Rebella Accountancy | 507 E. First Street, Suite A | Tustin, CA 92780 | Phone: 714-619-0667 | Fax: 714-544-0236

       

 

 

Monica Rebella, CPA/IAR - President

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Feature Articles

 

- Review of IRS's treatment of conservative groups intensifies; Agency under 30-day top-down review

- IRS steps up guidance under Health Care Law as 2014 mandates loom

- Senate passes Internet Sales Tax Bill that will require state sales tax on all online purchases

- FAQ: How are vacation homes taxed?

- How do I? Calculate imputed interest on bargain-rate loans

- June 2013 tax compliance calendar

 

 

 

Home Office Red Flag, Make Rental Property Losses Tax Deductible & Tax Deductions for Business Entertainment Meals!



Myth: Home-Office Tax Deduction Is a Red Flag for IRS Audit

The man-on-the-street interview will tell you that claiming a home-office deduction is a red flag for IRS audit. Of course, we know that the man on the street who did the interview is without knowledge.

But what about all the publications that say the home-office tax deduction is a red flag for audit? For example, if you put “home office” and “red flag” in Google with quotes as you see here, you find 157,000 results.

What’s interesting in the Google search is that many of the published articles now say that the homeoffice tax deduction is not a red flag. The problem is that lots of the other articles say that it is a red flag. Who’s right? Why?

Facts:  The IRS does not publish its audit flags. That’s a shame. So how do tax professionals, newspapers, magazines, and newsletters know if the home-office tax deduction is a red flag or not? Good question. The people who say that the home office is, or is not, a red flag don’t cite any authorities to back their claims.

What We Know:  Last October a group conducted a two-hour continuing education webinar for CPAs and enrolled agents. During the webinar they asked the following polling question—a question that participants have to answer to prove attendance and attention:

Question G from the webinar for CPAs and enrolled agents: Do this: Think of yourself and how many clients you have who have claimed the home-office deduction for each of the last three years. Now with that number of clients in mind, what percentage have been audited by the IRS in the last three years?

Answers:


 - No audits at all—73 percent
 - Fewer than 5 percent audited—22 percent
 - Five to 10 percent—5 percent


During live seminars given to one-owner and husband-and-wife owned businesses we found that the rate of audit for those who claimed the home-office deduction was no greater than the rate of audit for those who did not claim the deduction.

In fact, we found hundreds of instances where the business owner claimed the home-office deduction and experienced an audit, but he was never asked about the home office during the audit.

Obviously, the IRS examiners conducting these audits did not carry in their audit bags any home-office tax deduction red flags.

Conclusion:  Based on surveys and the answers to questions during the seminars, the home-office deduction is not a red flag.

What Is a Red Flag?

As you know, the IRS does not publish its audit flags. Further, the flags are secrets that have not been exposed.
 


 

Make Your Rental Property Losses Tax Deductible


Lawmakers do not like your rental property.  The IRS does not like your rental property.  If you want to deduct your rental property losses, you need to run and survive the passive-loss gauntlet. This article will give you safe passage.

Big Picture

Tax law allows you to qualify to deduct your rental property losses.
 

One way to qualify (albeit for a limited deduction) is by Qualifying for Rental Real Estate’s Tax-Favored $25,000 Allowance.


The second way to qualify is by (1) materially participating as a (2) tax law-defined real estate professional. That’s what this article is about.

Test 1: Real Estate Professional


The test for real estate professional status is an hours-worked test. You pass this test when in real property trades or businesses in which you and/or your spouse materially participate

 

1) you OR your spouse individually work more than 750 hours, and that more-than-750-hour-work effort by you OR your spouse individually is more than half of that individual’s total work effort for the year.

2) Example. You own and materially participate in five rental properties and also operate an unrelated business. You spend 900 hours on the
rental properties and 800 hours on your unrelated business.


You are a tax law-defined real estate professional for purposes of deducting your rental property losses because you


1) materially participated in the properties (more on this later),
 

2) worked more than 750 hours on the properties (or in tax law-approved real estate activities
 

3) spent more time on your rental properties than you spent on your unrelated business.

If you are married, you can count your spouse for purposes of materially participating in the individual rental properties or in a group
of rental properties, but you may not count your spouse for purposes of the 750 hours or the more than 50 percent tests.


Test 2: Material Participation
 

Passing test 1 is only part 1. You next need to pass the material participation test as shown in the listing below:
 

As a tax law-defined real estate professional, you may deduct rental losses for
Each rental property in which the combined efforts of you and your spouse result in material participation (if you did not elect to group the properties), or
If you elected to group the properties, the combined efforts of you and your spouse result in material participation in the property group.


As a tax law-defined real estate professional, you may deduct rental losses for
 

Each rental property in which the combined efforts of you and your spouse result in material participation (if you did not elect to group the properties), or
 

If you elected to group the properties, the combined efforts of you and your spouse result in material participation in the property
group.

Note This

For the real estate professional test, either you or your spouse individually had to pass the test.


