Real Estate Professional - IRS Audit

[Roy Williams]

Hi Folks,

Our friends at the IRS are auditing my 2009 return, mostly because of my real estate professional designation.
I have a full time job and the rentals take up all of the rest of my time and I easily spend more time on them.
I own 10 properties with a total of 30 units. Based upon your experience, as long as I can show a weekly log (which I can) of my time spent on my properties are they going to make much of a fuss over it given the amount of real estate I own?

Thanks!

[Jon Holdman]

Dave O, you are absolutely right. If you have a full time, W2 job, you probably can't claim the RE professional designation.

Unfortunately, a common myth for rental real estate is the ability to offset ordinary income with the passive losses generated from a crummy rental. That's often used to dress up a junk rental and make it look good. The people selling such deals conveniently forget to mention the $100K AGI limit or depreciation recapture. When you take deprecation (or, even if you don't but should have), the basis for the property gets reduced. When you sell, your gain is higher by the amount of depreciation taken (or allowed). And you'll pay depreciation recapture tax on the amount of gain up to the deprecation taken or allowed. That's your ordinary rate, but currently capped at 25%.

Bottom line is that good rentals actually produce taxable income, even after accounting for depreciation. Any rental that has to have "offset ordinary income" lipstick is a crummy rental, at least on a cash flow basis.

And, no, I don't think the IRS tolerates any inflation (i.e., lying) about the RE professional hours. That designation is intended for people who spend a significant chunk of their time doing real estate. Managing rentals, per the quotes I posted above, doesn't actually take all that much time. OTOH, if you don't have full time employment, and you're managing 50 units or you're brokering real estate, or any number of other activities, you can certainly get this designation.

[Cheryl C.]

Jon, I'd have to disagree with your definition of "a crummy rental" but you are certainly entitled to your opinion.

Do you have a cite to rulings or case law regarding "50 units"? This seems excessive unless I am a very poor manager.

Do any rulings, etc., that you are aware of delineate "activities" included/excluded? Having been audited on this, I am curious if there are now different regs, ruling and case law to review.

[Chris Martin]

I agree with Jon and I think this sums it up. "Bottom line is that good rentals actually produce taxable income, even after accounting for depreciation. Any rental that has to have "offset ordinary income" lipstick is a crummy rental, at least on a cash flow basis."

The $25K limit seems pretty reasonable, unless your "rental" is a $500K house boat or yacht that is named "Write Off" or (if you are a builder) "First Draw". These "investments", like the crummy rentals, are designed to offset income, IMO.

[Dave O]

Hi Jon,

Well stated.

I am in complete agreement and the "on-paper" losses we try to show (or trump up) only takes us down a road that is lined with restrictions. For those that fit within the guidelines, more power to them and I am glad it is available for them. I just do not fit anymore and will not change my W-2 status in order to do so. Time to pay the "Man".

Thanks for sharing what we should all be seeing (and living).

[Jon Holdman]

I believe we've disagreed about this previously, Cheryl. Notice I specifically stated "at least on a cash flow basis". There are lots of properties where you might take a loss because you believe there will some driver that improves the rental situation, the value of the property, or both.

And, there is certainly validity to holding break even or even loser rentals for long enough to pay them off. Most paid off rentals will generate some cash flow.

A crummy rental, IMHO, would be a $100K house that rents for $1000 a month. That fits the classical "1%" criteria. Of that $1000, $500 goes to expenses, vacancy and capital. That's the 50% rule which has been debated ad-nauseaum elsewhere in the forums yet has always been supported by anyone who produces any real data. With 25% down with a 30 year loan at 6%, the payment is $449.66, leaving $50.34 a month or $604.05 a year in true cash flow. "Phoney cash flow" (rent-PITI) is probably something like $300-400 a year, and I've seen MANY similar deals offered on the MLS or by wholesalers with such silly claims of cash flow.

The cash on cash return is 2.4%. Haven't looked at CD rates in a couple months, but I think that's probably possible right now. Its the cash down payment that's generating income here, not the property.

Now, lets add lipstick. First year interest is $4,474.95 and depreciation is $2,909. NOI is $500 a month, $6000 a year. Subtracting interest and depreciation leaves a passive loss of $1,384.04. If you're in the 28% tax bracket and 5% for state taxes and you can offset this against ordinary income, you'll have a tax savings of $456.73 for the year. Not much, but add that to your $604.05 in cash flow and you've almost doubled it.

Run the same deal with a $65K house that rents for $1000 a month. You get $2,492.63 a year in true cash flow for a 15% cash on cash on your $16,250 down payment. Subtract interest and deprecitation and you're left with taxable income of $1,200.38 from your rental. Depreciation is $1,890.91 which helps with sheltering some of the rental income.

