Tax Court Corner: Don't Lose Your Real Estate Rental Deductions

Real estate is a tricky part of the tax code. And if you don’t follow the rules, the IRS can be quick to disallow some or all of your rental real estate expenses.

Background. By default, the IRS assumes real estate investments are passive activities. As a passive activity, generally passive losses are matched against passive gains and any excess losses are carried over into future years. There is a $25,000 loss exception if your income is below $150,000 (joint filer) and you actively participate in the rental activity.

If you want to take full advantage, you must meet professional real estate rules with material participation standards. But it can get tricky. In the 2023 court case of Gregory F. Teague and Rachel S. Teague v. Commissioner, the taxpayer’s real estate professional qualification came into play.

The Facts. Gregory and Rachel Teague own two rental properties: (1) a duplex in New Hampshire, and (2) three cabins in Maine. In 2017, they renovated their Maine cabins but failed to keep detailed records of the time they spent on renovations. That year, they reported nearly $6,000 of net income from their New Hampshire duplex and a nearly $30,000 loss from their Maine cabins. The taxpayers fully deducted the loss from their Maine cabins, which—when netted with their New Hampshire duplex—showed a rental real estate loss on Schedule E of nearly $24,000. The tax court sought to determine if Gregory qualified as a real estate professional. If he did not, their losses would be limited due to income limitations.

Gregory obtained his real estate license in 2013. To qualify as a real estate professional in the eyes of the IRS, he must show that (1) he spent more than 750 hours on a real estate business in which he materially participated, and (2) more than half of the personal services he performed in any trade or business that year were performed in real estate businesses in which he materially participated. Because Gregory failed to keep records of his time spent renovating the Maine cabins, and because the time estimates he provided did not seem fully credible, the tax court ruled that he did not qualify as a real estate professional. The Teagues’ real estate losses were not fully deductible.

The lesson. Qualifying as a real estate professional isn’t simple or easy. If you don’t qualify, your losses will likely be limited. Keep good records of time you spend on real estate activities. Please call if you have questions about your rental property activity.

And understand your standing with passive income rules. They can get complicated, especially if you are active in short-term rental sites like VRBO, Airbnb, and Booking.com.

Your Go-To 2024 Tax Moves

It’s never too early to start thinking about tax planning strategies for 2024. Here are some ideas to help you get started.

• Forecast your taxable income. Consider conducting a taxable income forecast and update it once a quarter. Use this information for your 2024 estimated tax payment obligations. You can also use your forecast to budget how much you’ll need to save each month so you won’t have a huge tax balance to scramble to pay at the end of the year. Your starting point for this forecast can be last year’s income, but with investments or potential business income, this exercise becomes more important.

• Prioritize retirement and savings plans. Take time to review your 401(k), individual retirement account (IRA), health savings account (HSA) and other savings accounts to ensure you’re maximizing your tax savings. Establish a regular contribution schedule early in the year, while taking into account new maximum contribution limits. And if you’re working, take full advantage of your employer's retirement contribution matching program.

• Turn losses into tax savings. Selling assets such as stocks, bonds, limited partnership interests, and collectibles for less than you paid for them can result in a capital loss. The loss can be applied to offset capital gains and then used to reduce ordinary income, up to an annual limit of $3,000 ($1,500 if you’re married and file separately). Any remaining balance can generally be carried forward to future years. Keep in mind that capital losses caused by the sale of investments within your retirement accounts are not deductible.

• Conduct an investment strategy review. If you have not already done so, now is the time to conduct a review of your investment portfolio. This will help you create a tax-efficient strategy that allows you to allocate assets to accounts where tax savings can be maximized. For example, you may want to re-balance your investments to align to your retirement plan risk goals.

• Keep great records. You know you drove the miles, donated the items to charity, had the medical expense, and paid the daycare. How can the IRS be disallowing your valid deductions? Remember that without correct documentation the IRS is quick to disallow them. So set up good record keeping habits. Create both a digital and paper folder system separated by income and expense type. Keep a contemporaneous mileage log and properly document your charitable contributions.

Your Tax Season Checklist

With tax filing just around the corner, now is a great time to look through your tax filing plan for 2023. Here are some ideas:

• Collect and upload your documents to your portal. Missing documents - even just one - is a significant reason why filing a tax return is delayed. Documents you’ll need include K-1s, W-2s, 1099s and other forms you receive from your business, employers, brokers, banks and others. If you detect any errors, contact the sender immediately to request a corrected copy. We will alert you to any documents that are missing based on the previous year filing, but any new taxable events and/or accounts we will not have record of, so make sure to include those forms.

• Put a due date reminder on your calendar. Mark April 15, 2024 on your calendar as the due date for filing your 2023 individual tax return, and gift tax returns; making contributions to a Roth or traditional IRA for 2023; and for paying the first installment of 2024 individual estimated taxes.

• Remember deadlines for business returns. If you own a business or are in a partnership, the deadline for filing partnership and S corporation returns is March 15. Calendar-year C corporation tax returns are due by April 15. Six-month extensions can be requested for partnerships and corporations.

