Key Income Tax Rules and Opportunities for Landlords

George Adams CPA MBA

 January 27, 2022

This article was adapted from a presentation given to a Bangor area landlord association

Introduction

Hello everyone. My name is George Adams and I’m a CPA based on Brewer. I have over thirty years of experience as a tax accountant, and one of the primary areas I practice in is real estate.

I’d like to thank you and your organization for inviting my wife and I to dinner tonight and giving me an opportunity to talk about key tax rules as they apply to your industry.

Real estate is one of the most complex areas of tax law, with many obscure rules, exceptions and traps for the unwary. Here in this presentation I’m going to focus on what I believe are five of the most important concepts landlords and others in the real estate business should know about.

If anything I say is unclear, please make a note and ask me about it in our subsequent Q&A.

Everyone should have a handout that accompanies my presentation. If you don’t please raise your hand and my wife will get one to you.

Allright let’s get started. Please turn to page one, Topic One, “Keep Good Records and Audit-Proof Your Business.”

Topic One: Keep Good Records and Audit-Proof Your Business

As a business owner you should keep good records for a completely selfish reason: to protect yourself and your business in case you are audited. Under the general rule of Internal Revenue Code (“IRC”) Section 61(a) everything is taxable income, EVERYTHING, unless you can prove otherwise. The burden of proof is on you.

You may loan money to your business, or transfer funds from one account to another. These transactions are not taxable, unless you are unable to prove what they are. Without good records, the IRS will say that all of your bank deposits are taxable income.

Similar rules apply to business expenses, which must be ordinary and necessary to even be deductible. You need third party receipts or other credible documentation to support your deductions. Without such evidence the IRS will disallow the deduction. The rule for deductions is brutally simple: Prove it or lose it.

Many people ask me how long they need to keep records and receipts. The answer is, at least three years, but no more than seven. This is derived from the Statute of Limitations that restricts the IRS on how far back it can go when conducting audits.

Now what happens if, through no fault of your own, you lose all your records and receipts? Catastrophes happen from time to time. The truth is that the IRS is not very accommodating in these cases. But for years the courts have acted, again and again, to restrain and limit the powers and perceived excesses of the IRS. And one important protection the courts have created for taxpayers is something called the Cohan Rule.

The Cohan Rule says that if you lose all your business records you are allowed to reconstruct them using reasonable estimates and third party information. Believe me, this is a difficult and expensive process. And for this reason you should always regard the Cohan Rule as Plan Z, NOT Plan B. It’s the last resort. See:

http://www.law.cornell.edu/wex/cohan_rule

One final point on records and the tax returns that are created from them. Every tax return contains two very important numbers. The first number is obvious and everyone knows about it: taxable income. The second number is invisible and few know about it: Risk, specifically, the probability that a tax return will be audited by the IRS or Maine.

The best way to prepare tax returns is to simultaneously minimize BOTH numbers. I.E., minimize taxable income by finding the legal minimum tax and, also, minimize the risk of an audit. See Appendix A for a table by entity and income level of recent IRS audit statistics and who they are picking on.

Let’s move on to Topic Two: Real Estate Professional Status.

Topic Two: Real Estate Professional Status

This topic could be very important to those of you who have substantial losses from rental real estate.

Before I talk about the tax benefit of being a real estate professional let me explain the general rule that applies to landlords who have net real estate losses.

If you materially participate in running your real estate business the IRS will allow you to deduct net losses up to $25,000. However, if your modified adjusted gross income (“MAGI”) exceeds $100,000 the IRS will start to take away this $25,000 allowance for rental losses. If MAGI exceeds $150,000 the IRS won’t allow you to deduct any real estate losses! Incredible, but true.

So what happens to the losses you can’t deduct? The answer is that they become “suspended losses” carried forward to future years. Every year the maximum deduction is $25,000, subject to phase-out if MAGI exceeds $100,000. It’s possible your suspended real estate losses will grow year by year by year. The IRS will allow you to deduct these suspended losses only when you completely dispose of the rental property in a taxable transaction.

Obviously these are very restrictive rules that add insult to injury. It’s bad enough you lost money in your real estate business. It’s even worse to have the IRS tell you that you can’t deduct what you lost.

