How to Claim Passive Losses without getting Audited

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How to Claim Passive Losses without getting Audited

Kyler J Sloan

Investor · Maggie Valley, NC · Member since 2020 · 284 posts · 85 votes

I have poured my cash into STR construction projects, and so actually have a loss which nearly equals my income.

Using the "STR Loophole", this should enable me to deduct these expenses from my W2 income.

However, this also puts me at risk of an audit.

Are there any other STR investors who have struggled with this?

Is there a "rule of thumb" for avoiding an audit? -- i.e. "Do not allow your losses to reach X percent of your income".

I just wondered if there was a threshold that I should be wary of.

Thanks in advance.

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Nathan GesnerBusiness Member

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Real Estate Broker · Cody, WY · Member since 2010 · 28k+ posts · 41k+ votes

Quote from @Kyler J Sloan:

My rentals made over $150,000 net cashflow last year, but my tax returns showed around $10,000 income because I wrote off all the LEGAL deductions. It's not going to generate an audit because it is completely normal.

Talk to your CPA and wrap your head around this. Writing off deductions is one of the many benefits of real estate investing.

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Michael BaumPro Member
Olympia, WA · Member since 2016 · 8k+ posts · 7k+ votes
3y
Hey @Kyler J Sloan this is really a question you should field to your CPA. If you are doing a bunch of STR builds, then you really need a CPA to guide you through this. You don't want to rely on any of us. We aren't hacks, but this is a very specific situation.
If the IRS manages to actually hire those 87k new agents, then audits will be coming for all of us so get a good CPA. We have one lake house and we have a CPA.
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John UnderwoodPro Member
Investor · Greer, SC · Member since 2014 · 13k+ posts · 17k+ votes
3y
Quote from @Michael Baum:

Hey @Kyler J Sloan this is really a question you should field to your CPA. If you are doing a bunch of STR builds, then you really need a CPA to guide you through this. You don't want to rely on any of us. We aren't hacks, but this is a very specific situation.
If the IRS manages to actually hire those 87k new agents, then audits will be coming for all of us so get a good CPA. We have one lake house and we have a CPA.

As Michael said, you absolutely need a good CPA on your team.
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Kyler J Sloan
OP
Investor · Maggie Valley, NC · Member since 2020 · 284 posts · 85 votes
3y
Quote from @Michael Baum:

Hey @Kyler J Sloan this is really a question you should field to your CPA. If you are doing a bunch of STR builds, then you really need a CPA to guide you through this. You don't want to rely on any of us. We aren't hacks, but this is a very specific situation.
If the IRS manages to actually hire those 87k new agents, then audits will be coming for all of us so get a good CPA. We have one lake house and we have a CPA.

I do have one, but he went home for the night, and this was on my mind.
He gave me some options, but yes I would say that I should trust and rely more on his expertise.
1 Reply
Jeremy Horton
Rental Property Investor · Somewhere over the Rainbow · Member since 2021 · 1k+ posts · 1k+ votes
3y
Quote from @Kyler J Sloan:

Quote from @Michael Baum:

Hey @Kyler J Sloan this is really a question you should field to your CPA. If you are doing a bunch of STR builds, then you really need a CPA to guide you through this. You don't want to rely on any of us. We aren't hacks, but this is a very specific situation.
If the IRS manages to actually hire those 87k new agents, then audits will be coming for all of us so get a good CPA. We have one lake house and we have a CPA.

I do have one, but he went home for the night, and this was on my mind.
He gave me some options, but yes I would say that I should trust and rely more on his expertise.

Call him in the morning - if it's legit then there's nothing to worry about
0 Reply
Nancy Bachety
Rental Property Investor · North Fork, NY · Member since 2016 · 1k+ posts · 631 votes
3y
Trust but verify. What @Michael Baum said first, to ask your CPA was good but actually, we do know a lot and can help answer your question.
You’re wondering if you increase your chances of getting audited because you’re qualifying for the short term rental loophole. It’s a fairly knew concept to the irs and they all don’t know everything about it, and sometimes a good CPA doesn’t either.
We got called out on it but I armed myself with tax code law and cited them in my rebuttal. The agent actually told me he read my answer, looked it up, and, as long as I send him my guest lists indicating less than 7 night stays, I win. He was thinking I needed to meet the rep status but no way was I because I had a w2 that year.
So, track your hours for material participation and work your w2 without fear.
4 Reply
Linda WeygantPro Member
Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes
3y
If the expenses associated with your STR are prior to the IN SERVICE date, then most of those expenses may need to be depreciated rather than deducted. Hopefully your CPA can guide you on this.
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Nathan GesnerBusiness Member
Moderator
Real Estate Broker · Cody, WY · Member since 2010 · 28k+ posts · 41k+ votes
3y
Quote from @Kyler J Sloan:

