IRS Audits for Real Estate Professionals, II

Why has the IRS targeted real estate professionals at this time?  According to their own December 20, 2010 report:

Actions Are Needed in the Identification, Selection, and Examination of Individual Tax Returns With Rental Real Estate Activity.

In August 2008, the Government Accountability Office stated that “at least 53 percent of individual taxpayers with rental real estate activity for Tax Year 2001 misreported their rental real estate activity, resulting in an estimated $12.4 billion of net misreported income.”

Internal Revenue Service (IRS) data show that during Tax Year 2001, 8.7 million (6.7 percent) of the 130 million filed individual income tax returns had rental real estate activities. Specifically, taxpayers reported net rental real estate income of approximately $47 billion on 4.2 million tax returns and $31 billion in net rental real estate losses on 4.5 million tax returns.

Prior to 1986, taxpayers were allowed to deduct from their income all of their rental real estate activity losses without any restrictions, regardless of their participation or management of the property owned. This condition raised concerns regarding the significant numbers of tax shelters that allowed taxpayers to lower the amount of their taxable income.

On October 22, 1986, Congress enacted The Tax Reform Act of 1986. This provision added Passive Activity Loss (PAL) rules that limit the taxpayer’s ability to deduct losses from rental real estate activities. In general, losses generated by passive activities can be deducted only from income generated by passive activities.

The United States has one of the highest tax compliance rates in the world at 83.7 percent. However, each percentage point of noncompliance costs the Federal Government approximately $21 billion, which equates to more than $345 billion in annual lost revenue.

Exceptions to Passive Activity Losses

1. Permits a taxpayer with modified Adjusted Gross Income (AGI) of $100,000 or less, who owns at least a 10 percent interest in any rental real estate activity and has active participation in that activity, to deduct up to $25,000 of non-passive income with that portion of the PAL.

2. Taxpayers engaged in a rental real property business may treat rental real estate activities as non-passive if they materially participate in the rental activity and meet both of the following conditions:

• More than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates.

• The taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

The IRS uses computer programs to screen the more than 130 million tax returns filed each year for questionable issues that should be referred for further review by the Examination function. Tax returns selected for examination are reviewed by examiners who focus their attention on specific or a limited number of issues that the IRS believes to be questionable. There is a large variety of tax returns with rental real estate activity, and the laws pertaining to them are numerous and complex. As such, this condition requires IRS examiners to use their professional judgment when reviewing tax returns to determine the validity of information reported by the taxpayer.

Read complete report: http://www.treasury.gov/tigta/auditreports/2011reports/201130005fr.pdf

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