Full-time real estate professionals, defined as someone who spends more than half of his or her working hours in real estate activities, can fully deduct losses---including depreciation, interest expense on loans and property taxes.
But those who don't fit into that category are typically considered to be "passive" real estate investors with a limited ability to deduct their losses, says Alan Weiner, a CPA and tax partner at the firm of Holtz Rubenstein Reminick LLP in Melville, NY.
Robert Marvin, a spokesman for the IRS, said the tax agency can't comment on individual taxpayer cases. However, he indicated that the agency is paying more attention to real estate activity because it is one of the areas where research shows there is a large tax gap, meaning taxpayers are underreporting income to the IRS. The tax gap in income from rents and royalties is about $13 billion and $11 billion for capital gains. (Income from real estate activity is included in, but not exclusive to, both categories.) Mr. Marvin said that several thousand returns of real estate professionals have been audited since last year and approximately 3,000 are under audit now.
Real Estate Professional or Passive Investor?
The IRS advises its auditors to do the following when trying to discern whether a taxpayer is actually a real estate professional:
* Determine whether the taxpayer materially participates in one or more of such real estate trades or businesses as rental, construction or leasing.
* Determine who is the real estate professional: husband or wife.
* Request and closely examine the taxpayer's documentation regarding time.
* Scrutinize other activities the taxpayer is engaged in to determine whether claimed time makes sense.
Sources: IRS's Passive Activity Loss audit-technique guide and The Wall Street Journal, February 28, 2007