My rentals made over $150,000 net cashflow last year, but my tax returns showed around $10,000 income because I wrote off all the LEGAL deductions. It's not going to generate an audit because it is completely normal.
Talk to your CPA and wrap your head around this. Writing off deductions is one of the many benefits of real estate investing.
The DIY Landlord Book4.7247 Reviews
Website View Page
6 Reply
Todd Goedeke
Contractor · Sheboygan, WI · Member since 2016 · 921 posts · 266 votes
3y
@Nancy Bachety yes, you are right. STVRs with material participation are considered active investments using schedule C, similar to other actively run RE businesses or other small businesses. Those losses can offset W-2 income when using cost segregation. As you said keep track of construction management hours and/or management hours in case of audit.
1 Reply
Carlos Ptriawan
Member since 2019 · 7k+ posts · 4k+ votes
3y
Quote from @Kyler J Sloan:

I have poured my cash into STR construction projects, and so actually have a loss which nearly equals my income.
Using the "STR Loophole", this should enable me to deduct these expenses from my W2 income.
However, this also puts me at risk of an audit.
Are there any other STR investors who have struggled with this?
Is there a "rule of thumb" for avoiding an audit? -- i.e. "Do not allow your losses to reach X percent of your income".
I just wondered if there was a threshold that I should be wary of.
Thanks in advance.

people is just so scary when hearing the word audit.
it's not really that bad at all. I've audited in 2000 something (unrelated to real estate) and the irs guy understands the situation, so they just cut the penalty by half.
sometimes we worry too much, as long as it's documented, go ahead! if they don't agree, go visit the auditor, and have your baseline argumentation coming as well. they're very professional overall.
sometimes , the best way to understand things is also to understand the exact tax language, word by word. I know some tax guy here would not agree with me but that's not my problem.
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Kyler J Sloan
OP
Investor · Maggie Valley, NC · Member since 2020 · 284 posts · 85 votes
3y
My CPA is ultimately concerned that an audit could result in these "expenses" being reclassified as improvements that they depreciate instead of allowing them to be expensed.
I do have quite a bit of paneling work which was purely for aesthetics, while other jobs were actually necessary to bring the rental into service.
He suggests that I expense the latter and not the former.
Sounds reasonable, but i am curious about other perspectives.
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Michael BaumPro Member
Olympia, WA · Member since 2016 · 8k+ posts · 7k+ votes
3y
Depreciation can get really complicated. The paneling sounds like an expense to me. You don't depreciate paint and paneling could be in that vein.
For example we did a bunch of work on our house after buying it and we expensed it all. Redid the deck railings, refinished the deck surface, repaired various small things and did some exterior paint work.
The new washer and dryer were depreciated as was the dishwasher. We replaced the A/C unit 2 years after and that was also depreciated.
0 Reply
Carlos Ptriawan
Member since 2019 · 7k+ posts · 4k+ votes
3y
Quote from @Michael Baum:

Depreciation can get really complicated. The paneling sounds like an expense to me. You don't depreciate paint and paneling could be in that vein.
For example we did a bunch of work on our house after buying it and we expensed it all. Redid the deck railings, refinished the deck surface, repaired various small things and did some exterior paint work.
The new washer and dryer were depreciated as was the dishwasher. We replaced the A/C unit 2 years after and that was also depreciated.

these are part of gray area, it really depends on context when you need to do something.
eventually one tax expert would not agree but i personally okay to be challenged in audit for this. It's really not that bad.
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Linda WeygantPro Member
Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes
3y
Quote from @Kyler J Sloan:

My CPA is ultimately concerned that an audit could result in these "expenses" being reclassified as improvements that they depreciate instead of allowing them to be expensed.
I do have quite a bit of paneling work which was purely for aesthetics, while other jobs were actually necessary to bring the rental into service.
He suggests that I expense the latter and not the former.
Sounds reasonable, but i am curious about other perspectives.

Yeah - they're concerned about this because that's actually the correct way to report this. Please familiarize yourself with the concept of an IN SERVICE date and the fact that any expenses incurred to renovate the property prior to that date are depreciable, NOT deductible.
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Linda WeygantPro Member
Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes
3y
Quote from @Carlos Ptriawan:

Quote from @Michael Baum:

Depreciation can get really complicated. The paneling sounds like an expense to me. You don't depreciate paint and paneling could be in that vein.
For example we did a bunch of work on our house after buying it and we expensed it all. Redid the deck railings, refinished the deck surface, repaired various small things and did some exterior paint work.
The new washer and dryer were depreciated as was the dishwasher. We replaced the A/C unit 2 years after and that was also depreciated.

these are part of gray area, it really depends on context when you need to do something.
eventually one tax expert would not agree but i personally okay to be challenged in audit for this. It's really not that bad.

