Many real estate investors assume that if audited their records and receipts are all they need to win the audit. However, it’s not always having the receipts that allows for the deductions, but what motivates you and your intentions at the time.
Real estate investors need to understand exactly WHAT allows for a tax deduction? (It’s more than receipts). The Tax Code requires that you have a profit motive to deduct the expenses you incur in operating your rentals. If you don’t have a profit motive, then your deductions may be limited or disallowed.
When the IRS audits rental losses, it often looks to see whether your primary purpose in owning the rental is profit. If your primary purpose is to provide a house for your unemployed adult child or to demonstrate kindness or charity to tenants with hard-luck stories or that you’re too busy or lazy to find a tenant, then the IRS may disallow your deductions, since they don’t qualify as ordinary and necessary for a profitable enterprise (which is required by the Tax Code).
Do you show losses on your rental every year? That’s not necessarily a problem, because it’s quite common for rental properties to show paper losses on tax returns due to depreciation deductions and such. If however, the IRS claimed that you didn’t do enough to minimize the loss, would you know how to defend yourself and your management activities?
IRS’ OBJECTIVE FACTORS TO DETERMNE PROFIT MOTIVE
What is your primary motivating factor for your rental? Is it to:
- Get tax deductions?
- Help friends or family members?
- Have a place to vacation?
Note: It’s more difficult to convince the IRS that you have a profit motive if your rental involves fun or recreation, loses money, is located at a resort, and you spend vacation time there.
Do you allow your rental property to sit vacant for a substantial time?
This could bring into question your motive to make a profit, unless there is a good reason you’ve been unable to find a tenant. You should document your reasons in case you’re questioned by the IRS.
Managerial factors
- How do you conduct your rental activity? Do you operate in a professional manner; keeping good books and records?
- What kind of expertise or track record do you have in managing rentals?
- How much time and effort do you spend in your rental business? Full-time work is not required, but you must work regularly.
Presumption of profit
If your rental shows a profit for at least three years out of five consecutive years, you are presumed to have a profit motive. The presumption of profit applies to your third profitable year and extends to all later years within the five-year period beginning with your first profitable year.
Caution: The IRS doesn’t have to wait for five years after you become a landlord to decide whether your rental activities qualify as a “for-profit” endeavor. It can audit you and classify your venture as a not-for-profit activity at any time.
How to show profit motive. The following are steps you can take to help prove that you indeed have a profit motive and should be allowed to deduct all of the expenses you incur in the operation of your rental properties.
- Enter into the activity primarily to earn a profit.
- Collect fair-market-rent (FMR) based on location and condition of your rental. If you collect less than FMR your profit motive is questioned. If the rents you receive are below FMR, document why it’s necessary.
- Keep records of rents on comparable properties (comparable rental ads from local newspaper want ads, print listings for similar rentals in the same neighborhood from craigslist.com; letters from property managers; documentation—the more the better).
- Try to earn or show a profit (even if it is a small profit). It’s not necessary that you earn a profit from your rental, but be prepared to defend the economic circumstances that caused it.
Election to postpone determination that activity Is engaged in for profit
If you are starting your rental activity and do not have three years showing a profit, you can elect to have the presumption made after you have the five years of experience required by the test. You may choose to postpone the decision of whether the rental is for profit by filing Form 5213.
You must file Form 5213 within three years after the due date of your return (determined without extensions) for the year in which you first carried on the activity or, if earlier, within sixty days after receiving written notice from the IRS proposing to disallow deductions attributable to the activity.