If You Use an Arizona Property Manager, Get Ready for an IRS Audit

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90360_3287This past week we received 3 reports of Arizona property manager audits. Rumor has it that every property manager in Arizona is being audited. And what they’re looking for could surprise you.

It appears that the Arizona property management company itself is getting a once-through audit, but the real target are the clients of the property management company. They are looking, once again, for real estate investors to audit.

One of the IRS’s long-held contentions is that a real estate investor that hires a property management company can not be considered to be participating in the management. And that means any losses, by definition, are passive. They cannot offset other income.

Since 2008, the IRS has been focusing on real estate investors who have taken the Real Estate Professional (REP) status as a way to get full deductibility on their real estate losses. A REP has more than 750 hours per year in real estate activities and more spent in real estate activities than in any other trade or business. Plus, the REP has to materially participate in the properties. That’s where the trap is. The IRS has made the claim that if you have a property manager, the property manager is materially participating and you are not. That means your losses stay passive.

Passive losses cannot offset active income.

We’ve seen this type of audit blitz by IRS audit teams before. They are likely doing two things right now:

  1. Checking to see if they hit an unpaid tax mother lode. If there is a lot of tax money the IRS can shake loose, then they will expand the program to the entire country.
  2. Creating an Audit Technique Guide. (ATG) The auditors right now are mainly the more senior auditors. They are creating procedures for audit as they go. They’re testing what works and what doesn’t. Once they have the ATGs written and if there is deemed to be enough tax revenue to justify the expense, they’ll let loose the less experienced auditors to hit the streets with thousands of audits.

If you’re concerned about this for your situation, here are three steps to get ready:

Step #1: Determine if you are at risk. Do you have real estate losses? Did you take a real estate professional status? Do you use Property Managers? If you answered yes to all of the above, continue. Otherwise, at this moment, you aren’t at risk from this particular issue. BUT you could still be at risk due to other items such as improperly taken or reported Real Estate Professional status, incorrect basis or not following the rules when you dumped bad real estate.

Step #2: Get your records in order. Make sure your entities have the proper paperwork and that you’ve followed all of the guidelines. Verify that you meet the Real Estate Professional guidelines for hours and record-keeping. If you need to catch it up, do that now. Also, make sure you understand what qualifies for REP hours and what qualifies for material participation hours. You will need separate records proving the material participation hours.

Step #3: Identify your risks and work with an experienced CPA to minimize the costs if you are audited.

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