It’s not just the lack of receipts and records that cause most real estate investors to lose when audited by the IRS. Often, it’s their own testimony used against them that allows the IRS to reclassify their activity into something passive for a less favorable outcome.
To illustrate a difference in the Tax Code over active v. passive participation, let’s discuss two hypothetical neighbors living next door to each other, who appear to had done most everything the same, but who had very different tax outcomes when audited by the IRS.
Both neighbors used the married-filing-joint status on their tax returns, both had exactly the same income, the same deductions, the same number of dependents with kids the same ages and so on.
Both also purchased a rental house for the same price ($225,000), and both attempted to get a tenant, but were unsuccessful. Then they both hired a management company to find a tenant, but the management company was also unsuccessful.
After a few months the property declined in value. Since the property was difficult to rent and declining in value, both owners decided to take a loss and sell their “rental”.
You guessed it. Each sold their property for the same price ($175,000) and each incurred $10,000 in selling expenses. Each filed their tax returns showing an ordinary loss of $60,000 and each was audited by the IRS.
The IRS audit
The difference between the neighbors was the outcome of the audit. One neighbor didn’t go to the audit, but was represented by a tax professional. The IRS accepted their tax return as filed showing a $60,000 ordinary loss.
The other neighbor’s loss of $60,000 was also accepted, but was reclassified as a capital loss. This allowed only $3,000 to be deducted for the year of sale. The balance of the loss ($57,000) was to be carried forward to future years. Unless this neighbor had a future capital gain, it would take another 19 years to use it up at $3,000 per year.
What caused such a difference?
Why was there such a difference in the outcome of the IRS audits when it appeared that the situations were so similar? It was the testimony of the neighbor. During the audit, the IRS was able to get that neighbor to state that she and her husband had given up looking for the tenant a few months before deciding to sell the property. Thus, the IRS argued that it was no longer an “active rental”, but an “investment property”, therefore the loss wasn’t ordinary, but capital.
The only difference between the two neighbors was an activity; one property owner actively continued looking for a tenant, while the house was up for sale, while the other property owner kept it vacant while it was listed for sale. The IRS considered that both properties qualified as rentals from the first day that they were made available for rent.
It did not matter that the properties were never successfully rented, as long as they were available and marketed for rent. The IRS allowed all of the expenses for each property, as deducted (the management fees and other expenses incurred; even depreciation applicable to that period).
The difference in why the IRS was able to reclassify the second neighbor’s property came about by a change in the activity of the property owner immediately prior to the sale. One neighbor retained the rental status according to the IRS; the other property’s status was re-classified to “investment” status; thus only $3,000 per year of loss was allowed.
This example illustrates how complex the tax code is regarding real estate transactions. We highly recommend that our clients keep in touch with us regarding any changes in their actions or situation regarding real estate; there are just too many things that can go differently than planned.