IRS audit of rental property

[imjulier]

Hi-

Has anyone out there been through an IRS audit of rental property? Notice of audit from IRS said it was limited to one out of two rental property's repairs that were for about $7K. Taxpayer decided to handle this on his own and met with the auditor. Notice after the audit looks like the IRS is either saying a portion was personal use or a portion was not for profit or not available for rent so most of the expenses are disallowed.

Rental property has been 100% rental since 2006 but it was the main home of the taxpayer prior to that. For the year being audited, taxpayer had not rented it for about 6 months while the taxpayer did repairs and tried to sell it. Not being able to sell it, it was rented again.

It seems reasonable to me that this has been investment property for 4 years prior to audit and that even through a repair and sell period of 6 months it would remain an investment property. Is there any basis for the IRS to limit the deductions to the extent of income because it was not available for rent? That disallows a lot of expenses.

Any thoughts are greatly appreciated.

[joanmcq]

Well, the first mistake was that the tp decided to represent him/herself. What the tp said to the auditor regarding the repairs is unknown, but he or she probably said something like "Oh, I was fixing it up trying to sell it, and so it wasn't rented then. But then I couldn't sell it, so I put it up for rent again". If the tp was trying to sell the property, it is probable the repairs were not deductible rental expenses, but selling expenses (capitalized to basis if the property had been sold). Therefore, it's likely the auditor is making the arguement that the property was not available for rent during that period, and so the expenses would not be deductible as rental expenses.

However, when put back into service, you could argue that the repairs would be capitalized, and depreciated.

[Jack from Ohio]

When the client didn't allow you to represent him, he sealed his fate with the auditor. Were it me, I would not get involved at this point. I hear... "I ain't afraid of the IRS." "This will be simple, I can handle it."

If my professionalism was not apparent enough for my client to let me represent them, then the client deserves what they end up with.

I guess I am fed up with clients not listening!!!!

[JohnH]

As long as they pay their bill, it doesn't matter much to me whether they listen or not. Just as long as they are willing to live with the consequences.

Years ago a church member asked my advice about a tax matter. After I told them what needed to be done, they thanked me and said they were going to take another approach (which was incorrect). A second church member who happened to be standing there during the conversation asked if it bothered me that the person was going to ignore my advice. I replied "There are plenty of people who pay me good money for advice that they ignore, so why should it bother me if someone ignores free advice?"

[kcjenkins]

I'm totally with Joan on this one. It's highly likely that the t/p did indeed seal his fate with just such dialog. But I also agree, the point at this time is not to argue about the capitalization of the expenses, but to argue that they could then be §179'd when he put it back on the market. And that this was what he intended.

[jainen]

>>this has been property.... Is there any basis for the IRS to limit the deductions<<

Of course there is--that's part of the definintion of investment property. Although a professional might have saved something in the audit, the FIRST mistake was not getting tax advice about taking it out of rental service way back when.

Depending on actual records instead of definitions, you may succeed in Appeals. It's a lot of work even to evaluate where the auditor was weak or if the taxpayer has a case at all. Get a substantial retainer up front, with a separate engagement letter requiring full cooperation from the client with no guarantee of specific results. In my opinion, capitalizing repairs is not a good argument. The strong position would be to document that the property remained a rental during temporary repairs, and the unrealistic sales effort was simply a back-up plan.

On the other hand, a percentage of 7K is not that big a tax bill, even with the automatic state audit to follow. Maybe the taxpayer can just shrug it off as one of life's unfair things.

[joanmcq]

I'm totally with Joan on this one. It's highly likely that the t/p did indeed seal his fate with just such dialog. But I also agree, the point at this time is not to argue about the capitalization of the expenses, but to argue that they could then be §179'd when he put it back on the market. And that this was what he intended.

Can't use Sec. 179 on rentals...Depending on the year, there may have been some bonus depreciation, but if the rental was taken out of service, the capitalized repairs are no longer 'new'.

Ugh, now I have to finish getting ready for what might be the first ever RDP community property random compliance audit. Tomorrow at 12:30. Don't have much of an idea what to expect; there are transfers between one partner and the other, but the non-audited partner's statements (or anything else regarding the partner) are not included in the audit. Just love blazing new ground.... :wacko:

[imjulier]

I believe Joan is right with the dialog between taxpayer and auditor.

What the auditor has done is limit the expenses to the extent of income (all expenses) which disallows a portion of mortgage interest, property taxes, insurance, utilities, depreciation, and repairs to the tune of about $16K in total. Also excluded is a carryover loss from the previous year with a resulting reduced carryover loss to 2011 which is not being audited but surely adjusted down the road. The audit result for 2010 is about $2500 in taxes and about $600 in penalties and interest. My guess is the impact on 2011 will be about the same if not a little more.

Unfortunately, I was the preparer on this one and didn't think that the expenses could be limited since personal use didn't apply and the property, even though under repair and not rented, was still a rental/investment property so not limiting the expenses was reasonable. As such, I will probably take jainen's positon that the property remained a rental and the sales effort was merely an effort to see if their investment property could be sold at that time.

