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Rental Accounting

Top 7 IRS Audit Triggers Real Estate Investors Need to Know

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 advisable to seek professional advice from a licenced CPA to ensure you file your taxes correctly.

IRS Audits

1. Filing Errors

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 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 you 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 misspelt name or an incorrect Social Security Number. However, some very common tax mistakes are basic mathematical errors.

2. Failure to Report Income

This could be something as simple as an oversight in your books, a missed zero or misplaced decimal. One big red flag is if you declare a lot less income than in previous years. Not only does this mean you’re 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.

3. Excessive or Vague Deductions

Overly large or unusual expenses such as a very large home office, or extensive travel expenses can raise red flags with the IRS. 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.

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 office equipment, and so on.

A final expense which 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.

4. Large Charitable Donations

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.

5. Tax Credits

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.

IRS tax filing

6. Filing Late

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.

7. Does it all Add up?

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.

Conclusion

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. Using Landlord Studio, this is made easy 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.

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Ben Luxon

Ben is an author and real estate enthusiast. His interest in all things entrepreneurial has led him to work with real estate professionals all over the world, distilling their knowledge into articles and Ebooks.

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