Real Estate Tax Filing Mistakes and How To Avoid an Audit

Tax season can be stressful for real estate investors, and sadly for us all, it’s unavoidable. Mistakes can lead to overpaid taxes or, even worse, trigger an IRS audit. Navigating these challenges requires a nuanced understanding of the IRS tax code—and, at times, what feels like more than a bit of good luck.

In a recent webinar, Logan Ransley, Co-founder of Landlord Studio, sat down with Thomas Castelli, a real estate CPA and host of the Tax Smart Podcast, to demystify some of the more phantasmal subtleties of tax returns and provide a roadmap for avoiding costly tax mistakes and potential audits.

Common Tax Filing Mistakes in Real Estate

If only filing your taxes was as simple as counting your cash at the end of the year and filling out a quick online form. If you want to maximize your real estate cash flow and stay compliant though you need to track all of your expenses (with supporting documents), and have a near superhuman understanding of complex entity structures, tax forms, and obscure tax relief programs. 

When asked, Thomas Castelli identified several frequent tax filing mistakes that can lead to unnecessary costs or IRS scrutiny.

1. Filing on Schedule C Instead of Schedule E: This mistake subjects rental income to self-employment taxes, which is incorrect and unnecessary. “Sometimes we see people filing their rental properties on Schedule C... this is usually due to a misunderstanding of how rental income is taxed,” Thomas explained. The correct form, Schedule E, is designed for passive income, which is how rental earnings are classified.
2. Missing Deductible Expenses: One major challenge for investors is understanding the difference between business and personal expenses. Confusion here can lead to improper deductions or missed opportunities. To overcome this landlords need to understand what qualifies as a deductible expense and maintain accurate records throughout the tax year.
3. Errors with Real Estate Professional Status (REPS): Claiming REPS allows investors to offset rental losses against active income, but strict requirements must be met. “Sometimes people are eligible for the real estate professional status and they don’t claim it, or they’re erroneously claiming it,” Thomas noted. Incorrect claims can trigger audits and penalties, which we’ll explore in more detail later in this article.
4. Not Carrying Over Form 8582 for Passive Losses: This form tracks passive losses, which can be carried over to future years. “We’ve seen that get lost in the shuffle for people,” Thomas said, which essentially wipes thousands of potential deductions off the board for people.

Landlord Tip: Using specialized property management and accounting software like Landlord Studio, can help streamline your income and expense management and tax reporting.

Real-Life Consequences of Tax Filing Errors

‘What’s the worst that can happen?’ you might be thinking.

It can be tempting to throw your hands in the air, bury your head in the sand, throw in the towel. Taxes, you might think, don’t have to be complicated. And in some ways, you’d be right. They don’t have to be. Except if you’re not prepared, if you don’t have hundreds of pages of impenetrable tax code in your back pocket ready for any situation, it could go pretty wrong indeed. “I’ve seen people not file taxes for years on end…” Thomas Castelli told us. “...and there’s a lot of back taxes, penalties, and interest that can accrue, among other things.” 

​He also talked about a common mistake he sees in the formation of entity structures. “Using S-corporations for rental properties is a big tax mistake... If you remove the property from the S corporation, it's treated as a sale. And if the property has appreciated, it could trigger significant capital gains taxes, even though you're not really selling the property. You’d have this tax consequence with no revenue or sales proceeds to pay it.”​

But it’s not just mistakes with entity structures that lead to tax headaches. According to Thomas, poor bookkeeping can also cause real financial pain: “We see a lot of mistakes when it comes to tax filing... sometimes people are filing rental properties on Schedule C instead of Schedule E, or they’re missing common expenses like rental property insurance or property taxes. These are the kinds of things that can slip through the cracks when your bookkeeping isn’t up to par.”

So, what’s the worst that could happen? Complete financial armageddon. Well, not quite. But, you get the point.

Bookkeeping Best Practices for Real Estate Investors

So, how can you avoid these costly mistakes? A big part comes down to maintaining solid bookkeeping practices. Thomas couldn't have said it better: “It’s garbage in, garbage out. If you don’t have your bookkeeping together, you could be missing out on important expenses.” And, of course, waiting until the end of the year to sort everything out is a not-so-tasty recipe for errors and stress.

Logan Ransley chimed in with a reality check: “One of the main reasons people turn to Landlord Studio is because they’ve tried using a spreadsheet, and it just becomes unmanageable—especially as their portfolio grows.” Things fall through the cracks, mistakes get made. Even something as simple as a misplaced decimal can wreak havoc on your end-of-year profit and loss.