For the material participation test, the law allows the combined efforts of husband and wife.

Group or Not
 

In the two tests above, note the words “materially participate.”
 

- To be a real estate professional, either you or your spouse individually must pass the time tests for the real property trades or businesses (including rental properties) in which you and/or your spouse “materially participate.”
 

- To deduct your rental losses, you and/or your spouse must “materially participate either in the individual properties or, if elected, in the group of rental properties."

Profits Not a Problem

For tax planning purposes, if your rental activity is showing a taxable profit, you don’t need to think or worry about being a real estate professional or whether or not you materially participate.

But since most real estate rental property investments operate in tax-shelter mode, especially in the early years of ownership, you generally want to deduct those rental property losses against your other income.

Before we address grouping as a possible enabler for deducting your rental losses, let’s examine the material participation standards that apply to an individual property.

Seven Possibilities for Material Participation
 

To materially participate in a rental property activity, you must answer “yes” to one of the seven standards in this listing.

You do this on a property-by-property basis if you did not make the formal tax election to group your properties. With an election to group your rentals into a single activity, you apply the seven tests for material participation to the grouped activity.

The material participation tests apply to the combined efforts of husband and wife without regard to ownership or whether or not a joint return is filed.

1) Did you and your spouse combined participate in the activity for more than 500 hours?


2) Was the combined participation by you and your spouse substantially all the participation in the activity when you consider all the
individuals who participated?


3) Are the combined hours of participation by you and your spouse (a) more than 100 hours and (b) more hours than the participation of
any other individual?


4) N/A (This test 4 for material participation under the “significant participation activity” does not
apply to rentals.


5) You and/or your spouse materially participated in the activity for any five of the 10 immediate preceding tax years.


6) N/A (This test is for material participation in a “personal service activity” and it generally does not apply to rentals.


7) Based on all the facts and circumstances, you and your spouse materially participated in the activity on a regular, continuous, and substantial basis during the year. You cannot pass this test with participation of less than 100 hours. Further, this is likely a “last gasp” try at material participation that’s problematic at best.


Example

You and your spouse own five rental properties and you did not group them. Your activities and results from the material participation
tests on each of the five properties are as follows:

Rental | What Participation Took Place | Material Participation
 

1 - You did all the work on property number 1 by yourself. It took 45 hours of your time for the year. - Yes
 

2 - On property number 2, you and your spouse each spent 75 hours and that was more than 100 hours and more hours than anyone else
spent. - Yes
 

3 - On property number 3, you had a total of 250 material participation hours and that was more than any other individual spent. - Yes
 

4 - On property number 4, your spouse spent 100 hours and you spent 250 hours and that 350 hours was more time than any other individual
spent. - Yes
 

5 - On property number 5, you spent 280 hours and that was more time than any other individual spent. - Yes

You spent 900 total hours and your spouse spent 175 hours. Your 900 hours
 

> are in properties in which you materially participated,
> exceed 750 hours, and
> exceed more than half of your total work hours in all trades or businesses in which you materially participated.

You are a tax law-defined real estate professional and you may deduct the losses on all five properties above.

Grouping

Let’s say that you failed to materially participate on one or more of the properties above. If that were the case and you had tax losses that you wanted to deduct, you would group the five properties into one activity.

Now you apply the seven tests to the group as if the group were one. In the above example, you would select the more than 500 hours of participation test to deduct the rental losses of the group.

Self-Rental

If you grouped a self-rental with your business that property is now part of the business and not a rental property subject to the passive loss rules.

Bad news. Under the self-rental rule, without the grouping with the business, your income from the self-rental is “non-passive income” whereas a loss is passive.

This gives you the worst of all worlds and makes your self-rental useless as a helper with your rental properties.

Protect yourself. Group your self-rental with your business.

Short-Term Rentals—Careful Here

Short-term rentals can cause trouble. For example, if the average stay over the tax year at a property is for seven days or less, the property is a hotel that you report on Schedule C as a business and not as a rental property.

Similarly, if the average period of customer use is 30 days or less and you provide significant personal services, that property is a hotel reported on Schedule C and not a rental property.

If the short-term rentals are not rental properties, you can’t group them with your rental properties or count them as rental properties for the various hourly tests.

Should the short-term rental hotels produce a loss on your tax return, you can deduct that loss only if you materially participate in the hotel activity.

Should you have a hotel property, keep this in mind:

A) You may not group the hotel with your rentals.


B) Time spent on the hotel does not count as “material participation” time for the 750-hour test.
 

C) To deduct a loss on the hotel, you need to materially participate in the hotel activity.
 

D) If you have a group of hotels, you may need to consider the grouping election for the hotels.
 




Protecting Your Tax Deductions for Business Entertainment Meals

Have you ever had to face these two conflicted tax laws?

1) The law that denies your deductions for personal living expenses (food).


2) The law that allows meals as tax-deductible entertainment.

Tax professionals know this conflict as the “Sutter rule” named after Dr. Sutter, who had a bad experience with the Tax Court. When the IRS and/or the courts invoke the Sutter rule, you lose your business meal deductions to the extent they don’t exceed your personal meal costs.

