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Author Archive for Kim M. Larsen EA CTFS – Page 6

Don’t Be a Target for the IRS

By Kim M. Larsen EA CTFS
Saturday, January 24th, 2015

If there’s one thing the IRS is most known and feared for, it’s the audit. It’s well-known by now that the IRS has had its eye on tax-exempt conservative groups, but what you may not realize is that they’ve now expanded that extra attention to entrepreneurs, owners of small businesses, and high income earners. This is atypical of their past trends, since they had previously focused efforts on watching large corporations. However, the number of revenue agents in the IRS has risen by more than 5,000 people in the last few years.

Who’s at Risk?

This expansion in auditing-capability primarily hits the upper-middle class and affluent individuals. Without raising taxes, this move has allowed the IRS to greatly increase total tax collections because more audits are performed and more revenue officers are available to collect unpaid taxes from citizens. Grumble if you will, but the decision-makers are probably pretty happy with their investment in extra workers. Estimates show that the IRS has an 18 to 1 return rate on each dollar invested in audits and collections.

Are you feeling confident that your business is too small to come under scrutiny? Think again. The IRS conducted a study involving 46,000 taxpayers, and the results indicate a $345 billion tax gap. Guess what else the study revealed—about two-thirds of that gap came from entrepreneurs, small business owners, professionals, and investors. The IRS has grown its means to act on suspicious tax returns, and it’s looking straight at you. That’s right; it’s moving about 30 percent of its auditors away from large corporations and using that workforce to scout out smaller prey.

What IRS Expansion Means for Your Tax Return

An audit can cost you a lot of money in professional fees, back taxes, interest, and penalties, so it makes sense to audit-proof your return now. Don’t assume that you make too little for the IRS to be concerned with you. Although the top earners have the highest audit risk (those earning more than $1 million have seen a dramatic increase in audit rates recently), even individuals making $200,000 are experiencing the effects of increased tax surveillance. Your risk of audit may not be as high as the 1 in 8 chance that millionaires now face, but it is trickling down to businesspeople with more modest incomes.

In order to understand why you may be audited, it helps to understand the process used by the IRS. It has several different methods for selecting returns for audit, and one that has been in use for decades is called the discriminant index factor (DIF). Basically, a mathematical formula is used to score a return, often based on the ratio of income to deductions. The process breaks down like this:

  • You send in your tax return, and the systems at Martinsburg West Virginia National Computer Center run the numbers.
  • Your return gets a DIF score. The higher the score, the bigger the chance that additional taxes may be able to be collected from you.
  • IRS employees audit the returns with the highest score first (i.e. the returns that will bring in the most additional revenue).

The formula for DIF scores is regularly updated using an analysis of intensive audits, the Taxpayer Compliance Measurement Program (TCMP). It’s conducted every few years. For a TCMP audit, every single piece of information on the return is analyzed. For people reporting business receipts on their personal income tax return (Schedule C and Schedule F), gross business income is used to determine DIF score, not net business income. Red flags that generate a high DIF result may lead to your receiving a letter of inquiry, or even the dreaded examination of your tax return.

Avoiding the Audit

After computer DIF scores are assigned to the returns, IRS employees then select which returns will be audited. This process usually starts later than June. A computer formula may assign you a high DIF, but in the end it is up to classifiers working in the district offices to determine whether your return raises red flags. So, even if a high DIF result brings your return under scrutiny, you can follow some simple rules to keep down your chances of being selected for audit.

Take a look at some basic tips for making your return less likely to be audited:

