Rental Real Estate Tax Loss – How to Avoid an IRS Audit

If you own rental real estate, the government is thinking about you…and not in a good way. The Government Accountability Office reported that 53% of taxpayers with rental real estate misreport when they file their tax returns. That means many property owners overestimated real estate tax loss. The bottom line is that owning rental real estate is now an audit flag.

These inflated tax losses cost the Treasury over $12 billion. Well the Government just called…and they want their money. As a result, the Treasury Administration revamped how they audit returns with rental real estate. That means more audits, and if you are one of the lucky ones who fall under their stare you’re going to have to come up with a great deal more substantiation when you submit your return.

If you filed a return more than three years ago, no worries. You’re shielded by the three-year look-back. If you filed a return after that, beware and get ready.

Who should be most concerned?

The higher the marginal tax bracket you find yourself in, the greater the chances are that you’ll be audited. That’s because the Treasury nets a lot more when they disallow an expense at the 35% bracket than at the 10% bracket.

Another group of people who should worry about this are those who don’t keep meticulous records. As I said, you’re going to have to report more data. You need to report the type of property (condo, single-family home, multi-family or commercial).

How to Avoid an IRS Audit

You should keep records and be able to substantiate the number of days the property was rented versus occupied by you. If you use the rental yourself for more than 14 days in a year (or 10% of the days others rented it at fair market value) you should limit your deductions to mortgage interest, taxes and some losses plus direct expenses like advertising.

You can’t use depreciation to create losses other than to offset rental income. You can carry these losses forward, but they are probably going to be the #1 target in an audit.

Now, if you claim to be a real estate professional, you might get an exemption to these limits, but you’ll find yourself under the Treasury’s microscope. To qualify as a real estate professional, you have to spend more than 50% of your time and at least 750 hours during the year on your rental property empire. If you don’t qualify, the maximum loss you can claim in any one year is $25,000.

If you aren’t a real estate professional, you probably have unallowed passive losses. That being the case, the Treasury may require you to submit Form 8582. This is going to make it easier for them to audit you. Even though these new rules are engineered to lasso the tax cheats, it’s going to make it harder for everyone.

To summarize, keep meticulous records. Be squeaky clean if you are in a higher tax bracket, and don’t be too aggressive. The kids in DC are watching.

Other Resources:

U.S. Government Accountability Office

CBS News – What’s Your Tax Bracket