Can I deduct my rental losses???

I often receive letters and emails from retired individuals in need of financial advice. Many of their queries mention that they attended one of those free lunch seminars offered by investment advisors and estate tax.

While I could ask what enticed them to attend, I’ve already heard the answer lots of times. They fell for the seminar promoters’ promises of free gourmet meals, along with tips on how to earn excellent returns on their investments, eliminate market risk and grow their retirement funds.

I also could ask them to tell me what happened right after they finished their meals. I also already know that answer. They were pitched investments in rental properties and other kinds of tax shelters. The promoters assured them that they would acquire properties that generate IRS-approved losses.

Just how would such losses benefit the investors, according to the promoters? Well, they could use them to erase taxes on their income from, say, salaries and business profits.Wannabe landlords want me to answer pretty much the same questions: Are those assurances reliable? How much are they allowed to deduct for rental property losses?

My answers are always the same. Potential investors should recognize that these kinds of promises are red flags because the IRS sets strict limits on losses from investments in tax shelter deals, such as limited partnerships.

How much does the agency allow owners of rental properties to write off for losses? It all depends.

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The IRS generally allows tax shelter losses only to be offset against income from similar investments. It prohibits the use of shelter losses to wipe out taxes on non-shelter income, such as wages and stock market profits. These tough anti-shelter restrictions are, however, subject to several exceptions for investors.

One of the exceptions authorizes limited relief for losses up to $25,000 suffered by relatively small-scale investors in rental properties, be they multi-family homes, condominiums, cooperative apartments or stores. To qualify, property owners must be “active” managers.

For most landlords, satisfying this stipulation is a slam dunk. All they have to do is help make decisions on such essentials as approving new tenants, deciding rental terms and okaying capital or repair expenditures. 

What they needn’t personally do is mow lawns, make repairs or answer middle-of-the-night calls from tenants. As long as the owners actively participate, they can delegate day-to-day operations to managing agents or others hired to collect rents and run the properties.

If lower- and middle-income landlords meet these qualifications, they can offset as much as $25,000 of their annual rental losses against other income. Note that the ceiling drops from $25,000 to $12,500 for married persons who are filing separate returns and live apart for the entire year. The law bars any offset for married couples who live together and file separate returns.

Fat cats should forget about the write-off. The full $25,000 deduction is available only for individuals with adjusted gross incomes (AGIs) below $100,000—before subtracting any shelter losses. More bad news: The offset phases out. It shrinks by $1 for every $2 of AGI beyond $100,000 and vanishes completely when AGI surpasses $150,000.

Even more bad news: There’s no inflation indexing for these dollar limits. They haven’t increased since they were introduced by the Tax Reform Act of 1986, when Ronald Reagan was in the White House. Other fine print worth noting: The break is authorized solely for an investor who owns at least a 10 percent interest in the property.

Claiming rental losses increases the likelihood of investors’ returns drawing the attention of the tax enforcers. The IRS suspects that many investors are incorrectly deducting losses. Investors who undergo audits will likely have to provide proof of their active participation in management decisions, ownership of at least a 10 percent interest and correct computation of their deductions under the AGI test.

Thanks to Julian Block for this timely information

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 300 and counting). 

2019 Inflation Adjusted Vehicle Depreciation Limits

The IRS on Tuesday provided the limitations on depreciation deductions for passenger automobiles first placed in service in 2019 and the amounts of income inclusion for lessees of passenger automobiles first leased during 2019 (Rev. Proc. 2019-26). Passenger automobiles include trucks and vans. The amounts in the revenue procedure are inflation-adjusted as required by Sec. 280F(d)(7), using the automobile component of the chained consumer price index for all urban consumers (C-CPI-U). The earlier consumer price index was replaced by the C-CPI-U by the law known as the Tax Cuts and Jobs Act, P.L. 115-97.

For passenger automobiles to which the Sec. 168(k) additional (bonus) first-year depreciation deduction applies and that were acquired beforeSept. 28, 2017, and placed in service during calendar year 2019, the depreciation limit under Sec. 280F(d)(7) is $14,900 for the first tax year; $16,100 for the second tax year; $9,700 for the third tax year; and $5,760 for each succeeding year.

For passenger automobiles to which the Sec. 168(k) additional (bonus) first-year depreciation deduction applies and that are acquired after Sept. 27, 2017, and placed in service during calendar year 2019, the depreciation limit under Sec. 280F(d)(7) is $18,100 for the first tax year; $16,100 for the second tax year; $9,700 for the third tax year; and $5,760 for each succeeding year.

For passenger automobiles for which no Sec. 168(k) additional (bonus) first-year depreciation deduction applies, the depreciation limit under Sec. 280F(d)(7) is $10,100 for the first tax year; $16,100 for the second tax year; $9,700 for the third tax year; and $5,760 for each succeeding year.

Sec. 280F(c) limits deductions for the cost of leasing automobiles, expressed as an income inclusion amount, according to a formula and tables prescribed under Regs. Sec. 1.280F-7. Table 4 of Rev. Proc. 2019-26 contains the income inclusion amounts for lessees of passenger automobiles first leased during 2019. It shows income inclusion amounts for a range of fair market values for each tax year after the automobile is first leased.