But there is a way to deal with this horrible situation. It’s called Real Estate Professional status. If you satisfy the requirements to be classified as a real estate professional for income tax purposes then ALL of your real estate losses would be fully deductible from that point forward. You will never again have to deal with losses that are non-deductible. You will never again have suspended losses.

So how can you become a real estate professional? You must satisfy two requirements defined in IRC Section 469 (c ) (7)

Once you satisfy these tests ALL of your real estate losses will be FULLY deductible.

Here’s some fine print that may be relevant: Those of you who work full-time in a side job not related to real estate will have to work hard to document the time you spend running your own real estate business. And those of you who use a property management company to operate your real estate business will have an even harder time claiming real estate professional status.

The Tax Court case of Hassinipour v. Commissioner (2013) shows that the IRS is determined to challenge people who claim real estate professional status in order to deduct their real estate losses. Be aware of this, and prepare accordingly.

If you want the inside scoop on the IRS game-plan to audit people who claim real estate professional status see key excerpts from their playbook in Appendix B.

Now let’s move on to related Topic Three: “The Aggregation Election.”

Topic Three: The Aggregation Election

The Aggregation Election provided by IRC Section 469(c)(7)(A) is a real lifesaver for those of you with significant real estate losses who own many rental properties. And no, this is not the aggravation election, though your income taxes may be very aggravating if you don’t make this election when you should.

So what is the aggregation election and why should you care about it? Here’s an example that will illustrate how it can help you.

Let’s say you own twelve rental properties, and that your total real estate losses for the year exceed $25,000. You heard what I talked about in the previous topic on real estate professional status and believe you qualify to claim this status. You spend more than half your time taking care of real estate properties and you spend more than 750 hours per year in such businesses.

But there is a snag. The 750 hours per year requirement applies to EACH of your rental properties. You have a math problem. There are only 8,760 hours in a year, and if you own twelve rentals and must satisfy the 750 hour standard for each you are going to run out of hours. Even if you claim to work all the time, even if you claim to dream (or perhaps have nightmares) about your rental properties the fact is there just aren’t enough hours in the year for you.

What can you do?

The answer is to file an aggregation election with your income tax return, which consists of you telling the IRS to treat ALL of your rental properties as a single property solely for the purpose of satisfying the 750-hour per year requirement.

All of sudden the math becomes much easier. If you file this election it doesn’t matter if you own dozens, hundreds, even thousands of properties. All you have to do is spend over 750 hours per year managing them all and you will be able to claim real estate professional status and deduct in full ALL of your real estate losses. What a wonderful answer.

The aggregation election is the counter-part, the crucial second step needed for you to become a real estate professional and be able to deduct all of your rental losses.

And now a word of caution: this election is not for everyone. What if you have prior year suspended losses (because you didn’t know about real estate professional status) and what if you are planning on selling one of your properties? You may want to wait until after you sell a property before filing the aggregation election.

Under the complete disposition rule of IRC Section 469(g) all suspended losses related to a property become fully deductible only when you sell the property. If you file an aggregation election before you sell then all your properties are treated as a single property and you would have to sell ALL of your properties in order to deduct prior suspended losses. Thus, it may be wise to wait in this case.

Here is an example of the wording of the aggregation election to file with your tax return:

Taxpayer is a qualified real estate professional and hereby elects under IRC Section 469(c)(7)(A) to aggregate all properties of __________________ as a single rental real estate activity.

Let’s move on to Topic Four, “Depreciation for Landlords.”

Topic Four: Depreciation for Landlords

What is depreciation and why should you care about it?

Depreciation is a deduction allowed by the IRS for property and business assets. It is typically one of the largest expenses for landlords. Depreciation deductions are determined by the type of property subject to depreciation. Congress and the IRS have stipulated certain methods for claiming depreciation that are based on how long business assets are expected to last.

Commercial real estate is usually depreciated using a straight-line method over 39 years. “Straight line” simply means the depreciation deduction is the same every year.

Residential rental property is depreciated straight line over 27.5 years. Carpet and flooring are considered 5-year assets and can be depreciated in several ways. Business vehicles are considered 5-year assets.

