Many IRS audits are designed to be focused on basic tax issues, but real estate deals can be complicated and confuse the basic facts and key issues of your tax situation. Here are five common tax issues that frequently get audited in the real estate industry:
- “The Basis for the Loss” – Many real estate ventures start with a contribution of capital, negotiation of debt, and a group of investors or owners. Each participant has a share of equity and debt (tax basis) that allows them to deduct losses – and the real estate venture generally provides an allocation of loss to each participant. Therefore, the IRS asks each participant to calculate their own tax basis, and since tax basis is a cumulative calculation over the history of the venture, it is important to maintain an updated calculation to report the correct annual loss.
- “Nontaxable Rent” – Many rental properties are designed to provide cash flow to cover property costs of real estate taxes, mortgage interest, and maintenance costs. Even if net cash flow is neutral, there can be a tax loss including tax depreciation. The tax loss is subject to personal tax limitations, such as passive loss limitations, tax losses in excess of basis, and losses which create an NOL rather than a current tax benefit against other income. In situations where a tax loss is created, these limitations should be considered to determine if the loss generates current benefit.
- “Capitalize Your Costs” – Uniform capitalization rules generally apply to real estate development and construction. The IRS developed Section 263A as a tax guide to identify what type of costs need to be added to the purchase price of real estate and what circumstances cause the rules to apply to costs on an annual basis. Therefore, if you deduct some of these costs prior to the sale of the real estate, you may have an IRS adjustment for an early deduction of these annual costs. Certain pre-production costs (such as engineering and design, permit and zoning fees, and real estate taxes) and certain production costs (such as interest expense and direct improvements) are covered under the guidelines in Section 263A. It is important to factor in these rules to quantify the proper tax treatment of expenses.
- “Buy Low, Sell High” – If you have gain on a real estate project, you need to consider how to report the gain. The IRS does not assume the gain was reported properly, so they consider how property was purchased and held by the business. The tax treatment is very different based on the circumstances. The sale of most investment property may create capital gain based on length of the holding period. The sale of inventory generally creates ordinary income based on the costs of purchasing and developing the property. The sale of business property can create Section 1231 gain, which consists of different rules for the appreciation in value and for any depreciation previously claimed on the property. If the proceeds of the sale are reinvested in similar property, there are “like kind exchange” rules which defer the gain on a complete reinvestment of the proceeds. It is important to keep details of the history and sale to properly support the gain to the IRS
- “Act Like a Pro” – If an investor in rental real estate loses money, some of the losses may not be currently deductible if the investment is passive. A passive activity is one in which the investor does not materially participate and does not spend enough time on the activity. However, a real estate professional generally spends significant time in management and operations of the business, and they must meet special tests based on the number of hours spent in the activity. In any given tax year, the best way to pass these tests is to keep an activity log or calendar and record the number of hours spent. So if you want to support deductions for your real estate losses, be prepared to keep your daily calendar and support your full-time role spent in the business.