IRS Requirements and Audit Triggers for Rental Property Owners

The Internal Revenue Service (IRS) requires landlords to report all of their rental income on their annual tax return. Normally, real estate investors use Schedule E to report their rental income and expenses. Failing to report your income accurately can lead to audits, penalties, and legal repercussions. 

In this article, we explore the essential IRS requirements for landlords, including how to accurately report rental income and the types of documentation necessary to support your claims. 

Additionally, we will discuss what mistakes sets the alarm bells ringing at the IRS and might trigger an audit. 

Essential IRS Requirements for Landlords

There are specific guidelines from the IRS that landlords must follow when fulfilling their federal tax obligations. These requirements cover everything from how to report rental income to allowable deductions and which records to keep in the case of an IRS audit. 

Reporting Rental Income

It’s important to note that rent payments are not the only form of income that landlords are expected to report.  Rental property owners must report all income sources related to their rental busines on their tax return. This is usually done on Form 1040 Schedule E (as mentioned above). 

Here are some of the forms of income the IRS requires landlords to report on their tax returns:

• Advance Rent: Any rent received in advance, eg. before the rental period it covers must be included in income for the year it is received.
• Security Deposits: If you make deductions from a tenant’s security deposit to cover unpaid rent, repairs, or fees this amount should be reported in the year it is received as income. This is only true for the amount deducted - if you return the full amount, or the deposit is still being held this does not count as income (this is one of the reasons landlords should never commingle funds).
• Payments for Lease Cancellations: Any payments received for canceling a lease are considered rental income in the year received.
• Expenses Paid by Tenants: If a tenant reimburses you for an expense that you initially cover, such as for utilities, then the landlord must report this amount received from the tenant as income, and then deduct the expense (actual cost of the utilities in this example). 

Deductions for Rental Property Expenses

Under IRS laws, landlords can deduct various expenses related to managing and maintaining rental properties. Common deductible expenses include:

• Mortgage Interest
• Property Taxes
• Operating expenses such as utilities and maintenance costs.
• Depreciation

It is important to note that improvements cannot be deducted as expenses but can be depreciated over time.

Get a complete breakdown of your rental property tax deductible expenses here.

Required Documentation

Landlords must maintain detailed records to support reported income and deductions. Essential documents include:

• Receipts and Invoices: For all expenses incurred.
• Bank Statements: To verify income and expenses.
• Lease Agreements: To document terms of rental agreements.
• Travel Records: If travel expenses are incurred for property management or repairs, these must align with IRS guidelines

The Best Way To Track Your Rental Property Income And Expenses

When it comes to tracking income and expenses for your rental properties there are several ways to go about it. The traditional method used is a simple rental property spreadsheet and physical receipts. This, however, is time-consuming and incredibly hard to keep your records accurate. 

Thankfully, there’s a better way. Landlords that leverage software report saving as much as $500 per property each year in additional deductions. 

Landlord Studio is a property management and accounting software designed specifically for landlords. Automate income tracking with our rent collection system, track expenses on the go using the mobile app, and connect your bank accounts to import and quickly reconcile transactions in real-time. You can even digitize receipts. 

At the end of the year instantly generate your P&L or run the purpose-built Schedule E report.

Make tax time less stressful, ensure you file an accurate end of year tax return and never miss a deductible expense again. 

Importance of Good Record-Keeping

Here are some of the advantages maintaining accurate records has for landlords:

• Audit Preparedness: In case of an audit, having comprehensive records can help substantiate reported figures, reducing the risk of additional taxes or penalties.
• Financial Monitoring: Good records allow landlords to track the performance of their properties effectively.
• Tax preparation: Organized documentation simplifies the process of preparing tax returns and ensures all eligible deductions are claimed.

Note: Landlords should keep all relevant documentation for at least 3 years after filing their tax returns, as this is typically the period during which the IRS can audit returns. 

How Does The IRS Know You Have Rental Income?

The IRS has several mechanisms to uncover unreported earnings. We outline a few of these below.

Routine Tax Audits

One primary reason individuals invest in real estate is to generate income. However, as income increases, so does the likelihood of an IRS audit. While the overall chance of being audited is less than 1%, higher-income taxpayers face a significantly elevated risk. 