No, the 50 units is a made up number. The guidelines are 750 hours a year or more time than you spend on anything else. Those are pretty clear. In a bad month, I'll spend 15 hours on a rental. That's four showings and a lease signing. In a good month, its two minutes to write and mail a receipt after the tenants deposit it. With 50 rentals, I'd assume I'd have 3-5 vacancies at all times, but I'd probably show more than one at a time. So, 15 hours a month for showings. Maybe another 15-20 hours on maintenance, assuming I was doing the little stuff myself and hiring out the big jobs. Accounting would be more complex, but I'd have a better system, so budget five hours for that. That's 40 hours a month, which is only 480 a year. Yep, you're right that's not enough to justify the RE professional designation.

Now when I'm actively buying, I commonly spend 20 hours a week between reviewing listings, viewing properties and making offers. So doing that full time would probably qualify.

Fix and flipping full time would probably qualify, but you're not depreciating those properties in any case.

[Dave O]

Jon,

I did not share it earlier, but years ago I had 18 units with "normal" managing and operating activity, with a full-time W-2 job, and I do not remember spending a lot of "hours" managing and operating them (by the way, good math examples).

W-2 or not, just managing and operating multiple units is not an "hour" intensive effort 52 weeks a year. If it was, would most want to put in the time for the rewards (rhetorical question).

[Cheryl C.]

Jon, right you are. We have been over the cash-flow/appreciation discussion many times on different threads.

Last night I read many articles on the requirements for real estate professional. From what I gather their primary tactic is to disallow enough hours to get you below the 750.

Calendar and log was mentioned as essential in every article. There seems to be a question as to whether time spent reviewing listings and locating properties can be included as "hours". The IRS is claiming that this does not count as it is an "investment activity"

I find this absurd. I can't find a ruling on this or a Court case.

[George P.]

I think the idea that the IRS is trying to pass on to investors with the limitations on passive losses is the following: "Do not buy properties that do not make sense financially. And if you do, eat your loss".

Just saying....

[Jon Holdman]

Keep in mind these passive losses don't disappear. They're carried forward over time as a "disallowed passive loss". When you sell any property, you can apply the carried forward disallowed passive losses to the sale, which may provide some tax savings on that house.

I believe these rules are really in place to prevent the "tax shelters" of old where a syndicator created an investment that generated big passive losses for their investors, specifically intended to offset regular income.

Appreciation will be great if we ever start getting it again. Even then, it has to be taken with a grain of salt. Bill Bronchick runs one of the REIAs in our area and is fond of asking "wouldn't you want to buy your parent's house for what they paid". Even if they paid $50K for the house 30 years ago and its now worth $150K, that's just under 4% annual appreciation. And, they didn't pay $50K. That was the price. Factor in the interest on that loan, insurance, taxes, and the inevitable updates (I'm sure we would all consider a 1981 house to be "dated" at this point), and you'll often find they actually put out much more cash than the $150K they can get if they sell now. I for one would bet prices are more likely to stay flat or even continue to fall in many areas than to start any sustained appreciation.

[Dave O]

Hello Everyone,

I am not sure who is interested, but I thought I would share some details to my RE professional audit.

I do not have an office appointment. The IRS wants me to mail back information within 15 days. The following is a summary of the seven (7) requirements in the IRS letter that I must respond to:

1. Detailed log of services and hours.
2. Hours worked with W-2 wages.
3. Contract between us and any tenants receiving free or reduced rent for managing or otherwise caring for the properties.
4. Contract between us and the company managing our rental property.
5. Rental leases.
6. Any management fees or other fees netted out of gross rents.
7. For any vacant property, evidence to verify our attempt to rent out the property.

Through doing my homework, and feeling it is the right thing to do, I am just going to answer each one with an honest and forthright response. I expect to hear that we owe additional tax for 2009. Reminds me of the saying: "Pay me now or pay me later". Unfortunately, I am in the "later" part and will have penalty and interest. Stay tuned.

[Mitch Kronowit]

Originally posted by Jon Holdman:
A crummy rental, IMHO, would be a $100K house that rents for $1000 a month. That fits the classical "1%" criteria. Of that $1000, $500 goes to expenses, vacancy and capital. That's the 50% rule which has been debated ad-nauseaum elsewhere in the forums yet has always been supported by anyone who produces any real data.

Then Southern California is full of "crummy" rentals. Gee, why am I competing with so many other landlords then? :crying:

I know this horse has been beaten into a boneless pulp, but continuing to throw out these "rules" as a litmus test is a huge DISSERVICE and DANGEROUS principle for new investors who believe a good investment MUST meet one or both of these guidelines. This could force them into markets, areas, and certain properties that are simply bad investments regardless of what the "numbers" say.

