Your Records Could Make — Or Break — Your Tax Deductions
A recent decision by the U.S. Tax Court in a case involving a married couple’s real estate activities included both good and bad outcomes for them on some of their deductions. On both counts, though, the court’s ruling came down to their record keeping.
The challenged deductions
The couple filed the case after receiving a notice of deficiency from the IRS for almost $48,000 in underpaid taxes for the 2008 to 2011 tax years. The husband was a full-time pilot, and the wife was a part-time ski instructor. They owned three rental properties in Vermont.
The wife oversaw all rental and management activities for the rental properties. She participated extensively in repairs to and renovation of the properties. Other than occasional help from her husband, no one else assisted in overseeing and managing the properties. For the years at issue, the wife spent 1,003, 1,228, 835 and 864 hours on the rentals, respectively, compared with only 199.25, 53.25, 90.75 and 96.25 as a ski instructor.
The couple claimed losses from the properties on their tax returns for each of the years. After examination, the IRS disallowed the losses on their rental activities, as well as some depreciation expenses taken on a truck used in the rental business.
Rental activity losses upheld
Section 469(a) of the Internal Revenue Code generally only allows deductions for passive activity losses to the extent of passive income from other sources — such as positive operating income from other rental properties. One significant exception to this rule is that up to $25,000 of losses may be deducted, although the exception itself has exceptions in that the ability to deduct the losses from passive activities is subject to a phaseout based on AGI. A passive activity is any trade or business in which you don’t materially participate. Rental activity is generally treated as passive regardless of whether you materially participate in it.
But rental activity won’t be treated as passive if you can show that:
- More than half of the personal services you provided during the year were worked in a rental activity in which you materially participated, and
- You worked more than 750 hours during the tax year in a rental activity in which you materially participated.
In the case of a joint return, one of the spouses must satisfy both requirements on his or her own.
The court found that the wife had materially participated in all of her real estate activities during the relevant years. Moreover, she had maintained contemporaneous logs of the time spent on the rental properties, showing more than 750 hours of work for each year. The IRS agreed that she’d worked less than 200 hours as a ski instructor each year, so more than one-half of her work was in the rental activities. (The court also noted that the wife had summarized her logs into activity summaries to support the claimed deductions.)
Depreciation deductions defeated
Turning to the couple’s depreciation deductions related to a truck, the court noted that taxpayers are required to maintain records sufficient to substantiate the expenses underlying their deductions. In the case of deductions on property used as a means of transportation, you must substantiate:
- The amount of the underlying expense,
- The time and place of travel or use of the property,
- The business purpose of the expense, and
- The business relationship of the people using the property.
The couple claimed almost $18,000 in depreciation deductions on the truck, but didn’t provide a mileage log for it. In addition, the husband testified that his wife didn’t like to drive it and that he would park it at the airport for up to two weeks at a time while he traveled for his work. The court therefore concluded that they’d failed to substantiate the expenses related to the truck.
Document, document, document
It really can’t be said enough — if you want your deductions to hold up to scrutiny, you need to keep adequate records. For rental activities, that means logs of the amount of, and how you spent, your time working on them. For vehicle expenses, you’ll also need detailed records. Ask your tax advisor for specifics in your situation.
Poor records can lead to penalties, too
If your tax deductions are disallowed, it’s not just back taxes you have to worry about — you could also end up on the hook for penalties, including “accuracy-related” penalties. The IRS can impose a penalty of 20% of the portion of underpayment of tax attributable to the taxpayer’s negligence, disregard of rules or regulations, or substantial understatement of income tax. “Negligence” includes any failure to make a reasonable attempt to comply with tax laws, such as the failure to keep adequate books and records.
You may be able to avoid accuracy-related penalties by proving you had reasonable cause for underpayment and acted in good faith. Relevant factors include:
- Your effort to assess the proper tax liability,
- Your knowledge and experience, and
- Any reliance on the advice of a professional, such as an accountant.
Generally, the most important factor is your effort to assess the proper tax liability.