IRS Ramps Up Potential Issues with Schedule E

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Earlier this month, the IRS sent out over 21,000 letters to tax preparers reminding them of the penalties for tax return fraud. The letters were right on the borderline of being threatening. Now we’re learning that the IRS is planning to follow up with visits to 10% of those tax preparers. And they’re going to do it during tax season.

The interesting thing is that the IRS is not tackling some of the major issues these days with returns – such as how to report missing or incorrect Form 1099-A and Form 1099-C reports or solving once and for all the question of when self-employment is due on member-managed and manager-managed LLCs – but instead is focusing on Schedule A, Schedule C and Schedule E.

Schedule A is for itemized deductions and is pretty much a no-brainer to complete. The only possible tax compliance issue, other than out and out mistakes or fraud, will be deductibility of mortgage interest. For some tax payers, the amount that is deductible may be limited if their house declines in value or they have a big ticket mortgage.

Schedule C is for Sole Proprietorships and was the subject of Tuesday’s blog entry.

Schedule E can be a little more problematic. It’s where you report flow-through entities such as the K-1s from a partnership or S Corporation, royalties, and, of course, real estate.

And guess what, that’s the IRS is after again. Here is what they are specifically targeting:

  • Rental income and expenses not being properly reported.
  • Rental depreciation not being correctly calculated.
  • Limitations surrounding passive activities, basis and at-risk rules not properly
    considered or calculated.

The rental income and expenses will be pretty straight forward. You’re either reporting correctly, or you’re not.

There will need to be proof for the depreciation showing that you have the correct basis for depreciation and that you’ve properly allocated personal property, real property and non-deductible land.

The sticky point, I think, will be the passive activity limitations and at-risk rules. With properties going upside down, non-recourse loans and bad cash flow, there are a lot of people who have lost money that may not be fully deductible. This is the part where you want to make sure you have an experienced real estate tax accountant helping you calculate what you can deduct, where and when. The IRS has been hitting the issue with real estate hard for a while now. The audits continue on Real Estate Professional status and they are looking hard at basis when assets are sold.

Make sure you’re taking the right real estate deductions, in the right way. Otherwise, you could be looking at a major problem.

Oh, and by the way, I did NOT get one of the letters. Phew! I’m glad I don’t have to worry about the IRS suddenly showing up this tax season.

Tax Survival for 1099-A and 1099-C Recipients

What to Expect in Taxes for 2011

The 2011 IRS Survival Guide for Real Estate Professionals with Real Estate Investments

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