The IRS has recently issued internal memos that appear to be focusing on increasing audits of rental real estate activities. The Treasury Inspector General for Tax Administration examined tax returns from 2001 and has found that many rental real estate owners are underreporting the taxable income from those activities. They are recommending an increase in the auditing of rental activities in the future. Because many of our clients maintain residential and commercial rental properties, we felt a quick review of some of the pertinent areas that may be on the audit list would be pertinent at this time.

All real property rental activities are reported on IRS Schedule E. The rental income and related expenses are shown separately for each property owned. The main area of concern for the IRS in most situations is the rental income received. Clients should maintain written rental agreements with each lessee to show the monthly rental amount and the term of the rental. This agreement will help to verify the rental income received for each property. Receipts should also be kept for all rental expenses including advertising, insurance, taxes, utilities, management fees, and repairs and maintenance. Taxpayers should also maintain a log or other record of the travel and mileage related to the maintenance and upkeep of the property. The main area of contention in the expense area with most IRS auditors stems from the difference between a deductible repair expense and a major improvement that needs to be depreciated over the life of the property. An improvement adds value to the property or extends the life of the property. A new bathroom or new roof would be an improvement. Repairs to an existing room or a small roof repair would be considered a deductible repair.

Another major area of concern to the IRS is the deductibility of rental losses for certain higher income taxpayers. The tax code was changed in 1986 to limit the rental losses that taxpayer’s can use to offset other income on their tax returns. These limitations are called the Passive Loss Rules. Now, current tax law has set a limit of $25,000 in rental losses that can be claimed in a year for taxpayers that actively manage their rental properties. Another limitation is that the $25,000 loss limit is phased out for taxpayers with income above $100,000 and the full deduction is phased-out for income over $150,000. These losses are not lost, but are carried over to future years under the Passive Loss Carryover Rules. These losses can be used to offset other passive income or the gains on the sale of other rental properties. The losses are fully deductible upon the sale of the property that they were originated. This complex calculation is done on form 8582, and is one of the major areas of concern for the IRS. They have found that many taxpayers have not been correctly filing the IRS Form 8582 that is used to calculate the correct passive loss carryovers.

There are other issues that have been litigated between taxpayers and the IRS in recent years concerning rental properties. A taxpayer’s active management in his or her rental property can be a key issue in the allowance of a rental loss deduction. The IRS can deny deductions based upon the taxpayer’s lack of adequate records regarding their active participation in the properties. Maintaining good records for the purchase price of the property and the subsequent improvements for as long as you own the property can be important in the calculation of the gain or loss on the sale of that property many years down the road.

If you have questions regarding the ownership and tax attributes of owning and rental residential or commercial property please feel free to contact our office at (717) 838-2387.