By the way, I understand that the IRS was "audited" and the results indicated that 50% of rental property owners under/over-state income/expenses so efforts toward auditing rental properties will be stepped up. This must be part of that effort. I also saw that the IRS may disallow expenses if ythere is a loss for 3 or more years...much like the hobby rules. Really? I don't have a client who makes a profit on their rental properties because with both interest expense and depreciation create a loss every year. Do your cleints with rental properties generate income for tax purposes? What am I missing?

By the way, I appreciate everyone's comments.

Julie

[joanmcq]

Mine have income, but I have two properties without mortgages. As do several of my client's rentals. I stress to my clients with rentals or thinking about buying rentals that positive cash flow is a good idea, although in the early years you do often get a tax loss simply because depreciation is straight line and mortgages are front-loaded for interest. Any audit where you can show positive cash flow should fly.

There are also a lot of situations now where people are renting houses they may have sold if conditions were better. In my area, rents are fairly high, while real estate price remain low. Getting some of your money from a house rather than selling at an extreme discount due to heavy foreclosure activity in an area (not to mention preserving your credit rating) could also be a decent business purpose to renting out a property.

[mcb39]

I have clients with rentals that show either a loss due to depreciation and mtg int and others that show a profit because they have no mortgage. There are so many variables. Lately have had a lot of them sitting empty; but still available for rent. Also, some getting trashed. It has gotten to be a tough market unless they have high-end properties and/or long term renters. IMO

I also agree that the client in the original question shoud not have gone it alone........but you can only lead a horse to water.

[jainen]

>>Do your cleints with rental properties generate income for tax purposes? What am I missing?<<

You are missing the last factor in the hobby loss determination, as stated on page 5 of Pub 535. "whether... You can expect to make a future profit from the appreciation of the assets used in the activity." Unless one is a slum lord, we generally expect residential rentals to generate taxable capital gain in spite of annual operating losses.

The reason I said the sales effort was "unrealistic" is that six months is not long enough to list property in a buyer's market except at a quick-sale price. Especially when the house is all torn up. Meanwhile, there is a business purpose in testing market value, and it makes sense to do that when the property is otherwise vacant anyway. On the other hand, a long period of repairs begins to look like a capital improvement. If Julie's client decides to fight, she must address multiple issues.

[Lion EA]

When I was at Block, they suggested we look at cash flow. If cash flow is positive and the tax loss occurs due to depreciation, we could count on Block sending a good EA to the audit and, if necessary, paying out under their POM guarantee. Unless the client failed to report all rental income or couldn't document all expenses.

[imjulier]

Thanks for everyone's comments. Lots to think about but I have been coaching the client towards the idea that the IRS stance might be reasonable and they are starting to see that side of it too. Now, I just have to decide if there is any merit in trying to fight it because there won't be any documentation to support that they were trying to rent it during that time and I'm pretty sure they said as much to the auditor. Hmmmm....always an adventure.

Julie

[jainen]

>>there won't be any documentation to support that they were trying to rent it during that time<<

Think creative. Maybe the Realtor listing or one of the work orders identifies it as rental property. Maybe a business license or landlord insurance still covered the period. Maybe he wrote about it in his blog.

One CAN'T have a tenant during major repairs; that doesn't mean he changed its usage. Same with allowing a Realtor to ask around about it. Six months is not a long vacancy--it's just a couple of months to schedule the work, a couple of months to complete the project, and a couple of months to find new tenants. Perfectly reasonable.

Just remember to cooperate fully with the IRS so you can remind them that if you have to go to Tax Court the burden of proof will shift on to THEM. (Of course, don't try that line until everything else has failed!)

[BulldogTom]

OMG - Jainen taking the side of the stupid taxpayer instead of just letting them suffer the consequneces of their own stupidity. NEVER, NEVER, NEVER let the client go it alone. Because when they do.....well....stuff happens.

I am 100% in agreement with Jainen on the strategy to use. Appeal that muther....and with good ammunition. I would almost do it on a contigency (which is legal if it is an appeal) just to prove to the clients how dumb they are and how smart you are and how they should NEVER NEVER Ever do an audit by themselves again.

Tom

Hollister, CA

[jainen]

>>Hollister, CA<<

What happened to Lodi? Oh I remember now--KPIG had to shut down the Paradise simulcast. Of course you couldn't stay. I feel it, but I kind of lost track when Travus T. Hipp died. Chin up--Cousin Al lives right there in Hollister!

[imjulier]

Auditor "forgot" to provide for mortgage interest and penalties disallowed on Sch E on Schedule A but after making this adjustment, the taxes due are within the client's range of acceptable. Trying to determine if its worth fighting at this point. Does anyone know if the IRS systems are good enough to trace through the 8582 passive loss carryforward from the 2010 audit adjustment to 2011? Will a notice on 2011 be issued to the taxpayer as a result? If not, this ones probably done without appeals, but if so, its worth taking to appeals. The auditor was not smart enough to know this but are the systems smart enough to know this? Any info is helpful and thanks again for sharing.

Julie