  • Balance Your Deductions—Risk of being scrutinized increases with the more deductions you take compared to the size of your income. Time your deductible expenses right so that they are fairly even on a year to year basis.
  • Always Respond to Inquiries—If the IRS sends you a letter regarding missing schedules, send a response! Failing to answer makes you much more likely to be examined.
  • Remember Form 8283—When you make a non-cash charitable contribution, you must include this form.
  • File Your AMT—The alternative minimum tax is separate from regular taxes. You’ll need to use Form 6251 and send it in with your 1040.
  • Document Your Casualty Losses—Casualty losses are already a red flag for the IRS. You definitely deserve any deductions you are entitled to for such losses, but be sure to document all information about the date of loss, cost, and any insurance payments you received. And, include this information with the return, not when they’ve flagged you for auditing.
  • Report Any 1099 Income—If a client of yours reports a 1099 to the IRS, you’d better make sure you report it on your tax return. When you don’t, it’s considered a matching issue, and you will be contacted about it. In the case that you are contacted about a mismatch issue, respond to the IRS immediately to prevent an escalation of the situation.
  • Use an Entity Structure—Filing a high number of gross receipts for your small business drastically increases your return’s chance of being examined. However, when you switch from reporting these on a Schedule C to reporting them as a corporation, partnership, or LLC, you significantly reduce that risk. Not only does using an entity structure lower your chance of being audited, it also decreases your taxes. It’s an excellent option to consider if you are functioning as a proprietorship or independent contractor.
  • File On Time—This one should go without saying, but turning in your tax return by deadline (including extensions) can help you to avoid examination.
  • File a Paper Return—Filing electronically may seem easy, but there’s a reason the IRS encourages taxpayers to use this method. An electronic return can go right into their DIF scoring system and be ready for analysis immediately. Rumor has it that only about half of all paper returns even get scored in the DIF system. Most taxpayers are required to use the electronic filing system. However, you can opt out by attaching IRS Form 8948 to your paper return.
  • Watch Out for the Big Three—IRS agents are coming down hard on deductions for travel, automobiles, and entertainment expenses. The secret to having these deductions approved is documentation, documentation, documentation. Quick and dirty tip: The IRS requires 5 pieces of documented evidence, but all you really need is your receipt! It covers 1) date of the expense, 2) where the expense occurred, and 3) amount of the expense. Then, you simply write on the back of the receipt 4) the business purpose for the expense and 5) your relationship to the person or group you entertained. Simple! Just don’t forget the receipt—the IRS does not count credit card statements as receipts. For automobile deductions, you’ll also need to keep a mileage log.

Electronic filing has made auditing easier (and a bigger priority) for the IRS. Now that they need fewer employees sifting through paper files, they have allocated a larger portion of their workforce towards audits and collections. With this increased strength, they have turned their eyes toward smaller entities, but you can audit-proof your return by providing accurate documentation and following these tips. Don’t let the IRS intimidate you into forgoing deductions you have a right to!

Categories : Audits, Business Expenses, Cars, Trucks & SUVs, Casualty Losses, Corporations, Entertainment, Tax Planning, Travel

Legal Tax Benefits for Your Small Business at Year’s End

By Kim M. Larsen EA CTFS
Saturday, January 24th, 2015

Many people see the IRS as an entity that only seeks to take away their hard-earned cash. But, think of it this way. In a game of basketball, is the other team just going to let you win? No, but most teams will play fair, meaning you have an opportunity to score, just as they do. It’s the same with the IRS. Of course the IRS is going be aggressive in making sure you pay what you owe; however, it also expects you to play just as hard by making sure you receive the money owed to you.

5 Smart Tax Moves

The amount of potential savings is going to vary depending upon your company’s cash flow and its need for supplies and equipment. By playing the game correctly, you could save your business thousands in taxes. What you need is a smart strategy that can be implemented easily and safely, so check out these 5 tips for immediate savings:

  1. Stop Billing at the End of the Year—If your business operation is based on the calendar year, simply don’t send out invoices in November and December. Wait, instead, to request payment for those services at the beginning of January. With no invoice, insurance companies or customers are unlikely to send payment, which means less taxable income on your return. By waiting to bill, you’ve postponed those taxes.
  1. Purchase Office Equipment—After much anxious waiting from taxpayers in 2014, the IRS raised Section 179 expensing back to $500,000, as it had been in previous years. Unfortunately, the smaller $25,000 cap has been reinstated for 2015[1]. However, the limit in 2014 was not raised until nearly the end of the year, so pay attention towards the end of the year to see if the limit is raised again. If so, it will pay to go forward with equipment purchases rather than waiting.
  1. Pay Expenses in Advance—You have the IRS tax-deduction safe harbors to thank for this advantage. According to IRS Regulation 1.263(a)-4(f), cash-basis taxpayers can deduct qualifying expenses up to twelve months in advance[2]. Here’s an example of how it works. Let’s say you pay $2,000 per month in office space rent. To immediately get a $24,000 deduction, on December 31st you just send a check for the entire payment for the next twelve months.

