EXPLAINED: Tax strategy or an abusive position?

[Michael Plaks]

This post was prompted by a discussion of a specific STR-related tax strategy on another thread. But the concepts apply across a wide range of topics, so I'm posting my TED talk separately.

1. The annual nature of tax benefits.

One of the fundamental building blocks of our tax system is its annual focus. You're married in 2022 - you file as a couple. You're no longer married in 2023 (congrats!) - you file single. You remarry in 2024 (sorry) - you will file as a couple again. And so on, with every tax benefit. Family situation changes, location changes, employment status changes, businesses open and close - nothing is permanent. Except the government bureaucracy and people's stubbornness, of course.

We always report taxes for one specific year, and it changes from year to year. The system is designed this way.

For any tax benefit, for instance the STR loophole, you may qualify in one year, not qualify the next year, then qualify again the year after that. It is accommodated by the tax system, generally speaking.

2. Does the IRS demand consistent tax treatment?

Usually, with some exceptions, the answer is no. You claim your child as your dependent one year, then you don't, and then you claim her again. Problem? Not at all. Maybe she was someone else's dependent for a year (while you were serving time for tax fraud). Maybe she had a well paying job for a year and then went back to school and back on your payroll. Dozens of potential situations, and the IRS does not normally ask.

A property was claimed as a rental one year, then not, then claimed again. Problem? Nah. Maybe you took it off the market for a year and moved in yourself while your divorce was pending. Maybe your daughter lived there for a year while in school. Who knows. Again, the IRS does not normally ask. And if they do, you have an explanation, so there is nothing to worry about.

Your wholesaling business had $100k of income one year, then $0, then $100k again. Problem? Maybe. This will indeed appear suspicious to the IRS if they take a look. They are likely to ask questions. But if you had a reasonable explanation - went back to W2 job, was taking care of a sick parent, lost your source of referrals, etc. - they should not fuss. Especially if you have documents to prove your story.

3. When and why would the IRS compare two years of tax returns?

The IRS computers are not doing this. They are not even programmed to do far simpler sniffing tasks than this, and a year-to-year comparison is extremely hard to automate, both technically and logically.

Who does it, then? IRS auditors do, sometimes. First, one of your tax returns has to be flagged for an audit. While there are several reasons why you can be targeted for an IRS audit (including running for an office, it seems), the most common reason is the IRS computer finding enough "red flags" in your numbers. 

Example: claiming tax benefits from the STR loophole or from the Real Estate Professional Status (REPS) - which, by the way, are two completely separate things. Why? Because either one of these two tax claims accomplishes something that is normally prohibited: allows you to deduct real estate losses against high W2 income. It is a great tax benefit and, as any great benefit, it is frequently abused. They know it, and they are trying to stop it.

What is their stopping mechanism? Audits. So, the IRS computer flags your tax return. Then it goes to a human classifier who is going to review it with their eyes and their subjective judgment and decide: let it go or send it for an actual audit. In the near future, this task is likely to be passed to AI. Or maybe not so near future, considering the IRS notoriously being decades behind on technology.

Once your return is on an auditor's desk, he decides on the scope of the issues to be raised. Often it involves the auditor comparing your flagged tax return with the one before and the one after, three years side-by-side. Often but not always? Correct. Obtaining copies of two more tax returns used to be a difficult task for the auditors, due to their antiquated technology. Maybe they have solved this issue by now. Either way, it is more work for them, and they don't like extra work any more than we do. Bottom line: sometimes they compare your tax returns, and sometimes they don't.

4. Am I in trouble if they do catch inconsistencies from year to year?

It depends on three factors:

A. Are these inconsistencies breaking the rules? As I said earlier in this post, often inconsistencies are perfectly normal and can be easily explained.

B. If you're in the gray/grey area when the rules are not clear, how unclear are they, and what shade of grey (yes, yes, I get the reference) are you using? I.e. how far are you pushing the line?

C. Did you find yourself in this situation due to circumstances, or did you intentionally stage this situation? More on this below.

D. Does your auditor understand the tax law? Usually, they do not. It is not their job, actually. If you end up at a standstill with your auditor, be prepared to take your fight to the next level, called Appeals. Unlike auditors, these people have training and experience in tax law.

