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New Focus of IRS on Income Tax Reporting for Investment Rental Properties

2012 is proving to herald in a new era of sophistication for IRS’s efforts to monitor and enforce compliance of existing tax laws in the area of Investment Rental Properties.

The 2011 tax forms, introduced in January, 2012, revealed several new and more detailed questions on the Form Schedule E, Part 1 – Income or Loss From Rental Real Estate and Royalties.

New question –  Line 1:  asks for “type” of rental activity and provides 8 types of properties: 1. Single family residence, 2. Multi-family residence, 3. Vacation/Short-Term Rental, 4. Commercial, 5. Land, 6. Royalties, 7. Self-Rental, 8. Other (describe)

  • This type of detailed information had never previously been requested

Additional, expanded information question –  Line 2:  now explicitly asks for “the number of days rented at fair rental value and days of personal use” and provides a space for entering the number of Fair Rental Days and the number of Personal Use Days

  • In prior years the Form merely ask to indicate “Yes” or “No” whether “you or your family used the property during the tax year for personal purposes for more than the greater of 14 days or 10% of the total days rented at fair rental value.”

An individual tax client, outside of Northeastern North Carolina and also outside of the 4th Circuit Court of Appeals in which Northeastern North Carolina resides, recently received an IRS audit notice.   The audit focused on Investment Rental Properties activities reported on the taxpayer’s Schedule E.  The taxpayer / client reported a net loss of approximately $35,000 from three properties on his/her 2010 tax return.

In prior years, when taxpayers received an IRS notice regarding Investment Rental Properties reported on Schedule E, the notice typically just requested some additional information for the processing of the return.  In this case, the Form 4564 Information Document Request specified very detailed information for each property:

  • Copies of receipts, lease agreements and / or other records showing total amount of rents received
  • Explanation of the reason if units were occupied rent-free or below rental value during the year
  • Total number of days the units were rented and numbers of days the units were used for personal purposes
  • Evidence to verify ownership of property, including dates of purchase, cost basis, improvements, etc, including escrow papers and property tax bill for year of purchase
  • Statement from real estate agent of the fair rental value of the property
  • Accounting records detailing the expenses reported
  • Cancelled checks and receipts to verify expenses claimed
  • Copies of any payroll tax reports or 1099’s filed
  • Detailed depreciation schedule
  • Records, logbooks, etc showing total business and personal use of property.  If property had any personal use, written documentation of how taxpayer determined the amount of business vs. personal use
  • Cancelled checks and invoices for capital improvements and acquisitions, etc., including payments made to subcontractors for improvements, etc.

Due to the additional and more detailed questions on the 2011 Schedule E and the detailed questions from the Information Document Request, it is apparent the Service feels it needs more information to determine if taxpayers are appropriately reporting their rental activities for which deductible net tax losses are being claimed.

In a broader context, these occurrences could signal an effort by the Service to be more assertive relative to the whole category of Investment Rental Property tax reporting.  Prior to the Tax Act of 1986, reporting of gain or loss from Investment Rental Property was not distinguished from reporting gain or loss for general trade or business activities.  A tax gain was a tax gain or a tax loss was a tax loss.  Internal Revenue Code Section 469 was introduced in the 1986 Act (the purpose of which was to introduce the concept that activity of a certain type or with certain characteristics as a “passive activity”).   IRC 469 determined that a rental activity is “any activity where payments are principally for the use of tangible property,” including Investment Rental Property.  The effect of IRC 469 is, in many cases, to limit current deduction for losses arising from a “passive activity.”

The broad reach of IRC 469, with its limiting or current disallowance of losses for real estate investment activities, was viewed with alarm by the real estate industry.  The real estate industry felt such a broad effect could potentially discourage economic activity of the real estate industry and thus adversely affect the national economy.  Exceptions to the general rule of IRC 469 were subsequently enacted, including the $25,000 loss allowance exception in the case of active participation by the taxpayer and the Real Estate Professionals exception, to attempt to mitigate the effect of IRC 469 on the real estate industry.

However, subsequent to the IRC 469 original enactment, a Regulation was written applicable to IRC 469 stating that “an activity involving the use of tangible property is not a rental activity” if  “the average period of customer use for such property is seven days or less” during the year.  Essentially, the Service wanted to prevent the rental of tangible personal property from being categorized as a passive rental activity.  While preventing the ½ day rental of a surfboard from being categorized as passive rental activity makes sense, the Regulation also applies to the rental of an Investment Rental Property, and thus, makes the rental of such for seven days or less as not being the rental of real estate qualifying for the Real Estate Professional exception.

For approximately 25 years since the “seven day rule” Regulation was written, for all practical purposes the effect of the technical provisions of the Regulation has been effectively ignored by taxpayers and the Internal Revenue Service.  This might be changing.  Court cases appeared in 2011 in which the Service cited the Regulation.  And, noteworthy, the Revenue Agent involved in the audit mentioned above readily brought up the Regulation during my early discussions with her.

In Summary:

At this point, it appears to properly report Investment Rental Properties activities, taxpayers will need to be aware more information will be necessary to be considered, maintained, and documented.  And, unfortunately, it will also be necessary that we, as tax preparers, request more information from our clients as we report our clients’ Investment Rental Properties activities.

Frederick Hutchins, CPA/PFS, MTX, CFP

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