Example. Your Dutch treat meal deductions for business entertainment for the year are $12,000. Had you had the meals at home, your cost would have been $2,000. Under the Sutter rule, the IRS could reduce your meal deductions by $2,000 to $10,000—the business amount in excess of the personal cost that you proved.

But it is unlikely that you could prove your personal cost of meals. If that’s the case, then the IRS disallows $12,000—the usual result suffered by the victim of a Sutter attack.

This article explains the Sutter rule, gives you the triggers that can make you a target for a Sutter attack, and shows you how to keep your deductions if you are attacked.

Sutter Rule

In Dr. Sutter’s case, he lost the lunch deductions he claimed for attending St. Louis Chamber of Commerce and Hospital Council of St. Louis luncheon meetings. The court ruled that he did not spend any more money for those lunches than he spent for his personal lunches.

In a general comment to all taxpayers, the Sutter court stated that you can overcome tax law’s nodeduction-for-personal-expenses rule only by clear and detailed evidence that the expenditure in question was different from or in excess of that which you would have made for personal purposes

Triggers

Whimsical. The IRS invokes the Sutter rule at its whim. No standards exist, other than abuse in the eyes of the IRS.

The targets are “the wrong type and/or too many meals deducted as business entertainment.” The problem: no definition of too many.

In Revenue Ruling 63-144, the IRS says that it applies this no-deduction for the personal cost of a meal (e.g., the Sutter rule) largely to abuse cases where taxpayers claim deductions for substantial amounts of personal living expenses.

The Sutter rule does not apply to the cost of meals consumed in travel status. It applies to meals deducted as entertainment expenses.

In Fenstermaker, the court ruled that the IRS policy of abuse cases was too liberal and it applied the no-deduction-for-personal-meals—period rule. In this case, the court denied 68 business lunches in one year and 49 business lunches in a second year because the cost of the business lunches was no greater than the cost of the personal lunches.

In this case, Mr. Fenstermaker had both business and personal lunches at the Fort Hayes Hotel. Thus, the business lunch cost no more than a personal lunch and accordingly the court ruled that Mr. Fenstermaker’s business lunches were not deductible.

Your Defense

Your legitimate entertainment expenses have been under attack almost since inception of the income tax. Today is no exception. But here you will learn how to build a good defense against attacks.  Your defense comes in two forms: logic and legislation.

Under Sutter, in order for personal living expenses to qualify as a deductible ordinary and necessary business expense, you must demonstrate that the expenses were different from, or in excess of, what you would have spent for personal purposes.

If you have a number of deductible business meals with the same folks, you need

A) to ensure good future business benefit reasons for the entertainment, and
 

B) have proof that because of the entertainment you spent more than you would on a personal meal.

You need this same proof if you are having a good number of Dutch treat business meals. The fact that you pick up the tab for only yourself at tax-deductible entertainment does nothing to hurt your business reason for the entertainment, but it can raise a suspicion that you are absorbing personal and family expenses. The ability to show that when you go on a Dutch treat entertainment you spend more than you would personally adds proof to your cause.

Put business first. Use the conduct of your business as your first rule of thumb. Every business is different. Every individual is different. You might entertain often; the next person not at all. It doesn’t matter. What matters is your proof.

Let’s turn to the legislation that’s on your side. First, you have the Tax Reform Act of 1986, where lawmakers stated that the cut from a 100 to 80 percent business meal deduction simply reflects “that all meals and entertainment involve an element of personal living expenses.” Thus, you already have lawmakers saying that you absorbed the personal part of a business meal with the cut to 80 percent.

In 1993, lawmakers reduced the 80 percent to 50 percent believing this additional 30 percent reduction an appropriate contribution on your part to deficit reduction and a proxy for the personal consumption element of your meals and entertainment deduction.

But let’s not kid ourselves; there was only one reason for the cut from 80 to 50 percent: deficit reduction.  The personal consumption side was addressed in the 80 percent. That being true is sad. On the positive side, the now personal consumption element of 50 percent gives you a lot more defense against Sutter and Fenstermaker should the IRS try to impose them against you.

 


 

   

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As always you can call me at 714-619-0667 if you have any questions about investing, retirement or any other tax & accounting related issues. 

 

Regards, Monica Rebella, CPA/IAR

President, Rebella Accountancy

 
Disclaimer:  The opinions contained herein are not intended to be investment advice or a solicitation to buy or sell any securities. With any investment you should carefully consider the investment objectives, potential risks, management fees, and charges and expenses before investing.  Past performance is not a guarantee of future results. The investment return and principle value of any investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost.

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Monica Rebella, CPA/IAR | President - Rebella Accountancy | Certified Public Accountants
507 E. First Street, Suite A | Tustin, CA 92780 | Phone: 714-619-0667 | Fax: 714-544-0236
Email: mrebella@rebellacpa.com | www.RebellaCPA.com | www.MyDentalCPA.com