Is the IRS Targeting Real Estate Professionals for Audits?
According to Philip Panitz a nationally known tax litigator with Panitz & Kossoff the IRS is casting a very wide net against what they perceive as abuse in the area real estate. The IRS is claiming that too many passive investors are using losses from real estate investments to offset their other income.
Tyrone Adams, VP Member Services took some time to discuss a little more in depth with Mr. Panitz why the IRS is unwilling to allow legitimate real estate professionals who spend the requisite 750+ hours and over 50% of their time doing real estate endeavors, claim their losses.
TA: It appears this issue is not really new, are there other reasons the IRS is auditing more real estate professionals?
Panitz: Although the IRS never admits which taxpayers are in their crosshairs, it’s clear that real estate professionals are being targeted because previous audits of real estate investors have netted a large amount of tax adjustments due to loss disallowance. Success breeds success which leads the IRS to determine that there has been a tax gap or abuse in this area. In the 1990’s I averaged about two real estate professional cases a year and now I average about ten. There’s a reason for that.
TA: What does the law say about claiming failed investments on your taxes?
Panitz: A “failed” investment in real estate could mean one of two things. It’s either an ongoing investment that is losing the investor money in the short term when monthly expenses and depreciation exceed income or a loss upon complete liquidation of the investment. The distinction is significant. The IRS attacks “losses” that exceed income from the investment, particularly if they are offsetting other income on an investor’s tax return. However, when a property is liquidated for a loss, which is a capital loss that the IRS is not disputing the sale year as the appropriate time to take the loss. Unfortunately, if you are not a real estate professional, you can only write off $3,000 per year against other non-capital income.
TA: What are some red flags that would put our members at risk of being audited?
Panitz: Anytime an investor is moving losses from their Schedule E properties and offsetting other income from a W-2 job, you are almost painting the red flag “scarlet.” That screams to the IRS “audit me.” That doesn’t mean that the losses are not legitimate, and if the investor qualifies as a real estate professional they will be allowed, but it almost guarantees at least the IRS is going to look at it.
TA: What is the audit process like for small business owners?
Panitz: It’s surprising to some but the “audit process” for small business owners is excruciatingly painful, more so than large business owners. It comes down to time and money. Small business owners typically don’t have the resources to spend a lot of time gathering information to comply with the IRS’ numerous requests, and the common complaint is that an IRS audit takes the owner of the business away from their business without anybody to cover for them.
TA: If I am the broker/owner of an office and one of my brokers is audited will it have a domino effect and now the other brokers including me the broker owner become likely candidates for being audited?
Panitz: I have not seen in practice an audit of a real estate investor/broker causing additional audits of other brokers in the same office. Since most of the real estate professional audits are for properties deducted on a Schedule E of a personal 1040 tax return, these are “individual audits” and not company audits and the IRS auditor is focused on that particular individual.
TA: What do our members need to know or do to be prepared if they are audited?
Panitz: The best advice I can give real estate investors to support their deductions is to keep a contemporaneous log of their time managing their real estate investments, as well as the time they spend on real estate in general. Keep really good substantiation of their expenses, and sometimes it is handy to cross-reference their log to the expense item. IRS auditors usually go away a lot faster when the taxpayer isn’t just telling them the way things are, but showing them with objective proof the way things are. If you spend ten hours painting an apartment building, the entry of ten hours in your log might mention the cost of the paintbrushes, the paint, the tarp, the invoice from a painter if you paid someone else, the yellow page ad showing the painter you called, the phone calls you made shopping for a painter, all of these items objectively corroborate the time the investor says he spent on the project. The more the auditor is overwhelmed with the taxpayer’s thorough records, the more likely the taxpayer has bought him or herself a “no change” audit.
TA: How long does the audit process take?
Panitz: The audit process can take a couple of months, or a year. It will depend upon the taxpayers records, and if the auditor has to keep asking for additional information and how long it takes for the taxpayer to get back to the auditor. I typically recommend that the taxpayer NOT sign waivers of the statute of limitations, this will give the IRS unlimited time to keep asking for more information. The more organized the taxpayer, the shorter time period of the audit, and the less painful it will be.
TA: If the audit findings reveal some discrepancies intentional or not what happens? Fines? Criminal charges?
Panitz: If there are mistakes on a tax return, this normally does not result in criminal charges. Mistakes happen. On the other hand, if the audit reveals that the taxpayer was keeping a separate set of books and declaring 10% of what he was actually earning, you might be facing a criminal investigation for tax evasion. A normal audit, where the IRS determines that there is an additional tax liability could add some negligence penalties and failure to pay penalties plus interest. Of course, just because the IRS says that they have disallowed deductions doesn’t mean they are correct. A tax professional should always be assisting the taxpayer through the audit process, and sometimes that tax professional will advise the taxpayer to fight the audit because the auditor is simply wrong. The IRS is not infallible, far from it.
You can learn more about the IRS increasing audits on real estate professionals by going to Panitz & Kossoff website at http://www.pktaxlaw.com/.