IRS is Auditing My Real Estate Business

[Raquel Baranow]

My business is buying vacant land, cheap through tax lien foreclosure and then selling it. I own 125-vacant lots. Business is BAD, I haven't made a profit in years. I was holding some of the lots for investment but then economy went bad and taxes eat too much profit.

My biggest expense is paying the property taxes on the vacant lots. I deduct the taxes (average $25k/year) on Schedule C. IRS is "disallowing" ALL my Schedule C expenses, including use of car, home office, postage, HOA dues on vacant lots . . . I have receipts for everything.

On Form 886-A they said since my business did not make a profit in three out of five years per IRC 183(d) it is "presumed" that "an activity is not a business." They say I owe $6656.52 for 2010 and they just sent me another audit letter for 2011 . . . I'm thinking I should amend my 1040 but I don't know what strategy to take.

I made about $35k in interest from installment sales in 2010 and $18k in principle payments on the sales.

I never file Schedule A.

What should I do???

[Keith Barton]

Re-read your statement carefully - the word "presume" should make you stop & think (and if it doesn't - I'm telling you to stop & think about it).

Ultimately expenses are allowed if you incurring those expenses is reasonable and necessary to carry on a profit making activity. What is a profit making activity? Well now, that is harder to define. It really needs to be looked at carefully on a case by case basis. How about tree farming? Say I buy 50 acres and plant Christmas trees. How long do those trees take to grow before I can sell any? Let's call it 7 or 8 years on the faster growing trees. Does this mean I can't take any business expenses on my tree farm? No. It just means I have to justify to the IRS that the money I am spending is necessary and reasonable to spend on such a business and that the business is intended to make money.

The 3 in 5 rule is designed to be a general rule to help weed out those who aren't really serious about making money - since most legitimate businesses will need to make money in that time. However, some businesses take longer. Expenses on those businesses that take longer can be legitimately deducted - but ONLY if you can justify it.

Because the IRS presumes it is not a legitimate business, you have to overcome that presumption by fighting the IRS and proving to them you are legitimate (ultimately going to court if you choose to take it that far.)

It all depends on how much you value taking those deductions and how much hassle (and money) you are willing to spend....