Losses and taxes

[Jolene Adam]

About 10 years ago, Friend A (on advice from his CPA) and an IRS rep both told me that I should strive to not have a loss on my rental property for more than three years, or no more than three out of ? years (not sure of the number now...5?  7?)

Last week, Friend B insisted that while that rule may apply to other businesses, there is no such limit when it comes to rental property. He was shocked that I'm not reducing my tax burden each year by maximizing my losses. For example, his CPA had him report some reasonable maintenance costs that he did not actually incur. "Everybody does it." I'm not interested though, unless this is actually legal.

My main concern is that my _actual_ maintenance costs could cause me to have another loss year, and I don't want to push the envelope. The IRS explanations aren't entirely clear to me. Where can I learn more about how to handle losses at tax time, and get a better understanding of passive losses, carrying losses forward, etc.? Can I have a loss as often as I want to, as long as I don't use it to offset my other income? Or does that make my rental property a hobby and not a business, and thereby prohibit me from using rental expenses to offset rental income?

[Brandon Hall]

Hobby loss rules rarely apply to rental real estate. When losses are incurred, depreciation and amortization are often the culprits causing a negative tax loss. Further, just because you have a tax loss doesn't mean you have an operating loss.

But disregarding the above, real estate investment is generally undertaken with a for profit motive. Due to the appreciation aspect of real estate, while rentals may incur losses for many years, the investor may profit significantly once he/she sells the real estate. This is why it's difficult for the IRS to apply the hobby loss rules to your investment. 

It sounds like you personally don't have a CPA and you need one. I've dealt with smart real estate investors who were doing taxes themselves because (1) they thought they knew everything and (2) they wanted to save $600 in prep fees. While these investors are on the right track, they habitually miss deductions that a CPA would have caught. A CPA is likely reading the IRS code day in, day out and the prep fees will be paid for ten times over.

Friend A's CPA was wrong, so was the IRS rep that told you that. This happens all the time. Friend B's CPA will eventually be caught up in an ethics case and Friend B, if audited will pay major penalties and fines (how is he/she going to substantiate expenses that didn't occur?). By the way, you can tell Friend B that he/she is engaging in tax fraud. 

Get a CPA. Spend your time on earning more money and doing more deals, not decoding the tax regs.