You use the 1% "rule" assuming 25% down and 6% for 30 years. Yeah, that may thin out your cash flow, but our newest rental brings in just above 1% with 5% down and 4% fixed for 30. These "rules" assume a lot when it comes to financing.

The 50% "rule" may be the historical AVERAGE based on mountains of data (mostly multi-family residences if I recall correctly), but what's the standard deviation? I've seen many on here state they computed everything from 30 to 70% on some of their rentals, so the variation is wide. Unless you have a huge number of rentals (especially apartments), the statistics don't apply. A landlord with 4 SFR's in sunny SoCal is NOT going to have the same expense ratio as a 4-plex owner in Buffalo, NY.

Finally, as Mike McKenzie so accurately stated, the 50% "rule" simply gives you an estimate of operating expenses, AND NOTHING ELSE! It does not give you the TOTAL RETURN on your investment. For example, a property that doesn't cash flow at all, but doubles in value in 10 years returns arounds 7% in appreciation alone.

The 50% and 2% "rules" are handy tools, when understood and used properly. But just like a table saw or arc welder can help make wonderful things in the hands of a skilled craftsman, they can also spell disaster for the unskilled novice.

[Chris Clothier]

Roy -

My input is 2 simple things.

1. Do not try and go it alone with the IRS. The expense of having a qualified and seasoned CPA who has fought with the IRS for the rights of tax filers can not be under-estimated. IF you owe tax then they cannot assist you except to make sure that you are not over-taxed or asked to face any undue burden in the process. I know many investors who thought that they could face an audit alone only to be absolutely run over in the audit process and their proof over-ruled. Even those who were meticulous in their record keeping.

That bring me to my second point.

2. You cannot, according to the most recent horror story of an audit being done without professional help, count the travel time to and from your units towards your full time real estate duties. So if you spent 10 hours on a Saturday working on your portfolio with a lot of traveling to check on properties, collect rents, visit the hardware store, etc... the IRS is only interested in the time actually spent on those activities and not the time traveling between them. If your properties are spread out and you spend hours traveling to, from and between, it could be difficult to prove your hours spent.

That being said, each of us are only entitled to the deductions allowed by law and a good CPA or tax professional can always help you prepare your taxes to take advantage of every deduction allowed. Jon made some points about disallowed deductions that can be carried forward as losses. There are some many subtle nuances when it comes to the law that I could not recommend any stronger seeking the advice of a professional before and during your audit.

Best of luck with your investing,

Chris

[Dave O]

Hi Mitch - The unskilled rental property investor only needs to use simple math when it comes to rental property:

Revenue – Costs = Income

If the property is not on the “Income†side of this equation, then as a real estate investor that invests in rental property only, they should walk away. There is no other test needed. “Real†numbers and a calculator. Only tools required.

Granted, the investor can always “hope†the value swells up so that one day they not only get back their invested dollars (direct and indirect), but also all real losses that occurred while they held a “crummy†rental.

If value increases and you have the intent of one day dumping the property to get all your money back plus some, then bet on the come. I never counted on this and if it happens, then it is only icing on the cake. Buying rental property is about buying in the now. If the “now†numbers do not work, then walk away.

[Mitch Kronowit]

Originally posted by Dave O:
If value increases and you have the intent of one day dumping the property to get all your money back plus some, then bet on the come. I never counted on this and if it happens, then it is only icing on the cake. Buying rental property is about buying in the now. If the “now†numbers do not work, then walk away.

That is definitely the approach of 90% or more of BP members and you're all welcome to it. In my market, money is made in appreciation and right now, real estate is sitting on the clearance rack. Some of us have a longer horizon than "now".

[Roy Williams]

Hello everyone, while getting my docs together for the audit I reviewed my 2009 return and saw that the actual losses from the properties were less than $25k but that depreciation pushed me over the threshold. What a kick in the pants. Total losses including depreciation are in the neighborhood of $38-39K.

[Dave O]

Hi Mitch - I think that is the difference. Your market/niche might not be the same as a landlord's. So we are probably talking apples and oranges.

You did catch my attention on your "clearance rack" comment. I am making an assumption you are referencing the Southern California area, which is an area I have never thought of as a clearance rack area. In comparison, what past reference are the current values compared to? Are current values equal to late 1990's values? Just curious.

[Roy Williams]

I can tell you that in my personal experience, I purchased all my properties around 2006. Many of the sellers stacked the properties with tenants who weren't paying and then when I bought the place the economy tanked which magnified the problem.

My biggest issues are repairs (tenants trash the place) and making the tenants pay. Many of my tenants are on gov't assistance which is great because its a check to me but most pay cash (or really don't pay). Which means I'm constantly churning through tenants. Its a common practice for them to pay the first couple months then stop and enjoy the free ride for 3 months as I struggle to get the money then evict.

