By way of background, rental activity is generally treated as a “passive” activity under IRC Section 469. This means that any loss generated by a rental activity can only offset other “passive” income; either other rental income or income from an S corporation or partnership in which the taxpayer does not materially participate.
Section 469 does offer two exceptions to this general treatment of all rental losses as passive:
1. A taxpayer with modified Adjusted Gross Income of $100,000-$150,000 may generally deduct up to $25,000 of loss from a rental activity, provided the taxpayer “actively participates” in the management of the property.
2. Taxpayers who qualify as real estate professionals under Section 469(c)(7) may treat all rental activities as nonpassive.
In response to the audit’s findings, the Treasury Inspector General for Tax Administration made recommendations to the IRS — which the Service has accepted — to help clean up perceived abuses of the two exceptions to passive loss treatment discussed above. These recommendations include:
1. Increased IRS examination of Form 1040s reflecting a rental loss on Page 1 of Schedule E
2. Changes to Schedule E to allow the IRS to better scrutinize returns for potential exam. Tentatively scheduled for adoption in 2011, taxpayers will now have to signify the type of rental property (single family, mult-family, commercial, etc..). This will enable the IRS to more accurately identify questionable items, as expenses for a single family home will be different from those for multi-family residences.
3. Taxpayers will now be required to provide the actual number of days a property was rented and used for personal purposes. This will allow the IRS to determine if prorated expenses appear accurate.
4. Form 8582, which determines how much, if any, of a taxpayer’s passive loss can be utilized in a given year, will be required to be attached to the Form 1040. This will permit the IRS to track the use of prior year suspended passive losses in greater detail.
5. Lastly, the IRS will transcribe greater detail about those taxpayers identifying themselves as “real estate professionals,” including the amount of wage income earned by the taxpayers. Substantial wage, particularly if earned outside of real estate activities, may indicate that the taxpayer does not qualify as a real estate professional.
What does this mean for rental property owners? While it may indicate an increase in the likelihood of your rental loss being audited, as long as you’re keeping detailed, accurate books, communicating with your CPA, and complying with the existing law, there should be nothing to be afraid of.
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