• Keep great donation records. Cash contributions under $250 require a bank record like a canceled check, credit card record or a receipt from the charity. For larger donations, a receipt from the charity must be obtained before filing your return. Donations of property should include a photo, a receipt from the charity and a detailed listing of the items donated that are in good or better condition.

• Review your child’s income. Your child may be required to file a 2023 income tax return. A 2023 return is generally required if your child has earned more than $13,850, or has investment income such as dividends, interest, or capital gains that total more than $1,250.

• Contribute to retirement accounts. There’s still time to make 2023 IRA contributions — up to April 15, or until you’ve contributed the maximum allowed. That’s the lesser of your earned income for 2023 or $6,500 ($7,500 if you’re 50 or older).

• Calculate your estimated tax if you need to extend. If you file an extension, you'll still need to do a quick calculation to estimate your 2023 tax liability. If you still owe Uncle Sam any money, you'll need to write a check by April 15. Remember, filing an extension is only an extension of time, not of payment, so any balance due may result in penalties and interest.

Residential Energy Efficient Home Improvements - Update for 2023

If you make energy improvements to your home, tax credits are available for a portion of qualifying expenses. The credit amounts and types of qualifying expenses were expanded by the Inflation Reduction Act of 2022. We'll help you compare the credits and decide whether they apply to expenses you've already paid or will apply to improvements you're planning for the future.

Who can claim the credits

You can claim either the Energy Efficient Home Improvement Credit or the Residential Energy Clean Property Credit for the year when you make qualifying improvements. Homeowners who improve their primary residence will find the most opportunities to claim a credit for qualifying expenses. Renters may also be able to claim credits, as well as owners of second homes used as residences.

The credits are never available for improvements made to homes that you don't use as a residence.

Energy Efficient Home Improvement Credit

These expenses may qualify if they meet requirements detailed on energy.gov:

• Exterior doors, windows, skylights and insulation materials

• Central air conditioners, water heaters, furnaces, boilers and heat pumps

• Biomass stoves and boilers

• Home energy audits

The amount of the credit you can take is a percentage of the total improvement expenses in the year of installation:

• 2022: 30%, up to a lifetime maximum of $500

• 2023 through 2032: 30%, up to a maximum of $1,200 (heat pumps, biomass stoves and boilers have a separate annual credit limit of $2,000), no lifetime limit

Get details on the Energy Efficient Home Improvement Credit.

Residential Clean Energy Credit

These expenses may qualify if they meet requirements detailed on energy.gov:

• Solar, wind and geothermal power generation

• Solar water heaters

• Fuel cells

• Battery storage (beginning in 2023)

The amount of the credit you can take is a percentage of the total improvement expenses in the year of installation:

• 2022 to 2032: 30%, no annual maximum or lifetime limit

• 2033: 26%, no annual maximum or lifetime limit

• 2034: 22%, no annual maximum or lifetime limit

Get details on the Residential Clean Energy Credit.

Identity Thieves Love Tax Season

The vast amount of information shared online during tax season makes it a haven for identity thieves, and they're doing everything they can to take advantage of the opportunity! Here are several ways that identity thieves are targeting you, how to protect yourself, common signs of ID theft, and steps to take if you become a victim. Below are the ways identity thieves target you:

• Impersonating the IRS. Thieves call you and claim to be the IRS. They will try to intimidate you into making an immediate payment using a gift card or wire service. Remember, the IRS will physically mail you a letter as a means of first contact. And the IRS will never call you to demand an immediate payment.

• Filing a fraudulent tax return. Identity thieves try to file a tax return using your Social Security number before you do. So consider filing your tax return as quickly as you can to beat identity thieves at their own game.

• Phishing schemes. Be on the lookout for unsolicited emails, text messages, and social media posts that prompt you to share personal and financial information. These messages could also contain viruses, spyware, or other malware that could infect your electronic devices.

Common signs of ID theft. Here are some of the common signs of identity theft according to the IRS:

• In early 2024, you receive a refund before filing your 2023 tax return.

• You receive a tax transcript you didn’t request from the IRS.

• You receive notice that someone created an online IRS account without your consent.

• You find out that more than one tax return was filed using your Social Security number.

• You receive tax documents from an employer you do not know.

Other signs of identity theft include:

• Unexplained withdrawals on bank statements.

• Mysterious credit card charges.

• Your credit report shows accounts you didn’t open.

• You are billed for services you didn’t use or receive calls about phantom debts.

What you can do. If you discover that you’re a victim of identity theft, consider taking the following action:

• Notify creditors and banks. Most credit card companies offer protections to cardholders affected by ID theft. You can generally avoid liability for unauthorized charges exceeding $50. But if your ATM or debit card is stolen, report the theft immediately to avoid dire consequences.

• Place a fraud alert on your credit reports. To avoid long-lasting impact, contact any one of the three major credit reporting agencies—Equifax, Experian or TransUnion—to request a fraud alert. This alert covers all three of your credit files.

• Report the theft to the Federal Trade Commission (FTC). Visit identitytheft.gov or call 877-438-4338. The FTC will provide a recovery plan and offer updates if you set up an account on the website.

• Please call if you suspect any tax-related identity theft. If any of the previously mentioned signs of tax-related identity theft have happened to you, please call to discuss further steps.