The important point about depreciation is that when you buy or construct a building it is very much in your interest to allocate the cost to various types of components. Cost allocation matters because it determines how much depreciation expense you can claim. It is to your advantage to allocate as much cost as you can justify to things like carpet and flooring because these are 5-year assets that will give you a much larger depreciation deduction. New tax laws enacted in 2017 provided for accelerated depreciation deductions on qualifying real estate. This complex subject is outside the scope of my presentation today.

On the other hand all costs allocated to a building, such as the roof, siding, drywall, and HVAC systems will be subject to either 39 or 27.5 year straight-line depreciation (subject to possible accelerated depreciation options.)

Another important asset is called land improvements and consists of fencing, paving, landscaping and related assets. Land improvements are classified as a 15- year asset. Here again, it is to your advantage to maximize costs allocated to an asset that has a shorter asset life. If you could freely choose where to allocate a dollar of cost, you are better off allocating it to land improvements instead of to the building. This is because your depreciation deduction is larger for land improvements than for a building.

Here’s an example. Let’s say you bought a building and never allocated any portion of its cost to a paved driveway, fence, and finished lawn. Instead, you treated these costs as just another part of the building and are writing them off over 27.5 years. Assume a reasonable estimate of the cost of the driveway, fence and lawn is $10,000. Because you mixed the costs of these land improvements in with the building they are being depreciated over 27.5 years, and your annual depreciation deduction is $364.

If you had separated out the $10,000 cost of the land improvements from the building your annual depreciation deduction would almost double to $667.

There are major long-term consequences for your taxes on how you allocate costs to business assets. The goal is to maximize your depreciation deduction, and one way you can do this is to allocate building costs effectively. Make sure you carefully document whatever cost allocation you use.

Now, let’s move to the last topic: “Getting a Loan.”

Topic Five: Getting a Loan

Let’s say you plan to buy another rental property. You go to your bank and apply for a loan. What’s the first thing the bank is likely to ask for? Of course the answer is copies of your tax returns.

Now what if you’ve had losses from your rental properties? These losses will show up in your tax returns and your bank loan officer may ask about them. As a general rule bankers don’t like losses because it makes them wonder how a loan will be repaid. Many of you have heard the old saying: “Pay no tax, borrow no money.”

If you have losses from your rental business and are applying for a loan you must be able to show the bank how the loan will be repaid. The losses shown in your tax returns probably contain a significant depreciation deduction. Remember in the former topic I said depreciation is an accounting adjustment and not an actual outflow of money. Depreciation consists of writing off assets, not writing checks.

For this reason it is common to adjust losses shown in tax returns by adding back depreciation expense. In fact there could be many adjustments needed in order to translate the loss reported in a tax return into some fair and reasonable measure of your business cash flows and actual economic income. Tax returns don’t necessarily show your ability to borrow; cash flow statements do.

Thus, when your banker asks for tax returns you may want to give him or her a cash flow statement as well which proves that you can indeed afford to pay for a loan.

Conclusion

That concludes my presentation tonight. I hope this information is helpful and will assist you in managing your taxes more effectively. Some of these topics are complex. One thing I’ve learned in my thirty or so years as an accountant is that people have a choice when it comes to taxes: Simplicity or pay less tax. Which do you prefer?

Simplicity can be very expensive. Saving on taxes can be very complex. Like it or not that’s how things are.

And now here’s a short story about a client of mine who had a very unfortunate experience with a nasty tenant. It’s a cautionary tale about how important it is to screen your potential tenants and be careful who you give a lease to.

Dollars Down the Drain

Dollars Down the Drain: What You Don't Know Can Cost You a Fortune.

Once upon a time I had a client who owned several large apartment buildings. His rentals did well and he had few problems with his tenants.

Then one day my client noticed a sudden large increase in his water, sewer and natural gas bills. This occurred in an apartment building with a large boiler heated with natural gas that provided hot water to all the units. At first my client thought there was a leak, or some other mechanical failure.

He engaged a plumber to review the boiler system and pipes. But the plumber said everything was fine and in good working order. Meanwhile the bills for water, sewer and gas remained much higher than before. My poor client was frantic.