Thanks to Sally Schreiber, J.D. at the AICPA for this information
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Optimizing Residential Real Estate Deductions

The tax deduction rules for residential landlords have changed dramatically in recent years, with the release of the final tangible property regulations in 2013 (T.D. 9636) and the creation of the qualified business income (QBI) deduction under Sec. 199A by the law known as the Tax Cuts and Jobs Act, P.L. 115-97. Landlords are now much more likely than before to be able to deduct most of their current expenditures.

The starting point is to determine whether an expenditure is for a betterment, restoration, or adaptation. A comprehensive remodeling or correcting a preexisting defect would be a betterment or restoration and would need to be capitalized. The mortgage interest and property taxes incurred during construction may need to be capitalized as well.

If the expenditure is not a betterment, restoration, or adaptation, the next step is to determine whether it can be expensed under the de minimis, small taxpayer, or routine maintenance safe harbor. The de minimis and small taxpayer safe-harbor elections apply to businesses and farms as well as to rental properties.

DE MINIMIS ELECTION

Under the tangible property regulations and Notice 2015-82, expenditures for tangible property that would otherwise be capitalized can be expensed if the item costs $2,500 or less and the taxpayer makes the proper election. Taxpayers with applicable financial statements have a de minimis cap of $5,000 per item. The taxpayer makes the election annually by including a statement with the tax return citing "Section 1.263(a)-1(f) de minimis safe harbor election." The election is made in the year the tangible personal property is placed in service and is allowed in any year of ownership.

SMALL TAXPAYER SAFE-HARBOR ELECTION

Landlords with average annual gross receipts for the three preceding tax years of $10 million or less and for units of property with an unadjusted basis of $1 million or less can elect to write off repairs, maintenance, and improvements if the total of these expenditures does not exceed the lesser of 2% of the unadjusted basis of the property or $10,000 during a given year. Items deducted under the de minimis election are also included in the routine maintenance safe-harbor calculation (Regs. Sec. 1.263(a)-3(h)(2)). The taxpayer makes the annual election by including a statement citing "Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers," along with his or her name, address, and taxpayer identification number and a description of each eligible building property for which the election is being made. The election can be made on a building-by-building basis.

ROUTINE MAINTENANCE SAFE HARBOR

Recurring expenditures for repairs and maintenance that keep property in ordinarily efficient operating condition do not need to be capitalized and can be expensed in the year payment is made. However, they are included in the 2%/$10,000 small taxpayer safe-harbor calculation. No elections are required. Typical expenditures include those for painting; replacing worn-out or damaged plumbing, HVAC, and appliance systems parts; and certain structural repairs.

DEPRECIATION

Sec. 179 does not apply to residential rental property or any of its components or improvements or to other property used in conjunction with the rental property.

For property placed in service after Sept. 27, 2017, 100% bonus depreciation is available for components with a recovery period of 20 years or less. Consideration should be given to depreciating versus expensing if the property is profitable and the taxpayer qualifies for the Sec. 199A QBI deduction, because the unadjusted basis of depreciable property is included in the Sec. 199A deduction calculation.

SEC. 199A: THE QBI DEDUCTION

In January, the IRS released Notice 2019-07, which provides safe-harbor requirements for rental real estate to qualify as a trade or business under Sec. 199A. To qualify, the real estate must be owned directly or through a disregarded entity. Additional requirements to meet the safe harbor are:

• Separate books are maintained for each real estate enterprise;
• Annually, at least 250 hours of rental services are provided by the owner, agent, or contractor; and
• Contemporaneous records, including time reports, logs, or similar documents are maintained that show the hours worked, a description of the service, the date, and who performed the service.

The notice also states that rental real estate businesses that do not meet the safe-harbor requirements may still qualify for the Sec. 199A deduction if they meet the definition of a trade or business under Sec. 162 other than the trade or business of performing services as an employee (Regs. Sec. 1.199A-1(b)(14)). Specifically excluded from the safe harbor are residences used by the taxpayer during the year and real estate leased where the tenant pays all the costs of ownership, commonly called triple-net leases. The safe-harbor rules are effective for tax years ending after Dec. 31, 2017.

If the activity does not meet the safe-harbor requirements, the key is whether it rises to the level of a trade or business rather than an investment activity. There is no definition of "trade or business" in the Code. However, the courts have held that activities with a profit motive and with continuous and regular involvement by the taxpayer are trades or businesses (Groetzinger, 480 U.S. 23 (1987)).

Landlords with multiple properties who actively participate in the rental activities clearly have a trade or business in real estate and therefore qualify for the deduction. It gets murkier if, for example, the landlord owns one residential property and uses a property manager to handle all the activities. Most experts agree that triple-net leases probably do not qualify as a trade or business, but even that situation should be reviewed, especially if the landlord owns and manages multiple triple-net leases.

Real estate trades and businesses are required to file Forms 1099-MISC, Miscellaneous Income, for vendor payments in excess of $600 and to complete the questions at the top of Schedule E, Supplemental Income and Loss, regarding the requirement to file the forms and whether they were filed. This could be problematic in defending a position that the activity rises to the level of a trade or business if Forms 1099-MISC were required but were not filed in previous years. Owners could also be subject to penalties for failure to file Forms 1099-MISC and for failure to supply copies to vendors.

Each situation will have to be evaluated based on the facts and circumstances. Vacation homes are especially problematic, due to the profit motive requirement. And, since they are rarely profitable, such properties would more likely reduce the deduction rather than increase it.

Thanks to Janet Hagy, CPA for this article.