What happens is you get the deduction in the year you paid the money (not the year the money is due). Your landlord, however, does not have to report the payment until the following year since it was not received by mail until January. To prove that you mailed the check in the current tax year (and remember, the IRS always requires proof!), you can send the check certified or by registered mail so that you get a dated receipt.

Tip: Make sure your landlord understands what you are doing. You don’t want this strategy derailed because the landlord thinks it’s an error and your check is returned. Also, don’t send payment too early. Your landlord will not be happy to receive the check before January 1st and have to claim the full amount on the current tax return.

Remember, you can pay expenses for the upcoming tax year in advance, but no further out than that. That means you could not pay two years, or even eighteen months, of expenses in advance. Qualifying expenses for cash-basis taxpayers include office and machinery rent payments, business and malpractice insurance premiums, lease payments for business vehicles, and others.

  1. Pay with Credit Cards—For sole proprietors, expenses are deductible as of the day they are charged to their card. This method allows for immediate deductions of office supplies and other business necessities, and it has the advantage of proof in the form of your credit card statement. For those who own a corporation, this advice works in the same way as long as you have a credit card under your corporation’s name. However, if the card is in your personal name, the expenses are not eligible for deduction until you submit your expense report and the company reimburses you, so plan accordingly.
  1. Don’t Worry that You’re Taking Too Many Deductions—As long as you’re following the rules, you have no reason to hold back on your deductions. A great basketball player doesn’t hold back for fear of scoring too many shots. It is possible that your business deductions exceed your business income. When this happens, it’s called a “net operating loss” (NOL)[3].

Fortunately for you, in the case of NOL tax law allows you to claim refunds from as far back as the previous two tax years[4]. So, you may actually get back money you previously paid in taxes! Not only that, but if you still have unused losses after going back two years, you can carry those losses forward for up to twenty years[5]. That’s an astounding twenty-two year window during which you can benefit from the deductions made in one year, and it works that way no matter how you run your business (proprietorship, corporation, or other methods)[6].

Now that you understand just how much of an effect your deductions can have on your lasting tax benefits, you know to make those deductions count. Don’t avoid deductions for fear of a tax loss. Just because you have an NOL on your return does not mean your business is not thriving and successful. More deductions mean less regular tax paid and less AMT tax paid. So, keep documenting those deductions!

  1. IRC Section 179(b)(1)(B). ↑
  2. IRS Reg. 1.263(a)-4(f). ↑
  3. IRC Section 172(d). ↑
  4. IRC Section 172(b)(1)(A)(i). ↑
  5. IRC Section 172(b)(1)(A)(ii). ↑
  6. IRC Sections 172; 642(d); 512(b)(6). ↑
Categories : Business Expenses, Receipts, Records, Tax Planning

Use Cost Segregation to Raise Your Net Worth

By Kim M. Larsen EA CTFS
Saturday, January 24th, 2015

Tax planning tips often have two priorities—defer your income and accelerate deductions. Would you like to know an easy way to do the second one? You can make a huge difference in depreciation deductions by using a strategy called cost segregation.

What Cost Segregation Means

Cost segregation allows you to separate a building you own into two components, land improvement and personal property. This lets you to realize deductions on the building more quickly. Cost segregation, essentially, speeds up the depreciation of your deductions. Faster depreciation means more money in your pocket now.

How does it work? Let’s assume you have several buildings depreciating on a 39-year plan. By segregating the costs, perhaps 30% of each of those properties could be depreciated in only 5 years, instead. You can implement a plan like this regardless of when you purchased the building. It could be a place you have already owned for years, a renovation you are undertaking, or even a new property you plan to purchase.

Here’s a break-down of how a property’s costs may be segregated:

  • 20% spent on equipment
  • 20% spent on land improvements
  • 60% spent on the building

You could just lump all the costs together and slowly watch 100% of your investment depreciate over a period of up to 39 years. Or, you could separate the costs out and see 20% depreciated in 5 years and another 20% in 15 years. By depreciating the components separately, you raise your net worth! Getting this time advantage makes a huge cash difference for you.

Why Timing is Important

What do all those numbers mean to you? If you have a property that cost you $1 million, tax law allows you to depreciate the equipment, land improvements, and building all the way to zero. So, your property has the potential to produce $1 million in depreciation. That means deductions for you on your tax return. By using cost segregation, you can use those deductions sooner, giving you an edge on tax benefits. Those tax benefits mean more cash available to you now for investing to your advantage.