I became aware of this problem when I prepared the tax returns for this client and noticed that a relatively new boiler had failed and was replaced. Most boilers last 8 to 12 years or more. This boiler was only 3 years old when it failed. The contractor who replaced it claimed the boiler failed from overuse.

I also noticed the massive utility bills for this particular building, which were significantly higher than the other buildings owned by this client. The cause of the problem remained a mystery. In desperation my client considered going after the City, believing the problem had to do with City-owned water meters. Unfortunately, my client was barking up the wrong tree.

Unknown to us at the time my client had a disgruntled tenant who was secretly irate at a rent increase from a prior year. We surmised subsequently that this malicious tenant decided to get back at his landlord by constantly running the hot water all hours of the day and night. Because this tenant worked from home he could hear when plumbers and other repairmen showed up at the building to try to find the cause of the massive water consumption and very high utility bills.

My client and I even suspected that this tenant, who was an expert in various electronic devices, may have had some type of surveillance system to inform him when the landlord or repair workers showed up at the building, so he could temporarily shut off the hot water and evade detection.

My client described this tenant based on his own impressions: “He seemed like a nice guy, very quiet and methodical.”

The problem ended abruptly only when this tenant moved out, and my clients’ astronomically high utility bills returned to normal levels.

My client was so upset at this incident that he decided to install separately metered utilities for each unit. I recommended that he consult with an attorney to see if he could include a clause in his leases that provided for an extra rent surcharge in case of excessive utility costs.

My client’s issue went away and this horrible incident faded into the past. The new separately metered system he installed protected him from future incidents. This reminds me of an old adage engineers have:

Good luck is the byproduct of good design.

APPENDIX A: IRS AUDIT STATISTICS

Who Are They Picking On?

APPENDIX B: THE IRS GAME PLAN FOR CHALLENGING REAL ESTATE PROFESSIONAL STATUS

Source: IRS Audit Technique Guide

See here for full text:

http://www.irs.gov/pub/irs-mssp/pal.pdf

Real Estate Professional In A Nutshell

• Beginning in 1994, a real estate professional may treat rental real estate activities as non-passive if the taxpayer materially participates in the rental activities. The material participation requirement applies separately to each rental activity (unless the taxpayer made a timely election to group all his rentals as a single activity). These rules apply to individual taxpayers and closely held C Corporations. See check sheet and interview questions at end of chapter. 1 Issues
  
  
  
• To qualify as a real estate professional, the taxpayer must spend
  
  
  
• 1. More than 50 percent of his/her time in real estate activities;
  
  
  
• AND,
  
  
  
• 2. More than 750 hours in real estate activities.
  
  
  
• A real estate professional must materially participate in each rental activity for the loss to be deductible. Exception: A real estate professional may file a written election to group all rental real estate activities as one activity. As a practical matter, most elections were filed in 1995. However, the taxpayer may file the election in any year, and it will bind future years from that poin

Issue Identification

• Check to see if all Schedule E rental real estate losses have been deducted as non-passive, possibly not considering the fact that the taxpayer must materially participate in each rental activity.
  
  
  
• Look at the taxpayer’s occupation next to the signature block and Schedule E line 43. To be a real estate professional, the taxpayer must spend the majority of time in real property businesses and/or rental real estate.
  
  
  
• Review the Schedule E activities, Schedule K-1s for Form 1065 and Form 1120S returns, and W-2s for other indications regarding the nature of the taxpayer’s activities. Real Estate Professional To be a real estate professional, an individual must spend the majority of his or her time in real property businesses:
  
  
  
• Development or redevelopment
  
  
  
• Construction or reconstruction
  
  
  
• Acquisition or conversion
  
  
  
• Rental
  
  
  
• Management or operation
  
  
  
• Leasing
  
  
  
• Brokerage The taxpayer must meet each of the following two time requirements:
  
  More than 50 percent of his/her time working in real property businesses;
  
  AND,
  
  More than 750 hours of service during the year.

One spouse alone must meet both tests. In addition, services performed as an employee do not count unless the employee is at least a 5 percent owner.

Finally, before rental losses are deductible without being limited by the passive losses rules, the taxpayer must materially participate in each rental.

