The tax rules for rental properties can be complicated. Generally, all rentals are considered to be “passive activities,” and taxpayers with incomes over $150,000 are not allowed to claim their passive losses until they either sell the property or have passive income to offset the losses. In a recent audit I handled, I knew I’d better not be passive if I wanted our Members to win their case.
The Members had claimed a $15,662 passive activity loss on Schedule E. Their modified AGI was $178,330 so it was not surprising that the IRS had questions.
When reviewing their Schedule E for rental income and expenses, I noticed that one of the expenses claimed was for commissions. When I questioned the Members on their $11,316 deduction they explained that they had purchased the property in 2005 and sold it in 2011 — the year under audit. I asked them to provide Form 1040, Schedule E and Form 8582 for each of the years from 2006 through 2011. Coordination with them was difficult because the husband was in Texas where the documentation was kept and his wife, who had prepared the tax return, was working in NY and was only home on weekends.
In addition to other errors on the return regarding the rental property, depreciation had not been claimed for one of the years; instead they had deducted an expense for principal paid, which was pretty close to the depreciation expense that should have been taken. Knowing that the IRS could assign the “allowed or allowable depreciation” regardless of whether or not it was claimed, I looked at all options for recovering the depreciation expense for that year. The most complicated method would be for the Member to file a Form 3115 for a change in the method of accounting. A much easier option was to ask the examiner to allow the amount claimed for principal payments as the depreciation expense, which is what I did. The examiner agreed to this approach and eventually all the proper documentation was provided. After tracking the numbers and calculating the gain/ loss on the disposition of the rental property, I managed to turn a questionable $15,662 loss into an allowable $38,952 loss. The majority of this number was attributable to suspended losses the Members had not taken into consideration because they didn’t know the rules.
The Members were very happy with the $5,900 refund and plan to use some of the money on a retirement party for the husband who is retiring this year from the local fire department. After all, he deserves much of the credit for searching through all the tax documents and helping to facilitate the three-way conversations with his wife and me.
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