You may be asking yourself if it can really make that much of a difference. Consider this example: you 1) earn 6% on your investments after taxes, 2) are in the 50% tax bracket, and 3) have $2 million to depreciate. You can use modified accelerated cost recovery system (MACRS) to depreciate it over 5 years, or you can depreciate it on a straight-line schedule of 39 years. Given those circumstances, in today’s dollars you would have:

  • $852,624 investment earnings from using MACRS depreciation
  • $382,427 investment earnings from using the straight-line depreciation

As you can see, that’s a huge difference!

How to Make Cost Segregation Work for You

The cost segregation strategy may not be right for every property owner every year. Here are a few tips for knowing when it will pay off:

  • When passive loss rules aren’t limiting your real-estate deductions, and you are able to benefit from the advantages of a quicker deduction (cost segregation generates a bigger loss on your tax return, which does you no good if your losses are limited);
  • When you are in a position to benefit from the value over time, that is, you intend to keep the building or continue renting it out for the long-term; and
  • When you will pay less for a cost segregation study than what the actual cash benefits will be.

Let’s put it into real numbers for you. You have, for example, a modified adjusted gross income of $200,000 and are subject to passive loss rules. If you have a $35,000 net loss on your rental properties but no passive income, then the $35,000 is a passive loss. It’s not deductible this year, and you will have to carry it forward to next year to see if you can offset it with passive income then.

Qualifying to deduct passive losses is the number one piece to the puzzle of cost segregation. No current deduction available for your losses means no time benefit to the value of your money. Additionally, the longer the amount of time you keep the building, the greater than financial benefit to you when using cost segregation. You may even be able to apply a 1031 exchange both to defer taxes and take your cost segregation benefits from one building to another, giving you some flexibility in the amount of time you hold onto a property. You’ve got plenty to gain, including:

  • Quicker depreciation
  • Section 179 expensing of personal assets that qualify
  • Reduced transfer taxes (because you separated the costs of personal property and real property)
  • Possible reduced property taxes
  • Asset replacement identification (to write off an undepreciated item)
  • A write-off for the cost segregation study fee[1]
  • Look-back depreciation if you use cost segregation on a building you already own and have not segregated before[2] (Make sure you time this right; the IRS allows one automatically approved accounting method change every 5 years, so you would benefit from completing all cost segregations at one time.[3])
  • Owe no user fee to the IRS[4] (most accounting method changes require payment of $2,700)
  • A one-time chance to make a large adjustment by claiming all of the previous years’ depreciation in a lump sum (IRS Form 3115)
  • The opportunity to increase your benefit from a property inheritance

Just be aware that every financial action carries risk. Personal property’s depreciation recapture tax can be higher than that of real property. You could be looking at up to 10 percent higher tax rates when you sell the property (depending upon your income level), so be sure to consider that when making your decision. Hint: As always, watch out for the alternative minimum tax (AMT). For personal property, you can use a 150 percent declining balance depreciation instead of the AMT’s preferred 200 percent declining balance.

As long as you meet these guidelines, cost segregation can be a terrific option for raising your net worth. You will need to hire professionals to perform the study (typically CPA’s and engineers), so check with your tax advisor about whether this option is a good fit before moving forward. If it looks like you will benefit, you can look for a team to perform the study at The American Society of Cost Segregation Professionals . The cost segregation professionals will take care of all the documentation you need for proving your segregation to the IRS.

  1. See “Cost Segregation Applied,” by Jay A Soled, JD, and Charles E. Falk, CPA, JD,Journal of Accountancy, August 2004. You can write off this cost as a 162 expense. ↑
  2. Reg. Section 1.446-1T(e)(5)(iii). ↑
  3. Revenue Procedure 2006-12 ↑
  4. Revenue Procedure 2012-39 ↑
Categories : Business Expenses, Cost Segregation, Depreciation, Rental Properties, Tax Planning

How Commissioned Employees Have Vanquished the AMT and You Can, Too

By Kim M. Larsen EA CTFS
Tuesday, January 20th, 2015

When it comes time to prepare your taxes, you may have an unpleasant surprise waiting in the alternative minimum tax (AMT). Despite its intention of ensuring that top earners pay their fair share of taxes, the AMT really can be a kick in the pants for employees, who cannot deduct their business expenses. Particularly in the case of commissioned employees, this creates a huge difference in the amount of taxes they pay.