5. About your intentions.

If you have ever had teenagers or have ever been one yourself, you know that intentions is a flimsy concept. 

As flimsy as it is, the word intention is very often what it comes to. Having an intention to do something can work against you. On the other hand, accidentally finding yourself in the same exact situation often gives you an out. 

Example from the tax law. You buy a house near your New Jersey job, and you plan to move to Florida a year later, once you get your 401k vested and can retire. You cannot (legally) exclude your capital gain when you sell your NJ house next year. 

Variation: same job, but no plans to retire or move, i.e. no intention. Alas, the company closed a few months later, sending you into forced retirement. Relieved, you move to Florida. The good news is that now you can exclude capital gains on your NJ house due to the "unforeseen circumstances" exception. 

Conclusion: intentions matter. Unless you are married.

6. About intentions of the law.

Suppose the IRS is on your case, and you could not come to an agreement even with an Appeals officer. It happens. One option at this point is to take the IRS to court. Many people have, despite the hassle and the cost of doing so.

In some instances, the tax law includes a special provision called an "anti-abuse rule." Example: the famous $2,500 de-minimis safe harbor for deducting expenses that are normally depreciated comes, among other restrictions, with an anti-abuse paragraph. It specifically prohibits breaking a $10,000 invoice into four $2,500 invoices to get around the rule.

In many other cases, there is even less clarity. When the law is unclear, the courts often analyze intentions of the law and sometimes even intentions of Congress in writing the law. By definition, interpreting intentions is subjective. Yet courts do it regularly, and their decisions often reference intentions, as interpreted by the judge.

From this angle, it is useful to guess an intention of a particular tax law before trying to use it to your advantage. Example: the intention of Passive Activity Limitation (PAL) rules is to prevent high-income earners from reducing their taxes by merely investing money into real estate. We can be unhappy with this notion, but it IS the intention of the law, like it or not. 

Same example, part 2: Why are there so many restrictions on the REPS and STR qualifications? Because they defeat the intention of PAL. Why do these exceptions exist, then? Because the intention (ahh, the magic word again) is to allow a break to those who are not merely investing money in real estate but actually work in real estate.

7. The danger of signing up with promoters of a tax strategy.

A lot of times, you hear about a specific tax strategy (REPS, STRs, syndications, 1031s, DSTs, conservation easements, and so on) from promoters who target a specific group of people. Typically the target are professionals who make good money from their W2 jobs or 1099 commissions and are desperately looking for ways to mitigate their crippling taxes.

One word I used intentionally was "desperately." When taxes really bother you, you sometimes push your common sense and reservations aside and sign up for things against your better judgment. The results can be tragic. I have seen too many people not only getting in trouble with the IRS, but losing their investments to sketchy but appetizing "opportunities" to cut taxes. Beware.

The other word I used intentionally was "promoters." Be clear who is offering these opportunities to you and what is their motivation. Of course, their motivation is just being altruistic and "sharing the secrets" they discovered, because they want nothing other than "help a fellow investor." I was young once, and I believed back then in people's honorable intentions. (Yes, I used the word intention, again.)  I'm not young anymore.

When you check who is behind such a helpful project, you will typically discover that these people are making their money from selling you investments that purportedly bring along those enormous tax benefits. They are not tax experts, they are salespeople, usually on commission. Tax benefits are nothing but a sales tool for them - a hook. Try not to get hooked. 

I already pointed out earlier that common sense is often ignored when juicy tax benefits are brought into the conversation. That said, do ask yourself before signing on the bottom line: if this tax strategy fails the IRS scrutiny test - what happens then?

And keep in mind the favorite enforcement strategy of the IRS: they go after the promoter first. If they are able to bring down the promoter, they obtain a list of their customers and then go after every single customer, with their victory already pocketed. Easy pickings for them.

Conclusion

Tax strategies, loopholes, secrets of the rich, tax-free wealth... I certainly missed some buzzwords. This is all good stuff. Nothing wrong with trying to minimize your taxes. Heck, it is wrong NOT TO! Tax strategists like myself help you on this journey.

When there're benefits, there're always rules. When there're rules, there's a temptation to push these rules too far. Then you may be crossing into the abuse territory. For that, there are consequences.