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Here are some IRS court cases featuring real estate investors that show how important tax documentation and preparation is to protect you from huge penalties.
Real estate activities are considered passive by default. Passive losses, of course, may generally only offset passive income. Unless, that is, you qualify as a "real estate professional" under Section 469(c)(7), in which case you can deduct rental losses in full against nonpassive income.
In order to qualify as a real estate professional, a taxpayer needs to pass two tests under Sec. 469(c)(7)(B). The taxpayer must satisfy both of the following tests:
• More than one-half of the personal services performed in trades or businesses by the taxpayer during such tax year are performed in real property trades or businesses in which the taxpayer materially participates.
• Such taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
In part 3 of our series on audit-proofing, we will explore what tax expert, the late Al Aiello of www.alaiello.com advises investors to do to get over the dreaded FEAR of an audit and to know your rights in case you are ever audited.
1. Taxpayers' Rights. As a taxpayer you have rights, which have been expanded under The IRS Restructuring and Reform Act of 1998. Taxpayers can sue the IRS for damages caused by an IRS employee who "recklessly or intentionally" disregards provisions of the code or regulations in connection with collecting taxes. You can collect attorney's fees and related costs (such as expert witnesses) if you prevail in a case in which the court determines that the IRS acted without "substantial justification". (Refer to IRS Publication 1, Your Rights as a Taxpayer.)
2. Know the IRS hidden weaknesses. In the event of an IRS audit, there are IRS "hidden weaknesses" that can help you. Use "time". IRS auditors are under time pressure to close cases. They are rated by how many cases they close. So if your records are organized and you are persistent in your arguments on viable issues, the auditor may just want to move on to another taxpayer's case.
Misconceptions and Audit Proofing Strategies (Part 1)
You know that fear. It's the one that makes everyone paranoid around tax filing time. So many people let the FEAR of the IRS cause them to even overpay their taxes. The IRS's biggest weapon is FEAR, but this should not stop you from taking a legally aggressive position to save more of your hard earned money from Uncle Sam. Tax expert, the late Al Aiello of www.AlAiello.com, was particularly passionate about this subject and here's a review of some of his tips for those who fear the IRS and what to do about it.
Gray areas and being aggressive does not get you in trouble. Those previously convicted by the IRS got into hot water not because they exaggerated their charitable donations or took an aggressive position. It was because they committed serious FRAUD such as hiding millions in unreported income. Many areas of the tax law are gray. The gray areas are mainly with deductions. Therefore if you report all taxable income and you are legally & discreetly aggressive with your deductions, it is very unlikely you are going to get into any serious trouble with the IRS. With the IRS you do have rights! Your bill of rights is IRS Publication number 1, "Your Rights as a Taxpayer"
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