Examination Techniques:

• Determine whether the taxpayer materially participates in one or more of the specific real estate trades or businesses listed above.
  
  
  
• Determine who is the real estate professional, husband or wife.
  
  
  
• Request and closely examine the taxpayer’s documentation regarding time. The taxpayer is required under Reg. § 1.469-5T(f)(4) to provide proof of services performed and the hours attributable to those services.

See Chapter 4 for more on methods of proof.

Scrutinize other activities the taxpayer is engaged in to determine whether time claimed makes sense.

• Qualification as a real estate professional is a determination, not an election. A taxpayer may attempt to manipulate the passive activity rules by inappropriately claiming to be a real estate professional, or conversely, by not claiming to be one (for instance, if certain activities are generating net income).
  
  
  
• Material Participation for Real Estate Pros A real estate professional may deduct rental real estate losses only to the extent he or she materially participates in each rental activity. Unless the taxpayer elected to group his rentals as a single activity, each rental is treated as a separate activity. Under the material participation rules, the time of both spouses is counted. The material participation test then applies separately to each individual rental real estate activity. If the taxpayer materially participates in an activity, net income or loss from that activity is non-passive. If the taxpayer does not materially participate, despite being a real estate professional, the rental is passive and losses (or income) go on Form 8582. A taxpayer, who does most of the work in a rental, meets Test 2 for material participation in Reg. § 1.469-5T(a)(2). However, if there is on-site management, it may be difficult for the taxpayer to materially participate because:
  
  1. Rental activities, by nature, normally do not require significant day-to- day involvement, i.e. they are not time intensive.
  
  2. For many taxpayers using any kind of outside management, the only material participation test available is the 500-hour test. In many situations, the other tests will not apply.
  
  3. In many circumstances, an individual rental activity will not require 500 hours of participation, nor will the taxpayer have sufficient time available to spend 500 hours on each individual rental real estate activity.
  
  
  
• Examination Techniques:
  
  1. During the initial interview, question the taxpayer regarding time spent in all activities (personal, business, civic, family, hobbies, etc.).
  
  2. Request and closely examine the taxpayer’s documentation of time utilized for material participation in each activity. See the log Chapter 5.
  
  3. Look for time spent by others in the activity. Indicators: commissions, management fees, expenses for cleaning, maintenance, repairs, etc.
  

Election to Group Rental Real Estate

A real estate professional may make an election to group all rental real estate activities as one single activity. In order to make a valid election, Treasury Regulation § 1.469-9(g) requires a taxpayer to file a written statement and attach it to an original return. This election cannot be made on an amended return or during an audit!

Examination Techniques:

• Question the taxpayer in the initial interview whether an election was made, grouping rental real estate interests as a single activity.
  
  
  
• Request a copy of the return with the election. Request the original Form 1040, U.S. Individual Income Tax Return, from the IRS Center if doubts exist as to the documents furnished.
  
  
  
• Review prior and subsequent year’s returns for consistency.
  
  
  
• Closely scrutinize any passive income on Form 8582 line 1a. If the taxpayer is a real estate professional and did most of the work on the rental, gain on disposition does not belong on Form 8582. Real Estate Pro: Law
  
  
  
• IRC § 469(c)(7): Real estate professional defined (special rules for taxpayers in real property trades or businesses.
  
  
  
• IRC § 469(c)(7)(A)(ii) and Reg. 1.469-9(e)(3): Each interest in a rental real estate activity is a separate activity for purposes of meeting the material participation tests.
  
  
  
• Reg. § 1.469-9(g): Election available to group all rental real estate as one activity. Must be a written statement filed on an original return.
  
  
  
• IRC § 469(c)(7)(D)(i): Application of real estate professional rules to closely held C Corporations.

Exhibit 2.4: Real Estate Professionals

LAW: Under IRC § 469(c)(7) & Reg. 1.469-9, if the taxpayer spends the majority of his time in real property businesses, meeting the 1/2 personal services and 750-hour tests, rental real estate losses are no longer per se passive. If the taxpayer materially participates in each rental real estate activity, losses are fully deductible. If not, even though the taxpayer is a real estate professional, losses are passive and deductible only up to $25,000 (if MAGI is less than $100,000). The IRC § 469(c)(7) does not trigger carryover losses from prior years.

