Landing in a Tax Mess

Depreciation tends to be one of the more vexing tax concepts for buy and hold real estate investors. It became particularly vexing for Sharon and Steve N. earlier this year when they lost their Tax Court case regarding the depreciation expense they claimed in 2012 on their 3 California rental properties.

According to Tax Court documents, the N’s represented themselves at Tax Court. That makes me believe they probably also prepared their own tax returns. That, plus the fact the tax return contained a ‘rookie’ mistake by including the value of the land in the depreciable basis of their three rental properties.

For tax purposes land does not depreciate. While not inherently obvious to the average untrained taxpayer, removing the value of the land when calculating depreciable basis was something I was required to know as a first-year tax preparer for the Big Green Square company. Therefore, someone with less tax knowledge than I had as a total novice prepared their taxes. Which makes me think the N’s prepared it themselves.

Including the land value in the depreciable basis caused the N’s to claim excessive depreciation expense in 2012. After examining their return, the IRS reduced the amount of the allowed depreciation expense (in 2012) based on the assessments of land and improvement (building) value of the three properties made by the Los Angeles County Office of the Assessor. This resulted in the IRS issuing a notice of deficiency to the N’s for $5,297. (A notice of deficiency is essentially a tax bill. The IRS issues you a notice stating the amount your taxes paid for the year were deficient.) The N’s disagreed with the IRS determination of their tax bill and petitioned the Tax Court for relief.

By the time they got to Tax Court the N’s figured out they were not supposed to include land value in the depreciable basis of their properties. They continued with their petition, however, as they disagreed with the Los Angeles County Office of the Assessor’s estimate of the value of the land vs the value of the depreciable improvements to the land. They believed the allocation the IRS made to land value when reducing their allowed depreciation expenses was excessive. Note: they were no longer arguing the numbers they used for depreciable basis were correct. They were now arguing the numbers used by the IRS in the Notice of Deficiency were wrong, too. 

To demonstrate the inaccuracy of the Los Angeles County Office of the Assessor the N’s relied on two alternative methods of property valuation: land sales method and insurance method. They also raised questions about the inconsistency of the Los Angeles County Office of the Assessor.

The judge was not moved by the N’s “after the fact allocations” between land and building value. The Los Angeles County assessments were made at the time the properties were acquired, which makes them more relevant than the estimates the N’s produced years later. Likewise, the judge did not share the N’s concerns about the consistency or inconsistency of the Los Angeles County Office of the Assessor.

The Notice of Deficiency was upheld. The N’s depreciation deductions were limited by the amount determined by the IRS, and they were required to pay the $5,297 in back taxes.

My natural bias when reading Tax Court cases is with the tax payer. By the end of reading this particular case I felt like the N’s were somewhat fortunate not to have additional penalties to pay. I’m also curious as to whether the IRS is now looking at some of their returns from other tax years. They purchased 2 of those properties in 2003. It seems unlikely to me 2012 was the first year they didn’t get the depreciation correct. Perhaps more back taxes await the N’s down the road.

What might they have done to spare them some of this pain?

• 1. They need to get someone else to prepare their tax returns. Whoever did it the first time made a very basic error. (One I see frequently on self-prepared returns, BTW.) If my assumption they self-prepared is correct they should find a competent and credentialed tax professional. If they did hire someone, they should fire that person and find a competent and credentialed tax professional.
• 2. Don’t represent yourself at Tax Court. Get someone who knows what they are doing in this situation. The IRS keeps data on the results of Tax Court cases and tax payers who represent themselves (Pro Se) fare measurably worse than tax payers who have professional representation.

The hands-on nature of real estate investing attracts independently-minded folks who do not easily relinquish control of a situation to someone else. That attitude can work very well in real estate deals where a small mistake or two can be overcome with some good old-fashioned sweat equity. Where that mindset doesn’t always work so well is on your tax return. Small tax mistakes don’t always get overlooked, and sometimes turn into major headaches. Outsourcing your tax preparation to a professional will not only reduce your headaches, but it will also free up some time to do what you’d much rather be doing – finding your next real estate deal.