What You Need to Know about the AMT

The AMT was created during the 1986 tax reform, and it basically taxes income that is deductible under the regular tax, such as employee business expenses. Here are just a few of the types of employees who pay their own work expenses:

  • Mortgage brokers and bankers,
  • Insurance sales professionals,
  • Traveling sales professionals,
  • Real estate sales professionals, and
  • Emergency room physicians.

Why are commissioned employees particularly burdened by this tax? It’s because they often have a slew of business-related expenses that they pay out of pocket. Then, here comes the AMT to tell them they are not allowed to deduct any of those expenses. However, independent contractors performing the exact same duties as those commissioned employees can deduct many of their expenses.

What Employees Can Do about It

If your income level boxes you into the AMT, you don’t have to give up and lose thousands of dollars to additional taxes. And yes, it is potentially thousands. Take, for instance, the case of Dan Butts, an Allstate insurance agent. In one year, he paid about $10,000 more in federal income taxes than agents at State Farm.

What did Butts do wrong? Nothing—the difference lay in how he was designated by his employer. Butts was considered a W-2 employee, but the State Farm agents were independent contractors with 1099’s. Look at that scenario again. Butts did the same job, at the same pay, and with the same deductions as the agents at another company, but because of his designation, he paid $10,000 more in taxes.

That is a ridiculous situation for an employee to be in simply because the AMT does not permit deductions for business expenses! Fortunately, if you’re in a commissioned position, like Butts, you can do something about this unfair situation. He simply amended his tax return to put his W-2 employee commission earnings on the Schedule C form that self-employed individuals (including contractors) use. He deducted his expenses and saved that $10,000.

Of course, the IRS noticed that he used the wrong form, and he ended up going to court over the issue. . . and winning! Of note in this case is that the court granted Butts independent contractor status even though he had been employed as an employee with Allstate for years and enjoyed employee benefits[1]. The ruling went his way because he carried a “risk of loss”, just like the agents who were independent contractors.

However, you should keep in mind that using the Schedule C to avoid the AMT may work differently in various fields. For instance, a mortgage loan officer named Dan Cibotti worked for Liberty Trust Mortgage, Inc. as a commission-only W-2 employee. More and more commissioned employees are filing on Schedule C, and Cibotti was one of them. In his case, the court ruled that he was considered an independent contractor, despite having a W-2 that reported his income as an employee, because[2]:

  • He set his own hours and chose his own work location and method of finding clients;
  • His employer did not provide him an office;
  • He claimed a home-office deduction;
  • He was paid 100% on commission;
  • He had the possibility of gain or loss on his business activities; and
  • He received no employee benefits, such as a retirement plan or health insurance.

As you can see, the two situations were quite different, but each involved a commissioned employee who fought for his right to file as an independent contractor and won.

Going Forward

Now that other cases have set the precedent, it is becoming easier for insurance agents and other commissioned employees to avoid the AMT. In fact, the IRS, in chief counsel notice N(35)000-141(a), ordered its lawyers not to challenge individuals who claimed independent contractor status under the Butts precedent, but the IRS can be a stubborn entity. The notice that allowed independent contractor status also instructed the lawyers to:

  • Calculate self-employment tax on the agent’s net income and allow a credit just for the employee share of FICA and Medicare (i.e., employer payments are not included);
  • Calculate taxes on employee benefits, like employer-paid medical insurance and Section 125 contributions;
  • Calculate taxes on 401(k) contributions and make the taxpayer aware that they may not fall back on the Lozon decision, which concluded that such contributions were not taxable until withdrawn[3].

This notice has since expired, but if you plan to pursue independent contractor status, it would be wise to compare AMT savings with the potential tax disbursement outlined in the above IRS strategy.

Other Cases

Several other cases for independent contractor status have gone to court with varying results. Wesley Wickum, a district manager for Combined Insurance Co. of America, amended three years of tax returns and reclaimed $27,000. His salary included commission from his sales, bonuses, and override commissions based on the salespeople he recruited and supervised. In a funny twist, his company had previously considered the salespeople and managers to be independent contractors, but had changed the status out of fear of IRS penalties for wrongly classifying employees as contractors!

