If you have real estate rentals, you may have heard about the real estate professional (REP) loophole. One of the benefits of real estate investments is that you can create a tax loss legally while you still have cash flow that shows up every month.
The problem is that you lose the ability to take that loss against your other income as your income goes up. If you make under $100K, you can take up to $25K of the loss. If you make over $150K, you can’t take any of it.
The loophole is that if you’re a real estate professional, you can take 100% of the loss against your income, no matter how much the loss is or how much your other income is.
And that’s where the IRS comes in. This advantage is so big that there have been people taking it who really don’t deserve it. The IRS ramped up their auditors in this area without a lot of training plus the initial audit technique guide (the IRS auditor’s playbook) had wrong information in the beginning.
We had a lot of messy audits there for awhile. The auditors are better now, but they are that much more informed.
Some of the specific items that they will be looking for:
- Do you have a property manager? If you have a property manager, the chances are the IRS is going to challenge your material participation with the property. Remember there are 3 rules to claiming REP status: number of hours you personally work in real estate activities versus other activities, material participation in the property and each property must qualify. In this case, the IRS is looking at denying material participation.
- Do you have a log proving your REP hours? Are they truly ‘activities’ and not just you spending time researching online? (The IRS wants the ‘active’ in activity.)
- Can you prove material participation for each property you own? The IRS is strongly recommending that you aggregate your properties together. They’ve even changed the rules so that you can do this after-the-fact during the audit. Is the IRS really looking out for your best interest? Maybe not. If you sell one of the properties later, at a loss, you can’t take that loss against other income until you sell all the other properties in the aggregated group. Or if another property is later sold at a gain, the loss can be used against that gain.
The IRS determines how big and far-reaching the audit will be when you make the very first phone call after you get the IRS notice. That’s the time for a strategy. You can pull the fangs out of the audit, as long as you go into that phone call prepared.
If we can help, give us a call at 888-592-4769.