The Wall Street Journal recently ran an article regarding a tax controversy experienced by a California real estate investor living in Los Angeles represented by tax counsel in Westlake Village, Ventura County, discussing the investor’s ability to report his income and expenses as a full-time real estate investor. The IRS claims he is a passive investor and therefore is auditing past income tax returns to disallow certain items of expense, depreciation and other tax benefits related to real estate investing which might cost him hundreds of thousands of dollars in additional tax, penalties, and interest.
The Los Angeles real estate investor’s attorney currently has five U.S. Tax Court cases involving people who say they are full time real estate professionals whom the IRS is trying to reclassify as passive investors. Two years ago, that tax controversy attorney didn’t have any cases like this. Perhaps there is a trend toward trying to sweep real estate investors, many of whom are investing in areas including Los Angeles County, Santa Barbara County, Orange County where opportunities abound, in order to reclassify them passive investors.
The distinction between passive investors and full time active investors is crucial to the outcome of this kind of case. Generally, a full time real estate professional spends more than half of his working hours in real estate and more than 750 hours a year tending to real estate activities. Those professionals can fully deduct losses including depreciation, interest expense on loans and property taxes. Passive real estate investors are more limited in what losses and expenses they can deduct.
The IRS targets this group of investors because it is one of the areas where research shows there is a large tax gap, that is, taxpayers are underreporting income to the IRS which creates a tax gap of $13 billion from rents and royalties and $11 billion for capital gains. Approximately 3000 income tax returns of real estate professionals are currently under audit.
If you invest in real estate and have been selected for audit by the IRS or the California Franchise Tax Board for your business activities, contact Mitchell A. Port at 310.559.5259 to discuss your situation.