You can see the repercussions on business. The AMT hurts a company’s best salespeople—those who make the most commissions. When such a worker is classified as employee instead of contractor, the AMT comes into play, and may cause the best salespeople to leave the company.

A sales agent named Paul Hathaway also amended three years of tax returns after learning of the Butts case[4]. He was a commissioned employee, and although his company provided a W-2 each year and gave him benefits, he paid his own expenses for food, samples, travel, telephone, stationary, and business cards.

William Johnson and Barbara Lewis, on the other hand, lost each of their cases for independent contractor status. Johnson was a full-time hospital equipment salesperson who worked on commission, but the court ruled that he was an employee because his employer 1) restricted him from hiring employees and 2) required that he file daily call reports[5]. Lewis sold hair care products to salons and also made commissions. The court ruled her an employee by status because 1) her employer required her to file daily sales activity reports, 2) her employer supplied her with leads, which she was expected to follow up on, and 3) she had a negligible “risk of loss”[6].

AMT Tax Savings

If you’re going to claim independent contractor status for your commissioned income, take these cases as examples what kind of evidence you need. Remember, your savings could be thousands of dollars. Need an example? Let’s say you’re a mortgage loan officer, like Wickum in the case above. If you made $200,000 and spent $125,000 in business expenses, you have a net income of $75,000.

With regular taxes, those business expenses are reduced by 2 percent, leaving a regular taxable income of $79,000 (.02 x $200,000 = $4,000; $125,000 – $4,000 = $121,000; $200,000 – $121,000 = $79,000). But, for AMT purposes, this employee gets no deductions on those expenses. That means the taxable income is the full $200,000. That’s a huge difference!

So, if the employee files taxes on Schedule A, the amount owed is $45,000. On Schedule C (as an independent contractor), it would only be $15,000. You can see why commissioned employees argue for their contractor status.

If your work situation involves unreimbursed business expenses and a status as employee, you have options to establish your status as an independent contractor for tax purposes. Since the IRS has established a position on this issue, you can start by discussing your status with the local IRS district director. If necessary, you can escalate the situation by requesting a private letter ruling from the IRS. This route does cost money, but it will likely be less costly than going to court. Litigation like the Butts case has not happened in years, so you have a good chance of a ruling in your favor if your circumstances and evidence are sufficient. The AMT seems to be here to stay for the present, so don’t let thousands of dollars slip away from you every year.

  1. Butts v. Commissioner, TC Memo 1993 478, affd. per curiam 49 F.3d 713 (11th Cir. 1995). ↑
  2. Dean Cibotti v Commr., TC Summary Opinion 2012-21. ↑
  3. Lozon v. Commr., TC Memo 1997-250. ↑
  4. Paul E. Hathaway v. Commr., TC Memo 1996-389. ↑
  5. William O. Johnson v. Commr., TC Memo 1993-530. ↑
  6. Donald J. Lewis, Jr., v. Commr., TC Memo 1993-635. ↑
Categories : AMT, Business Expenses, Cars, Trucks & SUVs, Depreciation, Employees, Entertainment, Home Office, Receipts, Records, Self-employment Tax, Tax Planning, Travel

Passive-Loss Rules Got You Trapped? You can Release Rental Property Tax Losses

By Kim M. Larsen EA CTFS
Saturday, January 3rd, 2015

If you’re feeling the pain from calculating your rental property loss deductions and finding that you can’t get some of that money back, you can thank lawmakers from 1986. That’s when the passive-loss rules came into being. These laws really complicated matters for taxpayers, but this article can help you to understand the ins and outs.

How Passive-Loss Rules Work

Basically, lawmakers have given you three possible tax buckets for any given taxable activity:

  1. Portfolio of stocks and bonds
  2. Active business activities involving material participation
  3. Passive-losses for rentals and other activities you don’t materially participate in

We’ll primarily look at the last one with this article. You’ll be happy to know that you do have some options for getting around the passive-loss problem. With the right knowledge, you can see tax benefits from your rental losses.

Before we delve into the solutions, let’s get an understanding of why you may have issues deducting your rental property losses. In order to get the tax benefit from your rental property loss, you (or you and your spouse) have to meet one of two requirements. To meet the first requirement, you must have passive income, such as from other properties or another source. Otherwise, you have to qualify as a real estate professional and actively participate in your rental property business.

