 21 of your 1040. The $12,000 of rental expenses were reduced to the amount of rents collected ($9,600), the excess disallowed.
The reduced expenses were allowed on Schedule A as miscellaneous itemized deductions, resulting in no tax benefit until you exceeded the standard deduction and the 2% floor on your AGI. Reporting expenses in this way subjects them to alternate minimum tax, which may totally eliminate the benefit in many cases.
Another downside to the IRS moving the rental income to line 21 of the 1040 is that it causes your AGI to be higher than it would have been for a normal rental, which could cause some of your other tax benefits to be reduced or eliminated, like IRAs, medical expenses, student loan interest, college credits and more.
As you can see, “not-for-profit” rentals result in bad tax consequences. Don’t let this happen to you.