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ContinueOwning and managing rental properties comes with several advantageous tax rules. However, they can be complex and often trigger IRS audits.
Owning and managing rental properties allows you to take advantage of a number of highly beneficial tax laws. However, these tax laws can also be highly complex, and as such the IRS often closely scrutinizes real estate income and expenses.
Generally speaking, if you make a small error on your tax return the IRS will simply let you know and charge you for the difference. However, if you make substantial errors or it looks like you are purposefully attempting to defraud the system you could trigger a full audit from the IRS which could come with hefty financial penalties.
In this article, we take a look at 7 common IRS audit triggers and how you can avoid them.
The tax laws surrounding real estate investments can be complicated, so it is advisable to seek professional advice from a licensed CPA to ensure you file your taxes correctly.
It’s a good idea to start tracking your income and expenses digitally to ensure accuracy.
A common question some real estate investors have is how the IRS knows if you have rental income. And with tax cheats costing the U.S. as much as $1 trillion a year this is a fair question.
However, it’s precisely because of the fact that this is a well-documented problem that real estate investors need to be extra careful with their income and expense tracking. The IRS plans to and has already started to implement plans to close this gap with more funding to increase oversight of tax returns.
The IRS can discover dishonest tax claims in a number of ways, including:
Investors who don’t report rental income may be subject to accuracy-related penalties, civil fraud penalties, and possible criminal charges.
Below we take a closer look at some of the key behaviours and reasons that might trigger the IRS to take a closer look at your rental income.
Make sure your 1099’s and W-2’s match up to what’s being reported to the IRS. This is the fastest way to get a letter from the IRS and potentially set off an IRS audit because the matching is automated and is one of the first things they look at.
Additionally, make sure you file your return using the right forms. For example, generally speaking, you will need to file your return declaring income and expenses for rental properties using a Schedule E, not a Schedule C which is for self-employed individuals rather than passive income.
On a final note, according to the IRS, the error rate for paper returns exceeds 25% – but, for electronic returns, the error rate is less than 2.5%. Errors can come from anywhere: a misspelled name or an incorrect Social Security Number. However, some very common tax mistakes are basic mathematical errors.
This could be something as simple as an oversight in your books, a missed zero, or a misplaced decimal. One big red flag is if you declare a lot less income than in previous years. Not only does this mean your business probably isn’t doing so well (meaning an audit could be devastating), but it suggests to the IRS that you’ve not entered some of your income.
If you are legitimately reporting all income, you shouldn’t have anything to worry about, but if there’s a chance you might not have reported everything (even by accident) which is why you appear to have made a lot less money, this won’t look good in an audit.
Another thing to look out for is accurately declaring your capital gains upon the sale of a property. Working out the exact amount of capital gains on a rental property can be tricky to calculate due to depreciation and depreciation recapture as well as any improvements or other capitalized expenses which might have adjusted the cost basis of your property over the years.
Overly large or unusual expenses such as a very large home office, or extensive travel expenses can raise red flags with the IRS and set off a full IRS audit. If your home office is larger than 20% of the floor space of your home then the IRS will likely want to take a closer look.
If you do deduct expenses for travel or list ‘other’ business expenses make sure you have the necessary documents. These documents should include receipts as well as documents proving the purpose of the travel or entertainment.
Software like Landlord Studio make it easy to record these expenses on the go, you can smart-scan receipts and store all documents digitally against each property.
Additionally, it’s recommended that you try to break up larger expenses and to be as descriptive about them as possible. An example would be instead of showing $5,000 of “other” expenses, you might show $1,000 for phone bills, $500 for educational materials, $1,000 for office equipment, and so on.
A final expense that raises eyebrows with the IRS is large maintenance expenses. Generally, expenses above a certain value should be capitalized and depreciated. As such deducting big single expenses as maintenance costs could invite interest from IRS officials.
Learn how you can streamline your rental accounting and management with Landlord Studio →
Donating to reputable charities is both a wonderful thing and also a good way to get a tax deduction. This deduction, however, should be tracked and recorded like every other with the necessary documents to prove you are accurately making your claim.
Additionally, the IRS has expectations for how much people will donate which they base on the annual income level of the individual. For example, they expect people making between $75,000-$500,000 to donate roughly 3-4% of their income.
If you fall within this income level, and you claim a charitable deduction greater than this, the IRS may be skeptical. As such, always make sure you keep detailed records showing the specifics of your charitable contributions.
Tax credits are a powerful way to reduce your tax bill, but because of this the IRS keeps a close watch on these. Unlike tax deductions, which lower the amount of income on which you will be taxed, tax credits are deducted from the amount of tax that you owe.
Some common tax credits include the child tax credit, the child and dependent tax credit, which is a credit based on day care expenses, and the earned-income tax credit.
The IRS wants to be paid, and they want to be paid on time. This might be difficult for some investors as unexpected expenses can occur at any time, and some end of year statements can be highly complex.
However, just because an investor’s tax returns may be more complicated than the average return, the IRS makes no allowances and wants a timely filing. By obliging them, you’ll stay off their radar and attract less attention.
One of the first things they’ll do is just make sure that everything appears right, that nothing seems obviously fishy. For example, if you have massive fluctuations in income year on year they might wonder why. Where is the extra coming from or going?
Or for example, if your rental property income is your only source of income and you declare significant losses year on year they might wonder how on earth you are paying your bills. When the numbers don’t obviously make sense, you are more likely to attract a little more attention which could turn into a full audit of your financials over the last few years.
The best way to audit-proof your tax returns is to maintain meticulous records of your income and expenses with all the necessary documentation to support the position you take. For example, if you claim mileage you should have a mileage book or use a system like Landlord Studio to record the distance and purpose of each trip.
Similarly, you should use a system to properly file your receipts so that you can reference them in the future should you ever need to. This is easy with Landlord Studio, as you can quickly digitize your receipt using your phone camera then and there. The system then reads the details of the receipts and enters the expense details for you, saving the digital version paired with the expense entry for your records.
Finally, it is important to understand that the things mentioned in this article may raise flags, but won’t necessarily lead to actual audits. Don’t hesitate to take deductions you are legally entitled to. However, do make sure to spend the time necessary to make sure that you have all your records at hand in case of an unwanted IRS visitor.
An IRS audit involves examining your business information and accounts to verify that the details your reported in your real estate tax return are accurate and in adherence with tax laws. Essentially, the IRS is cross-referencing your numbers to ensure there are no discrepancies in your tax return.
The cost basis refers to the initial value of an asset for tax considerations, typically represented by the purchase price. In real estate dealings, the IRS can confirm the cost basis by examining the closing statement from the property's purchase or any relevant legal documents connected to the property, such as tax statements.
The IRS conducts tax audits with the aim of reducing the "tax gap," which represents the variance between the amount owed to the IRS and the actual amount received. The selection for an audit can be random, according to the agency, or it may be triggered by connections to another audited return, such as involving transactions with an investor or business partner. However, more frequently, taxpayers are chosen based on identified suspicious activity.
An IRS audit will be triggered on your real estate tax return for any number of reasons (as outline above). However, there's nothing inherently malicious about an audit as long as you have kept accurate records and filed a truthful tax return. That being said even honest mistakes can trigger an audit, which is why many businesses undergo an audit at some point. A few IRS red flags include:
The audit can take place through mail correspondence or involve a face-to-face interview at locations such as a local IRS office, your residence, your tax preparer's office, or your business. Regardless of the venue, you may be required to furnish specific records for the IRS examiner's review. It is suggested that you retain tax records for at least three years after filing, although in certain situations, the IRS can audit returns up to six years old.
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