Closing tax gap; investing in residential rental properties

Question: Why is the Internal Revenue Service investing so much of the taxpayers' resources in their pursuit of the so-called tax gap? Does the agency think it can significantly increase tax revenues?

Answer: The IRS created "A Comprehensive Strategy for Reducing the Tax Gap" report in September 2006. This document outlined the strategy and related supporting principles for the planned activities of the IRS to improve compliance with the tax laws.

The IRS intends to improve the compliance rate (estimated in 2001 to be 86%) and collect the $290-plus billion that is left on the table, as determined by the IRS' 2001 National Research Program.

The attraction for working on the tax gap as the means to increase revenue is that it avoids the delays from Congress and complications associated with getting tax law changes passed. A high return is expected from the estimated necessary invested resources in the project.

The IRS' plan is to concentrate in the areas that predominantly contribute to lost tax revenues. The IRS found that uncollected individual income tax makes up more than 70% of the tax gap. The IRS has also determined that more than 80% of the deficiency is from underreported income or overreported deductions, mostly from individual businesses, and the lost revenue is predominantly due to taxpayers whose income is not reported by third parties.

As a response to these problem areas, the IRS created its multiyear strategy with seven components:

• Reduce opportunities for evasion.
• Make a multiyear commitment to research.
• Continue improvements in information technology.
• Improve compliance activities.
• Enhance taxpayer service.
• Reform and simplify the tax law.
• Coordinate with partners and stakeholders (such as state and local governments or tax practitioners' associations).

There has been significant attention and work done in this area since the release of the 2006 report, including the recently released report, "Reducing the Federal Tax Gap: A Report on Improving Voluntary Compliance" by the IRS and the Treasury Dept.

The latter report outlines planned steps for the IRS to reduce the tax gap, and targeted completion dates for those steps.

We should expect to see many changes from the IRS' activities to include modifications to tax forms, additional information required to be submitted to the government, investment in technology and changes in audit procedures.

There might be taxpayer benefits resulting from the IRS initiatives, as the agency has promised. The tax forms and tax laws should be simpler so taxpayers may avoid mistakes and unnecessary IRS correspondence. Improved IRS services are planned, and taxpayers' filing burdens are to be reduced.

Q: I am considering acquiring a few multifamily rental properties to diversify my investment portfolio. What are the tax and other ramifications associated with the holding of these properties that I should know about before making the investment?

A: Your plan to continue diversifying your wealth is an excellent approach. Investing in real estate property should enhance your current holdings but may create complications you didn't anticipate.

It is a challenge to find property in the right location and in reasonably good shape that generates positive cash flow and is priced appropriately for its leasing potential.

Ideally, you should find property requiring little maintenance with long-term tenants. Realistically, you should plan on tenant turnover every two years or so and investing in necessary repairs to keep the property in good shape. As a busy physician, you might not have the time to manage the property, including repairs and tenant issues, so you should hire a respected management company.

If you are looking for tax write-offs, it is not going to happen right away. Rental real estate activity falls under the passive activity rules, Congress' 1986 tax-law solution for reducing lost revenues from tax shelters. You might have an annual paper loss resulting from rental income less operating expenses, such as repairs, insurance, property taxes, depreciation and mortgage interest. But under the tax law limitations imposed on passive activities, the losses are not currently deductible.

Losses are carried forward to shelter future passive income from your real estate holding or other passive investments you may have. If you don't have passive income to offset your rental losses, once you sell the property you may recognize the prior years' losses and receive a nice tax windfall.

In the year of sale, your prior suspended tax losses will now be recognized and may shelter your ordinary income from sources such as your practice and investments, and gain from the real estate disposition will be taxed at lower capital gain rates.

It is important to look at a real estate investment over the complete holding period to understand its benefits. First, it should support itself and a portion of your household with positive cash flow, without incurring taxable income. Second, the appreciation associated with the investment is not taxed until it is sold. Should you choose to trade your property for other real estate, you can postpone the gain recognition. If you pass it on to your heirs, the appreciation will escape income taxation completely.

Finally, it adds another diversification element to your portfolio. Consult your tax adviser, but if you find the right property, this may be the right course of action for you.