The IRS Solution - Tax it All!

Sometimes I learn multiple lessons from reading a single Tax Court opinion. Such was the case recently when I read the opinion from Judge Nega regarding real estate investors Steven and Stacy E (SSE). The IRS and SSE disagreed on several issues and Judge Nega had to settle these matters in Tax Court.

SSE, living in Washington state, claimed 7 rental properties on their 2008-2010 tax returns. The IRS examined (audited) those returns and determined the following:

1. SSE under reported their income during all 3 years
2. SSE did not qualify for a home office deduction as claimed
3. SSE are not entitled to claim all their passive losses as neither is a real estate professional as claimed
4. SSE were not eligible for Schedule A mortgage deduction as claimed
5. SSE were not eligible for charitable deductions as claimed
6. One of the SSE properties did not qualify as a residential rental property
7. SSE were not eligible for a $3,000 capital loss deduction as claimed
8. SSE were negligent in the preparation of their tax returns and liable for a 20% accuracy-related penalty on the unpaid taxes.

The IRS made a redetermination of the taxes SSE owed for 2008 – 2010. SSE did not agree with the redetermination made by the IRS and petitioned the tax court for relief.

Before they made it to Tax Court the IRS conceded several issues.

1. The IRS allowed the home mortgage interest deduction on schedule A
2. The IRS allowed the charitable deductions as claimed
3. The IRS allowed the capital loss deduction of $3,000
4. The IRS reduced the amount of income they believed SSE failed to report
5. SSE also uncovered a tax deduction for $14,430 in 2009 they had neglected to claim, which the IRS agreed they were able to lawfully claim

I think it’s important to note the IRS concessions here. The auditor did not get everything right when s/he reviewed the SSE returns and supporting documentation. SSE were able to produce documentation prior to the court date disputing the auditor’s findings to the point the IRS wasn’t willing put the matter before a judge. If you ever receive a notice or letter from the IRS, go over every word in it. Do not assume it is correct. Many of them contain errors.

When they got to court the matters to be decided were:

1. Did SSE have unreported income?
2. Were SSE entitled to a home office deduction?
3. Were their claimed losses for rental real estate activity allowed?
4. Were they negligent and liable for the 20% accuracy-related penalty?

Unfortunately for SSE, the concessions the IRS made before court were as good as it got. SSE did not keep adequate records of their income, therefore the IRS reviewed bank deposits during the years in question to determine SSE’s income. All bank deposits are considered taxable income unless the taxpayer can prove otherwise. SSE argued that many of the deposits the IRS was including in income were actually loan repayments from friends and family, refunds, and shifting money between accounts. However, SSE could not offer any documentation to support these claims, so the deposits were all counted as unreported income.

With respect to the home office deduction, SSE did not provide any documentation or other evidence to substantiate the business use of their home. They also refused to allow the IRS auditor to inspect the claimed space. Therefore, this deduction was disallowed.

SSE had rented one of their SFHs to Steve’s brother, but the brother did not pay fair market rent for his use of the property. This property is therefore considered personal use property, and Schedule E deductions are disallowed.

Neither Steven nor Stacy could provide any documentation supporting their claim to be real estate professionals. Their excess passive loss deductions were disallowed accordingly.

In the matter of the 20% accuracy-related penalty for negligence the judge noted, “Negligence includes “any failure by the taxpayer to keep adequate books and records or to substantiate items properly.” Sec. 1.6662-3(b), Income Tax Regs. Petitioners were required, but failed, to maintain adequate logs and records to document their gross receipts and substantiate their deductions. Accordingly, we find that petitioners’ underpayments of Federal income tax were also attributable to negligence.”

Not a good day in Tax Court for SSE. We see here, as we frequently do, that record keeping by real estate investors is essential. Remember – the burden of proof rarely falls on the IRS in Tax Court. The IRS did not have to prove all those deposits were taxable income. SSE had to prove the deposits were not all taxable income, and they lacked the records to do it.

I know some of my bank deposits are not taxable income. Therefore, I believe SSE when they say not all their deposits were taxable income. Sure, some of those bank deposits were probably unreported income, but it seems reasonable to me that some were not. It also seems reasonable to me they had made loans to family, as they claim, and some of their bank deposits were repayments of those loans. What the Tax Court tells us is that it doesn’t matter what seems reasonable. It matters what you can prove with your books and records. SSE could not prove the source of their deposits, so they are all classified as taxable income by default.

That’s harsh, but that’s reality.

My two key takeaways from this case are to always question what the IRS says you owe. They are not always correct. SSE questioned some of the IRS findings and the IRS was forced to concede the points before going to court. The other is to keep good records. I regard my US and Virginia taxes as a necessary evil, but I’m determined not to pay a penny more than I owe. Seeing someone else paying taxes on money that probably wasn’t taxable income is enough to make me ‘scared straight’ to keep better records. I hope it does the same for you.