_____ Verify that one spouse alone meets BOTH of the following tests.

FIRST TEST: Are more than half of personal services in all businesses (T/B) for the year performed in real property T/B and rental real estate?

--Real property T/B = real property development, construction, acquisition, conversion, rental operation, management, leasing or brokerage. Time spent as an employee in real property activities counts only if the taxpayer is more than a 5 percent owner.

SECOND TEST: Does taxpayer spend more than 750 hours in real property businesses and rentals in which he materially participates?

_____ If answer is NO to either of above two tests, IRC § 469(c)(7) does not apply, and losses are generally limited to $25,000.

_____ If answer is YES to both tests, apply material participation tests to each rental real estate activity to determine whether each activity is passive or non-passive. While not seen often, the taxpayer may have made a one-time election to group all rentals as a single activity. Thus material participation is determined based on the grouped rentals. SeeIRC§469(c)(7)(A) and Reg.§ 1.469-9(g).

CONCLUSION:

• PerIRC§469(c)(7), the following rental real estate activities have been determined to be non-passive and current (but not carryover) losses are fully deductible: __________ Current losses are entered on Schedule E, but not on FORM 8582.
  
  
  
• Taxpayer is a real estate professional, but did not materially participate in the following real estate activities: __________ He does, however, actively participate, making management decisions. Losses are entered on FORM 8582 line 1a.
  
  
  
• Taxpayer does not actively participate in the following rental real estate activities: __________. Limited partners and Taxpayers who own less than 10 percent cannot rise to the active participation standard. Losses are entered on FORM 8582, line 3b (2b for years before 2002).

Exhibit 2.5: Real Estate Professional: Interview Half Personal Services Test

_____ Describe the work you perform as a real estate professional. Check occupations by signatures and W-2s.

_____ Who is the real estate professional, you or your spouse?

_____ Does the spouse claiming to be the real estate professional work full-time or part-time? If the taxpayer has a full-time job working 2080 hours a year in a non-real property business, he must work 2081 on his real property businesses to meet half-personal services test!

_____ What percentage of each real property business(es) do you own? Unless taxpayer owns 5 percent or more, time is not counted. See IRC § 469(c)(7)(D)(ii). If, for example, the taxpayer works full-time for a construction company, but does not own any of the company, he is not a real estate professional.

750-HOUR TEST

Time does not count for purposes of the 750 hour test and the half personal services test – unless the taxpayer materially participates in the activity. One spouse ALONE must meet the 750 hour test.

_____ Who performs the services, husband or wife? Hours by husband? Hours by wife?

_____ Approximately how many hours did you spend working on your rentals in the year under exam? Ask the taxpayer for supporting documentation (appointment books, diaries, calendars, logs, etc.) You may want to give taxpayer a log to be completed for each rental – and for each year under exam. Material participation is a year-by-year determination. Rentals are generally not time intensive.

_____ If non-working spouse claims to be the real estate professional, ask what other commitments he/she may have. Is the spouse a student? Is the spouse providing full-time care to young children?  

MATERIAL PARTICIPATION IN THE RENTALS

_____ Who monitors the rentals? Who collects the rent? Who does the repairs?

_____ Do you have a real estate agent or manager or employee responsible for any of the rentals? Ask for each rental property. Check Schedule E properties for large commissions or management fees. Also check for large labor expense – possibly a hired contractor spent more time than taxpayer. If there is paid management, it is a strong indicator taxpayer did not materially participate.

_____ Is anyone besides you involving with managing or overseeing any the properties? Does a relative or friend manage/monitor the property for free?

_____ Does a tenant receives free/reduced rent for managing the rentals – or for caring for the properties?

Photo Acknowledgements and Credits: Chicago Skyline by ©Jeff Turner | flickr.com / Composition & Modifications by Shawn Hill | VASTmicro 

LEGAL DISCLAIMER

George Adams
Certified Public Accountant Master of Business Administration
Tel: (207) 989-2700 E-Mail: GeorgeAdams@IntelligenceForRent.com
450 South Main Street: The HQ of IQ
Brewer, Maine 04412-2339

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