There is nothing grey about this area. This is one of the most black and white areas of real estate taxation. Expenses BEFORE the In Service date are depreciated. Expenses AFTER the in Service date are then considered for repair vs improvement and then applying De Minimus Safe Harbor considerations.

So frustrating to be the only tax professional commenting on this thread that is waving her arms and say HEY!! PAY ATTENTION!!! While the rest of y'all are leading this guy down ALL the wrong paths.

But yeah - as Turbo Tax says - All people are tax people.

@Natalie Kolodij, @Steven Hamilton II, @Ashish Acharya

Podcast Guest on Show #244
4 Reply
Carlos Ptriawan
Member since 2019 · 7k+ posts · 4k+ votes
3y
Quote from @Linda Weygant:

Quote from @Carlos Ptriawan:

Quote from @Michael Baum:

Depreciation can get really complicated. The paneling sounds like an expense to me. You don't depreciate paint and paneling could be in that vein.
For example we did a bunch of work on our house after buying it and we expensed it all. Redid the deck railings, refinished the deck surface, repaired various small things and did some exterior paint work.
The new washer and dryer were depreciated as was the dishwasher. We replaced the A/C unit 2 years after and that was also depreciated.

these are part of gray area, it really depends on context when you need to do something.
eventually one tax expert would not agree but i personally okay to be challenged in audit for this. It's really not that bad.

There is nothing grey about this area. This is one of the most black and white areas of real estate taxation. Expenses BEFORE the In Service date are depreciated. Expenses AFTER the in Service date are then considered for repair vs improvement and then applying De Minimus Safe Harbor considerations.

So frustrating to be the only tax professional commenting on this thread that is waving her arms and say HEY!! PAY ATTENTION!!! While the rest of y'all are leading this guy down ALL the wrong paths.

But yeah - as Turbo Tax says - All people are tax people.

@Natalie Kolodij, @Steven Hamilton II, @Ashish Acharya

lol, I expect this reply. I'm referring into "Expenses AFTER the in Service date are then considered for repair vs improvement" part.

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Kyler J Sloan
OP
Investor · Maggie Valley, NC · Member since 2020 · 284 posts · 85 votes
3y
0 Reply
Kyler J Sloan
OP
Investor · Maggie Valley, NC · Member since 2020 · 284 posts · 85 votes
3y
Also, is the "service date" strictly the date the property was brought into a serviceable state, or the date the listing goes live?

I made some rehab repairs, and then deferred listing it until I finished some improvements and repairs.

EDIT: Never mind. I looks like the former, based on the following definition --

"The term placed in service means the time that property is first placed by the taxpayer in a condition or state of readiness and availability for a specifically assigned function, whether for use in a trade or business, for the production of income, in a tax-exempt activity, or in a personal activity."
That is a relief. I can deduct a LOT then.

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Linda WeygantPro Member
Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes
3y
Quote from @Kyler J Sloan:

Also, is the "service date" strictly the date the property was brought into a serviceable state, or the date the listing goes live?

I made some rehab repairs, and then deferred listing it until I finished some improvements and repairs.

EDIT: Never mind. I looks like the former, based on the following definition --

"The term placed in service means the time that property is first placed by the taxpayer in a condition or state of readiness and availability for a specifically assigned function, whether for use in a trade or business, for the production of income, in a tax-exempt activity, or in a personal activity."
That is a relief. I can deduct a LOT then.

The In Service date is the date the property was ready and available for rent. Ready should be self explanatory. Available means it's being advertised (or listed on AirBNB or whatever sites) for rent. Ready means nothing if it's not available and available means nothing if it's not ready.
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Natalie KolodijBusiness Member
Moderator
Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
3y
There is no such thing as rental repairs before a rental is in service. Period.

This is like having operating expenses on a business before the doors are open to the public. It doesn't exist.

To the IRS all costs to get any Asset ready for it's intended use are added to it's basis/ capitalized.

I didn't have a chance to read through it all- but Linda knows her stuff and I'm guessing this is the point she already made.

The repairs vs. deminumus vs. capitalized tests all come into service one an asset is in service.

If you generated a bunch of losses with pre-in service expenses then those were incorrectly accounted for, and should be improvements/basis items.
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2 Reply
Craig Janet
Member since 2019 · 223 posts · 261 votes
3y
Your CPA is worried about an audit because you are expensing things that should be deprecated. There are some grey areas in the tax reporting AFTER its in service in regards to whether an expense is a repair or improvement.
To answer your question there is no magic number that will trigger an audit. How lucky do you feel?
1 Reply
Michael BaumPro Member
Olympia, WA · Member since 2016 · 8k+ posts · 7k+ votes
3y
Just an FYI, we had our place in service during the repairs. It was advertised but we were very selective of who we let rent it the first year. Mostly people we knew to get things sorted.
Our CPA is an investor as well so he knows his stuff. I don't claim to be an expert at all.
0 Reply
Kyler J Sloan
OP
Investor · Maggie Valley, NC · Member since 2020 · 284 posts · 85 votes
3y
@Natalie Kolodij I may not be a tax expert, but I can understand plain English:

Readiness generally means that the rental property is habitable and legally able to be rented. A taxpayer can generally claim that a rental property is ready if the property either receives, or is ready to receive, a Certificate of Occupancy (CO) by a state or local authority. The rules regarding a CO can vary between different localities; however, if the property is legally allowed to be occupied it should meet the readiness requirement.