[Mitch Kronowit]

Originally posted by Dave O:
I am making an assumption you are referencing the Southern California area, which is an area I have never thought of as a clearance rack area. In comparison, what past reference are the current values compared to? Are current values equal to late 1990's values? Just curious.

Everything is relative. Even Nordstroms has a "clearance rack" where your wife can find last year's Chanel dress marked down 60% to $500. :wink:

Here in Orange County, values are around their 2003-2004 levels. They may drop a little more, but several experts are calling for a bottom in 2012. There are many signs of support at current values. Notices of default are down and new construction is picking up at a rapid pace, especially in the multi-family arena.

More inland, such as Riverside and San Bernardino Counties, the values have dropped even more to older levels, late 90's to early 2000's depending on the area.

Rents are going up nearly everywhere as more former homeowners are looking to rent and many recent college graduates are starting to find employment and move out of their parent's house.

[Dave O]

Hi Mitch - Reminds me of a true story. In 1998 I purchased a triplex in Hemet for $89,000 and the numbers worked in regards to "Income" (including vacancy factor). In 2005 I sold the unit for $330,000, and the rents had not increased much at all over the previous seven years.

I shook my head at the investor thinking why would you put that much money into a multi-unit when there was no way the numbers worked as an income producing rental property.

I would assume that investor is still waiting on appreciation (if she is still in the game). I believe she came up from San Diego throwing her money around and did not even want to use the property management firm that I had worked with and who did a great job of keeping it occupied.

True story.

[Mitch Kronowit]

Originally posted by Dave O:
Hi Mitch - Reminds me of a true story. In 1998 I purchased a triplex in Hemet for $89,000 and the numbers worked in regards to "Income" (including vacancy factor). In 2005 I sold the unit for $330,000...

Very nice Dave! Yet I keep hearing over and over that real estate doesn't really appreciate. :roll:

We didn't buy anything between 2003 and 2008. The inflated prices simply didn't make sense. This correction has actually been an investor's dream come true. I'll hazard to guess most people saying real estate is a bad investment are the ones who bought in the time period I avoided and got burned... badly.

[Cheryl C.]

Mitch, we didn't buy between 2003 and December of 2008. I've bought 13 since and kept 8 of them. I can say that based on current comps we have had a 100% return of our cash in on these properties. I generally put 30% down.

A rough tabulation indicates that our RE net worth is about 18X current annual salary. If I add a sweet commercial investment made 3 yrs ago, it becomes 26X current w-2 income. Mine has always been an appreciation play. It may be crummy from a CF standpoint, but I'll take it.

We did do 2 very nice 1031's (in 2004 and 2005) but I don't count anything not involving "new" money. Those were 2 of my best buys ever.

[Roy Williams]

So what were your results when you waived the white flag before the audit meeting?

[Mark Wagner]

Cautions with regard to grouping activities:

1. Once grouped, the activities cannot be "ungrouped." You cannot change this designation from year to year. It can only be revoked due to a "material change" in the taxpayer's circumstances.

2. A break in the taxpayer's status as "real estate professional" is not a material change that can be considered in a revocation. The fact that the election is no longer advantageous to the taxpayer is not a material change that can be considered in a revocation.

3. Once grouped, any suspended losses on a single property that is disposed of are not released until the entire group is disposed. If new properties are added (and grouped) any suspended losses will, in theory, never be released.

It's this #3 that trip up many investors that take the "real estate professional" election. They want to group activities so they can be freed from the $25k loss limit, but then treat the properties as separate when disposed.

[Ebere Okoye]

The IRS recently released a report indicating their intent to perform more examinations of individual tax returns that report losses from rental real estate activity. The increased scrutiny was triggered by a 2008 report that found at least 53% of individual taxpayers with rental real estate activity for tax year 2001 misreported their rental real estate activity. The report appears to direct the IRS focus on those taxpayers claiming real estate professional status

Thus, similar to documenting expenses, documenting your time devoted to real estate related activities is extremely important given the IRS's intent to look more closely at real estate activities.

To read the full Treasury Inspector's Audit Report http://www.treasury.gov/tigta/auditreports/2011reports/201130005fr.pdf

I usually provide my clients with a real estate activity log that can help you in documenting your hours. It contains basically all he activity that you could possibly engage in for rental real estate.

In addition, you should also take the time to analyze your time at work. Working full time does not necessarily mean 2080 hours. Because if we are honest, we do not always clock in 8 hours. It's sometimes hours or sometimes 7 so the base hours for your regular job could be much lower than 2080 and with adding on more activity to the rental real estate log, you could exceed the regular work hours.

This is a coming avalanche so everyone needs to prepare for this