A few reasons that might make you more likely to be targeted for a routine audit include:

• Failing to report all taxable income.
• Earning substantial income.
• Claiming deductions, losses, or credits that are significantly higher than average.
• Reporting large losses from rental real estate.
• Engaging in cash transactions.
• Claiming 100% business use of a vehicle.

Even when you avoid these IRS audit triggers, there are some times when you’ll get selected for an audit. 

In such a scenario, using rental property financial management software like Landlord Studio can come in handy. This software can help landlords create a comprehensive paper trail by automating income and expense tracking.

IRS Automated Underreporter Program

The Automated Underreporter (AUR) program is a specialized division within the IRS that screens tax returns for discrepancies. This program identifies mismatches between the income reported by taxpayers and the information provided to the IRS by banks and other payers. 

Consequently, even if a rental property owner neglects to report rental income, the IRS may still discover it through third-party sources.

Paperwork and Public Records

There is also a variety of documentation generated from owning investment properties that can alert the IRS to potential unreported rental income.

For example, some states require that landlords obtain licenses to collect rental taxes from tenants and remit them to local authorities. If the IRS learns that an investor possesses such a license, they may investigate whether the rental income has been reported on tax returns.

Landlords are also required to fill out Form 1098, which reports mortgage interest payments made by a real estate owner, to be sent to both the taxpayer and the IRS annually. Failure to report this interest as an expense could also trigger an audit.

Additionally, property tax records can reveal ownership details about rental properties and may be cross-referenced with reported rental income. Applications for new loans or refinancing may also be scrutinized against existing IRS tax data to determine if reported income aligns with what is being used for loan qualification.

IRS Whistleblower Office

Consider a scenario where a landlord casually mentions their extra earnings from unreported rental income. This conversation could lead to an audit notice from the IRS. 

The IRS Whistleblower Office offers monetary rewards ranging from 15% to 30% of the collected proceeds based on information provided by whistleblowers. To qualify for a reward, disputed proceeds must exceed $2 million, and the taxpayer’s reported income must be above $200,000. 

Even if these thresholds are not met, whistleblower claims may still be considered at the discretion of the IRS.

Related Article: How Does The IRS Know If I Have Rental Income?

Common IRS Audit Triggers for Landlords

The best way for landlords to avoid IRS audit triggers is to ensure you stay compliant with tax and record keeping regulations. However, there are some common mistakes that property owners make when reporting or filing that could lead to unnecessary scrutiny by the IRS.

1. Filing Errors

One of the most frequent causes of audits is discrepancies between reported income and the information submitted to the IRS, such as mismatched 1099s and W-2s. The IRS employs automated systems to check for these inconsistencies, making this an easy way to attract attention.

Additionally, landlords must ensure they are using the correct forms when filing their returns. For instance, income and expenses related to rental properties should be reported on Schedule E, not Schedule C, which is intended for self-employed individuals.

It's also worth noting that paper returns have a significantly higher error rate—over 25%—compared to less than 2.5% for electronic submissions. Common mistakes include simple mathematical errors or typos, such as misspelled names or incorrect Social Security numbers.

2. Failure to Report Income

Oversights in income reporting can lead to serious issues. Whether due to a missed zero or misplaced decimal, failing to report all income can trigger an audit. A significant drop in reported income compared to previous years raises suspicion, suggesting that some income may have gone unreported.

Landlords should also be diligent in accurately reporting capital gains from property sales, as calculating these amounts can be complicated by depreciation and other adjustments over time.

3. Excessive or Vague Deductions

Claiming unusually high expenses can prompt the IRS to take a closer look at your returns. For example, if your home office occupies more than 20% of your home’s total space or if you report extensive travel expenses without adequate documentation, this could raise red flags.

To mitigate scrutiny, it’s advisable to provide detailed descriptions of expenses rather than lumping them into vague categories in your records. For example, instead of listing $5,000 under “other expenses,” break it down into specific items like $1,000 for phone bills and $500 for educational materials.

Large maintenance costs also warrant caution; significant single expenses should typically be capitalized and depreciated rather than deducted outright as maintenance costs.

