The rental of real estate is, by definition, considered a passive activity. Passive income is taxed like other income, and no special reporting is required. Passive losses, however, are typically limited and allowed only to the extent of passive income. That means if you have passive losses, but no passive income, the loss is not allowed.
Because of these passive loss rules, multiple years of rental losses may catch the attention of the IRS. That doesn’t mean the losses aren’t allowed, but if you are reporting losses, make sure you are claiming them appropriately. There are exceptions to the limitations, and rental real estate losses can be allowed.
We've all heard the quote, "Love what you do, and you'll never work a day in your life." Can you really take something you enjoy and turn it into a business?
We all have hobbies. Sometimes we might be able to make money with our hobby. You must report any income you make from a hobby, and any related expenses are deductible. However, so called "hobby losses" are not deductible. Expenses up to your total income are fine, but no more. What's worse, those deductible expenses are reported on Schedule A as miscellaneous itemized expenses, meaning they are deductible only to the extent they exceed 2% of your adjusted gross income. To be able to deduct expenses beyond your income, you have to be able to demonstrate you are not just reporting a hobby, but that you are actually running a business.
The IRS says, "If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income. Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit." (Publication 535, Business Expenses.) That doesn't mean you can't make a business out of what's fun.
If your activity shows a profit three out of five years the IRS presumes you're in business to make a profit. (The test is two out of seven years if your activity is related to horse breeding, showing, training, or racing.) Here are other factors the IRS considers when determining whether you have a hobby or are running a business.
The IRS often argues against activities as businesses when an element of pleasure is involved. However, there have been multiple court cases where people have demonstrated they were actually running a business. Some examples of winning taxpayers are:
While there are many other winners, there are also losers. Ultimately, to win this fight, you have to demonstrate you are following the steps to run a business, and not just loving your hobby and trying to write off the related expenses.
One of the questions we get asked most frequently is about how long documents should be kept. Here are some general guidelines based on our experience and federal statutes of limitations for income tax purposes. Your state may have longer statutes, so use this list as the guide, not the rule.
45 Days. Pay stubs usually have year-to-date information on them. Once you've received a new one you shouldn't need the previous stubs unless you are applying for a loan, etc. Bank receipts also can be tossed once you have reconciled with your bank statement. Other receipts and cancelled checks, unless needed as evidence for a tax deduction, can be discarded after 45 days.
3 Months. Most bank and credit card statements, as well as utility bills, are unnecessary after the account has been reconciled and/or paid. Unless you need a document as evidence for a tax deduction, discard your statements after three months. If you need to go farther back, the provider will have records you can request.
3 Years. Businesses should keep employment applications three years. Employee personnel files should be kept until three years after the employee is terminated.
4 Years. Businesses should keep all payroll tax records at least four years. This includes everything from the W-4 to health coverage forms. Personal insurance records should also be kept four years. Keep premium statements, documents for home claims, doctor bills, prescription records, etc. Documents for any pending claims should be kept longer.
7 Years. The IRS will generally ask any questions it has about tax returns within three years. However, they can go back as far as six years if you failed to report more than 25% of your income. If the IRS can prove fraud on your return, there is no statute, and no limit on how far back they can go. Most operational business records should also be kept seven years.
Until after.... Keep a file for each asset you own, whether it is a piece of real estate, an investment, or business equipment. The file should include information about the purchase date, how much you originally paid, subsequent cash investments/property improvements, depreciation, etc. These records should be kept at least three years after you dispose of the asset.
As you consider storage of records, remember that you don't have to keep boxes and boxes of files. Scan any documents you don't receive electronically and make a backup to keep them safe. Cloud storage is ideal, to prevent loss due to damage to hardware such as DVDs or flash drives. If you do keep paper documents, remember to shred them and not throw them in the trash. Identity theft is far to common for anyone to believe "it won't happen to me."
If you have more questions or want to seek clarity about a specific item, give us a call.
Next Step Blog
Our blog is intended as a tool to keep people informed about relevant tax and accounting issues. If you have a question or an idea for a post, let us know!