Availability generally means that the rental property is advertised to be rented. The property does not need to have a signed lease, as long as it is available to be rented and there is some attempt to make it known to the market. (Note: Advertising can be word-of-mouth advertising or something as simple as a “FOR RENT” sign with a contact number posted on the property. Documentation of attempts to advertise the property to the marketplace are helpful to demonstrate the position that the property was available.)

So, yes, a property can never be placed into service and yet be ready and available for rent. That would mark its service date by the definition above. If all further work must be classified as either a "repair" or "improvement", then that would imply that there can indeed be "repairs" to a property that has not yet been rented in the eyes of the IRS.
1 Reply
Kyler J Sloan
OP
Investor · Maggie Valley, NC · Member since 2020 · 284 posts · 85 votes
3y
Quote from @Linda Weygant:

Quote from @Kyler J Sloan:

Also, is the "service date" strictly the date the property was brought into a serviceable state, or the date the listing goes live?

I made some rehab repairs, and then deferred listing it until I finished some improvements and repairs.

EDIT: Never mind. I looks like the former, based on the following definition --

"The term placed in service means the time that property is first placed by the taxpayer in a condition or state of readiness and availability for a specifically assigned function, whether for use in a trade or business, for the production of income, in a tax-exempt activity, or in a personal activity."
That is a relief. I can deduct a LOT then.

The In Service date is the date the property was ready and available for rent. Ready should be self explanatory. Available means it's being advertised (or listed on AirBNB or whatever sites) for rent. Ready means nothing if it's not available and available means nothing if it's not ready.

Sounds like you are making up your own definitions here, and are not going off of those listed above
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Natalie KolodijBusiness Member
Moderator
Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
3y
Quote from @Kyler J Sloan:

@Natalie Kolodij I may not be a tax expert, but I can understand plain English:

Readiness generally means that the rental property is habitable and legally able to be rented. A taxpayer can generally claim that a rental property is ready if the property either receives, or is ready to receive, a Certificate of Occupancy (CO) by a state or local authority. The rules regarding a CO can vary between different localities; however, if the property is legally allowed to be occupied it should meet the readiness requirement.

Availability generally means that the rental property is advertised to be rented. The property does not need to have a signed lease, as long as it is available to be rented and there is some attempt to make it known to the market. (Note: Advertising can be word-of-mouth advertising or something as simple as a “FOR RENT” sign with a contact number posted on the property. Documentation of attempts to advertise the property to the marketplace are helpful to demonstrate the position that the property was available.)

So, yes, a property can never be placed into service and yet be ready and available for rent. That would mark its service date by the definition above. If all further work must be classified as either a "repair" or "improvement", then that would imply that there can indeed be "repairs" to a property that has not yet been rented in the eyes of the IRS.

You are right...you are not a tax professional. I didn't say beforeit was RENTED. I specifically said before a property is in service.

What you posted literally defines what I told you. In service is by definiton "ready and available for rent". It's what linda explained as well that you asserted she was making up.

In service date is when the property is both ready and available for rent. So all of your costs to get it ready for it's intended use are capitalized.

So if you buy a house that you need to put $10k of work into before it's in the condition for it's intended use as a rental...that is costs incurred before it is pre-in service. It is not "ready" to rent until those renovations are done and you haev a C/O or permit sign offs ect.

There are IRC sections that pertain to asset basis, there is Pub guidance, lots of court cases on the topic.

IRC 167

Pub 527

https://www.thetaxadviser.com/...

https://nbaa.org/wp-content/up...

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Steven Hamilton IIPro Member
Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
3y
Linda and Natalie are correct. End of story. They understand this backwards and forwards. You should strongly consider paying for competent guidance like theirs.

Tax is not plain English. It is definition built upon definition... etc. An audit can happen even if everything is correct. I carry a caseload of 25-50 open IRS audits. Everything here is discussed regularly in these cases. And it can mean some huge adjustments in the case of those who interpreted incorrectly.

You claim what is true and accurate, not what you think will avoid audit. Failing to claim expenses can lead to mortgage fraud or even major tax issues if you get certain refundable credits.

Not worth my time to comment further. Natalie and Linda nailed the replies perfectly. Your understanding is not that of an expert who has studied tax law. They took their time to give you guidance at no charge. That was kind of them.
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