4. Large Charitable Donations

While charitable contributions are commendable and can provide tax deductions, they must be well documented. The IRS expects donations to align with taxpayers' income levels; for instance, individuals earning between $75,000 and $500,000 are expected to donate about 3-4% of their income. Claiming deductions significantly above this range may lead the IRS to question your filings.

5. Tax Credits

Tax credits can significantly reduce tax liability but also attract IRS scrutiny. Unlike deductions that lower taxable income, credits directly reduce the tax owed. Common credits include those related to childcare expenses and earned income.

6. Filing Late

Timely filing is crucial; late submissions can raise suspicions regardless of the complexity of your returns. By meeting tax deadlines, landlords can minimize their chances of attracting unwanted attention from the IRS.

7. Does It All Add Up?

The IRS will conduct preliminary checks to ensure that reported figures appear reasonable and consistent over time. Significant fluctuations in income or losses reported year after year without a clear explanation may prompt further investigation into your financials.

Read more: Tax Implications When Buying a Rental Property

How to Prepare for an IRS Audit with Proper Record-Keeping

According to real estate experts, the best way to manage your financial records to regular updates. Allowing your receipts to pile up and leaving your accounting until the end of the year is a sure-fire way to make mistakes and miss deductions, leading to overpaid taxes and potentially triggering an IRS audit. 

Instead, real estate investors should leverage software, like Landlord Studio, that makes it easy to keep their records up to date throughout the year. 

This can not only help landlords maximize their end-of-year deductions but also allow you to track cash flow and profitability, identify unnecessary expenses, and better achieve your long-term financial goals. 

Key Considerations for Record-Keeping

Here are essential points the IRS emphasizes regarding effective record-keeping:

• Flexibility in Record Maintenance: The IRS does not mandate a specific method for maintaining records. You should retain any documents that could influence your federal tax return. 
• Retention Period for Individual Taxpayers: Individuals should generally keep the following records supporting their tax returns for at least three years:some text
  • Bills
  • Credit card receipts
  • Invoices
  • Mileage logs
  • Canceled checks or other proof of payment
  • Any other records supporting deductions or credits claimed

Establishing a designated area for tax documents and receipts is advisable. It is allowed to keep digital receipts rather than paper ones as long as they remain accessible for at least 3 years in case of an audit.

Best Practices for Record-Keeping

To ensure compliance and readiness in case of an audit:

• Maintain Comprehensive Records: Keep detailed documentation of all income and expenses to support the entries on your tax returns.
• Organize Records by Year and Type: Systematically categorize records using income and expense categories in line with IRS requirement.
• Separate Personal and Business Expenses: Utilize distinct bank accounts and credit cards for business transactions to avoid mixing personal expenses with business records.
• Document Everything: Ensure that all transactions are recorded with appropriate supporting documentation. This includes receipts for purchases and detailed logs for mileage or travel.
• Be Prepared for Inquiries: Understand what might trigger an audit—significant discrepancies between current and past returns or unusually high deductions can attract scrutiny.

While it’s possible that you may never face an audit, maintaining thorough records is a prudent practice that can provide valuable insights into your business operations even if you are not audited. 

If an audit does occur, having meticulous records will help streamline the process and potentially mitigate any issues that arise.

Related: 5 Top Rental Property Accounting Tips For Lanldords

Final Words: Landlord Studio and Audit-Ready Record-Keeping

Accurate reporting of rental income, proper documentation of deductible expenses, and maintaining detailed financial records are key to minimizing audit risks and ensuring maximum tax savings. From knowing what income to report to understanding the types of expenses you can deduct, good record-keeping is crucial for landlords.

Rather than relying on outdated and error-prone manual methods, landlords can benefit significantly from leveraging modern property management and accounting tools. Landlord Studio simplifies rental property accounting by automating income and expense tracking, storing digital records, and generating tax reports, like the Schedule E report, in seconds. This not only ensures compliance but also helps landlords maximize deductions and reduce tax-time stress.

Take control of your rental property finances and protect yourself from potential IRS scrutiny with Landlord Studio.

Create a free account with Landlord Studio today to manage your tax filing and report efficiently.

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