IRS Hot Button Issue: Rental Real Estate Activities

As mentioned in our previous post, we recently contributed to a Birmingham Business Journal article (subscription required) detailing the increase in IRS audits of individual taxpayers. The Treasury Inspector General for Taxpayer Administration (TIGTA) just last week put a new item on the IRS audit menu – rental real estate activities.

How hard could it be to report your rental activities? You take in rental income and you pay out some pretty common expenses – taxes, insurance, management fees, maintenance, interest, etc. On the bottom line, you either have income or loss. Simple, right? Maybe not!

The Government Accountability Office conducted a survey in August 2008 revealing that 53% of taxpayer’s reporting rental real estate activity did so incorrectly. While this percentage is alarmingly high and certainly represents at least some level of abuse, the fact is that tax reporting of real estate rental activities is painfully difficult. Getting it wrong is far easier than getting it right.

First, you must determine the nature of your investment. Unless you are a real estate professional, your rental activities are passive investments, meaning losses generated by these activities can only be used to offset income from other passive activities. If you have no passive income, these losses are not deductible. Instead, these losses carry forward and may be deducted to the extent of passive income in future years or when you dispose of the property.

However, there is an exception to the passive loss rules if you actively participate in the management and/or maintenance of the rental property. In this case, you are allowed to deduct up to $25,000 of these losses over the passive income limit. But wait…if you don’t own at least 10% of the rental property or your income exceeds $150,000 for the year, this exception does not apply and your losses deductions are limited to passive income.

For many taxpayers, the confusion and frustration does not end when you determine the nature of your investment. If you own vacation property that has elements of rental use and personal use, the extent of the personal use (in total and as compared to the rental use) determines the deductibility of certain expenses. If you own property that you rent to your business, there are circumstances where the passive activity rules apply and circumstances where they don’t!

Again, reporting of rental real estate activities is painfully difficult, but increased IRS audit coverage in this area will place a premium on knowing the rules and getting it right.