Given those requirements, here’s an example of how your rental property losses can end up trapped and unable to be deducted. For the example, you have only one rental property (i.e. you have no other passive income), and you do not qualify as a real estate professional for tax purposes. If your property has produced a tax loss of $10,000 each year for the past six years, and your taxable income is $180,000, you can’t deduct any of those $60,000 in losses because you don’t meet either of the above requirements, and they can’t be deducted from either of the other income buckets.

Your Options

Let’s take a look at the three options you have for navigating these passive-loss rules. It turns out that even if you don’t meet the above requirements, you may have an opportunity to deduct your losses in certain scenarios.

  • Get Full Loss Benefits—Taxpayers who have a modified adjusted gross income of up to $100,000 can deduct all of their rental losses up to $25,000.[1] As your income rises above $100,000, your deduction is reduced by 50 cents per dollar, and once you reach a modified adjusted gross income level of $150,000, you lose this ability to claim losses easily.[2] For a practical example of how this works, let’s say your modified adjusted gross income from your business was $85,000, and you had rental losses of $21,000. In this case, you would be able to deduct the full $21,000.
  • Waiting for the Benefit—Remember the $60,000 that were trapped in the example above? It turns out that you don’t just lose all chance of benefiting from those accumulated losses. They are still tax-deductible, but you have to find a way to release their ability to be deducted. In fact, here are four possible ways to get that money out of waiting:
  1. Change the rental property from passive to non-passive. If you’re the sole owner of your business, and you also own 100 percent of the rental property, you can simply convert half the rental property for business use (such as office space). Now 50 percent of you trapped losses can be released ($30,000) for use against the business income bucket[3]. If you operate as an S corporation, you’ll have to make a self-rental election.
  2. Produce additional passive income. If you produce, for example, $6,000 in passive income, you can release $6,000 of the trapped $60,000. Now, you just have to wait to release the other $54,000.
  3. Qualify as a real estate professional and prove your material participation in your real estate business. This option cannot release funds that have been waiting to be released because your qualification as a real estate professional is evaluated on a yearly basis. However, by qualifying, you are able to release your losses for the current tax year. So, the $10,000 for the year you qualify as a real estate professional will be offset against your business and portfolio income buckets. Other losses will have to be released using one of the other solutions.
  4. Sell your property. This option is further explained below.
  • Releasing the Full Amount—If you don’t meet the modified adjusted gross income threshold to take full advantage of loss deductions, there’s actually a very easy way to release the full $60,000 of our example losses. All you have to do is sell 100 percent of the property. When you sell to a third party, you can deduct the entire $60,000 at once. Here’s how you might handle this on your tax return:[4]
  1. You list your capital gain or loss on IRS Form 4797. It will be listed with your other Section 1231 gains and losses. A net gain will be taxed at the tax-favored rates of up to 15 percent, and a net loss will be limited to $3,000. But, don’t worry—anything over that amount can be carried forward.
  2. You also list any gain that is attributable to real-property depreciation (Form 4797). This will be taxed at the real-property depreciation recapture rate on Schedule D (up to 25 percent).
  3. You put the $10,000 loss for the current tax year on Schedule E.
  4. And, here’s the best part. You put the prior $60,000 of tax loss (in addition to the current year’s $10,000) on Schedule E, which finally ends up on your Form 1040 and the entire $70,000 offsets all your income.

To break it down for you, when you sell your property, you get to snub the passive-loss rules and pretend like they don’t even exist!

Passive-loss rules are frustrating, but know that you can eventually deduct your losses. You can even elect to group together multiple properties and use these exact same solutions. Getting the most benefit from your tax return is all about planning ahead. Now that you know how to get around the passive-loss restrictions, you can start planning for the techniques that work right for you and your properties.

  1. IRC Section 469(i). ↑
  2. IRC Section 469(i)(3)(A). ↑
  3. Reg. Sections 1.469-9(e)(4), Example (ii); 1.469-1(f)(4)(iii), Example 4. ↑
  4. Instructions for Form 8582 (2011), revised Jun. 8, 2012, ps. 7-8. ↑
Categories : Depreciation, Investments, Passive Income & Losses, Rental Properties, Tax Planning
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