NO, merely renting out your house, condo, or apartment does not attract IRS audits.
But yes, there are rental items that attract IRS scrutiny:
• Deducting expenses that are disproportionately high compared to rent collected.
• Deducting capital items that should be capitalized and depreciated.
• Claiming to be real estate professional.
Let’s discuss these items.
Rental Properties Produce Rental losses:
Most rental properties produce rental losses due to depreciation. Expenses for mortgage interest, real estate taxes, and repairs typically offset gross rents collected. It’s depreciation that produces tax losses. Such losses are considered passive and cannot be used to offset active income from wages and business income. However, you can deduct rental losses if you are an active participant in the management of your rental property.
Passive rules allow you to deduct a maximum of $25,000 every year. Deducting more than that amount triggers IRS activity.
Rental Losses For Real Estate Professionals:
Rental losses produce tax shelters that investors crave to reduce tax liabilities. A regular rental owner can deduct a maximum loss of $25,000 as described above. Real Estate Professionals, on the other hand, can deduct more than that amount. In a simplified example, you can deduct $100,000 of rental losses to offset active income of $100,000 to end up with a zero tax – if you are a Real Estate Professional. Claiming status of Real Estate Professional is tough. You have to follow strict rules. You need to spend a minimum of 750 hours a year (14 hours a week for 52 weeks) working on your rental property.
Operating your rentals should be your full-time job. If you have a full-time job outside rental activities, things get tougher. IRS may do more digging to see if you meet the standards to take the deduction. In my personal experience of defending new clients, a designation as a Real Estate Professional in a year with huge losses guarantees an audit.
New Rental Owners:
New rental property owners who prepare their own tax returns may not realize that some renovation costs need to be capitalized and depreciated over many years. Minor repairs to maintain your rental units in good operating condition can be expensed in the current year. However, costs that increase the value or extend its life have to be capitalized as an asset and depreciated over time (27.5 years for residential and 39 years for commercial property). A current deduction of $30,000 for kitchen renovation of a small 4-unit apartment is a red flag. It has to be depreciated over 27.5 years.
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Victor Santos Sy graduated Cum Laude from UE with a BBA and from Indiana State University with an MBA. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation in Pasadena, California.
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He has 50 years of experience in defending taxpayers audited by the IRS, FTB, EDD, BOE and other governmental agencies. He is publishing a book on his expertise – “HOW TO AVOID OR SURVIVE IRS AUDITS.” Our readers may inquire about the book or email tax questions at [email protected].