So, what can you do to stay on top of things? Here are a few best practices to keep your finances in check:

• Ditch the spreadsheet and use dedicated accounting software to minimize human error.
• Update your records monthly (or quarterly at the very least) to stay organized and ahead of the game.
• Digitally store your receipts and invoices so they’re just a few clicks away when tax season rolls around.

These simple steps aren’t foolproof, but they are steps in the right direction toward maximizing deductions, cutting down on audit risk, and saving yourself time.

Maximizing Mileage and Overlooked Tax Deductions

“If you don’t track it, you can’t deduct it,” Thomas Castelli points out. But, that’s what happens all the time. Landlords miss out on valuable deductions because they simply didn’t record it. 

Maximizing Mileage Deductions: Having a home office allows trips to rental properties to become tax-deductible. Thomas explained, “If you have a home office... that turns your home into a place of business.” However, detailed mileage logs are required to support these claims.

He recommended digital tracking tools, adding, “There’s software out there that makes it easy to track your mileage... but I see too many landlords trying to use spreadsheets, and they miss out on deductions.” Landlord Studio’s GPS mileage tracker automates this process, ensuring accurate records.

Other Overlooked Tax Deductions:

• Home Office Expenses: As well as helping you maximize your mileage deduction this allows you to deduct a portion of your mortgage, utilities, and other home expenses.
• HOA Fees and Bank Fees: Commonly missed but deductible as operating expenses.
• Depreciation: “Depreciation is a big expense... make sure that you take it,” because “the IRS will assume you do,” Thomas stressed and they will claim depreciation recapture when you sell whether you claim it or not. 

Related: Understanding Rental Property Depreciation and Depreciation Recapture

IRS Audits: Triggers and How to Avoid Them

Now we’re getting to the part of the article you’ve been waiting for. How do you avoid triggering an audit?

IRS audits might sound like your worst nightmare, but they don’t have to be if you know what to watch out for. Thomas gave us a little insider tip: “The IRS uses indexing systems that flag tax returns with expenses that are excessively high compared to industry norms.” So, if your numbers seem out of line, it could raise a red flag - and rightly so.

One of the big areas that’s been catching the IRS’s attention lately is the Real Estate Professional Status and the short-term rental loophole. These are ways for property owners to reclassify their rental income as active rather than passive, allowing tax deductions to be deducted against other active income like W-2 income. As Thomas pointed out if you're using either of these strategies, “you’re going to need to document your time and prove that you meet those requirements.”

Here's the issue: claiming the real estate professional status can be a huge red flag if you also have a W-2 job. The IRS knows that you can't possibly meet the time requirements—750 hours and more than half of your working hours in real estate—if you’re working full-time somewhere else. So, if you're using this status, you need to be very careful. Keep meticulous time logs, and make sure you meet those 750-hour requirements. Otherwise, you're openly inviting an audit.

Some common IRS audit triggers to keep an eye on:

• Misclaiming Real Estate Professional Status
• Trying to exploit Short-Term Rental Loopholes
• Sky-high Repair and Maintenance Expenses
• Excessive Miscellaneous Deductions
• Massive Home Office Deductions
• Reporting Losses Year After Year

So, how do you avoid the dreaded audit? It’s all about being organized and staying consistent. Here’s what you can do to minimize your risks:

• Keep detailed records and hold on to those receipts.
• Make sure your expenses are categorized properly.
• Track your time for REPS and short-term rental activities like a pro.

And, of course, use Landlord Studio to track your expenses and keep all your digital receipts in one spot.

Final Words: Using Landlord Studio for an Easier Tax Season

When it comes to tax season, staying organized and avoiding costly mistakes is key. With Landlord Studio, landlords can take the guesswork out of tax filing. By leveraging powerful tools like automated rent collection, smart receipt scanning, and comprehensive tax reports, you can keep track of your income and expenses seamlessly—reducing the risk of errors and maximizing your deductions.

As Logan put it, “We built Landlord Studio to make income and expense tracking easy... so landlords can stay on top of their finances and avoid tax filing mistakes.”

But it’s not just about the tools. Consulting with a real estate CPA like Thomas Castelli can provide the expert guidance you need to navigate the complexities of tax laws and ensure you’re making the most of your deductions.

Take control of your finances and set yourself up for a smooth tax season—because a little preparation now can save you big in the long run.

So, whether you're just getting started or looking for ways to streamline your tax prep, Landlord Studio has you covered. Create your free Landlord Studio account today and see how much easier tax season can be when you have the right tools in your corner.

Connect With Thomas Castelli for More Real Estate Tax Content

• Visit his website: Thomas Castelli, CPA 
• Listen to the Tax Smart Real Estate Investors Podcast 
• Join the Tax Smart Insiders Community 

Find him on LinkedIn Thomas Castelli, CPA, CFP® - Hall CPA PLLC | LinkedIn