Recently, I reviewed a tax return in anticipation of an audit for one of my tax consultation clients. They had received a notice that their 2012 tax return was being audited and they were concerned. Up until 2012, they had had a tax professional prepare their individual Form 1040 return, but then the CPA quit working and so they decided to do the return themselves. After all, they were going to get Turbo Tax and just follow the program. How hard could it be?
They followed as best they could what their CPA had done before, even though their situation had changed. One thing was true; they had a handful of real estate properties that were big cash drains. Because their income in 2012 was over $150,000 they couldn’t take advantage of the real estate losses against other income. That meant the properties cost them money, month after month, and none of it was tax deductible.
**Note: Their income was over $150,000. That meant their real estate losses were not deductible, unless one of them qualified as a real estate professional with material participation.
In the year before, when their CPA had prepared their tax return, the wife was only working on their properties. She didn’t have any other job. The CPA had prepared a Schedule C for the wife’s ‘business’ and recorded general real estate related expenses there. For example, Property #1 had property tax, insurance, interest and utilities. Those are all direct expenses against that property. And because they owned them personally, they got reported on the Schedule E. But, there were some expenses such as a home office, computer and business use of a car that were more general. Those expenses went on the Schedule C. The wife claimed real estate professional status that year, and so all of the losses were deductible.
**Although it’s not reported anywhere on the return, there are 3 tests for real estate professional when a couple if filing jointly. #1 One person has more hours in real estate activities than any other activity and at least 750 hours per year. #2: One or both people have material participation in the property. #3: Each property must qualify for material participation.
In 2012, the couple filed their return the same, even though the wife now had a job and no longer qualified.
And now the IRS is asking if they really qualified. We went through the return and found where the biggest holes were and came up with a strategy.
They used a reputable tax software, Turbo Tax, to fill in the forms, but what they didn’t realize was the tax strategy and law behind the decisions made before. This isn’t the first time that Turbo Tax got someone in trouble with the real estate professional status. There have been a couple of court cases recently where the “Turbo Tax” defense was used. The taxpayers lost.