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Real Estate Investor Tax AuditDear Taxpayer,

Your return has been selected for further review. Please contact us to schedule an appointment within 14 days from receipt of this letter.

Is there anything more dreadful than the notice for an IRS audit?  For most people, only the death of a loved one or loss of employment can top it.

If you’re one of the millions of Americans and Canadians who break out into hives at the mention of tax season, there are a number of ways in which you can reasonably avert the gaze of the dreaded IRS.  In fact, according to tax experts only 1 in every 100 tax returns ever gets a second look.

Given the hundreds of millions of returns filed every year, the IRS must filter by certain “red flags” as they electronically sort the millions of returns.  There are unfortunately some returns audited at random, with no red flag required for an invitation to a private party with the IRS, but in general taxpayers can minimize the number of red flags on their returns.

The bad news?  Landlords and property managers, by the very nature of their work, already have some red flags built into their returns.

Self-employed individuals are usually scrutinized more carefully than W-2 employees or 1099 payees.  So, entrepreneurs (who have not made it big enough to hire expensive accountants and bookkeepers) have to be especially careful when preparing their returns.  Knowing all the rules for what is allowed and what is not is essential here and can mean the difference between having a little extra in your pockets and maintaining your freedom.

Beware of your LLC, corporation and other such legal entities which may send up a red flag to the IRS.  While perfectly legal, the IRS has begun training agents on business-related triggers to look for when filtering returns of small businesses with these legal statuses.

Landlords are warned about claiming losses on rental properties.  Although there are many legitimate deductions for rental real estate, landlords with other income need be especially careful.  Also, landlords and property managers who claim to be full-time investors are placed under the microscope of a special program known as the Real Estate Professional audit project.  The project was implemented several years ago and examines the amount of time actually spent on real estate activities.

Most people know by now not to get carried away when deducting expenses for food, travel and entertainment, however if you don’t know or insist or making excessive claims for meals and such, your audit invitation may be in the mail.

Landlords and property managers may spend a lot of time in their cars going back and forth to visit their rental properties for various reasons.  While it may seem you’re always in your car for business purposes, don’t attempt to make that claim when you file.  Consider yourself warned: claiming 100% use of your vehicle for business is the equivalent of calling up the IRS requesting an invite.

Landlord Tax AuditThat messy room you’re claiming is an office may or may not be in the eyes of the IRS, but you run the risk of being audited when you make that claim.  The IRS has strict rules which it aggressively enforces when it comes to claims of home office space.  If your home office doubles as any other room in your home (play room for the kids, guest room, etc.), you might need to find something to wear to the party.

Individuals with higher incomes (over $200,000) and taxpayers with special circumstances are also at higher risk.  Special circumstances can include persons with very low incomes who claim earned income credits.  Most people with lower incomes believe they are exempt from IRS audits, but that is simply not true.  Any return that raises a red flag is likely to be pulled for further review or examination, as the IRS refers to it.  The complicated rules associated with claiming earned income tax credit makes taxpayers who claim it especially vulnerable to the watchful eye of the IRS.

Experts advise taxpayers to stick to plain vanilla tax returns when possible, but say they shouldn’t shy away from claiming any legitimate deductions, regardless of how unconventional.

Coming down with a case of amnesia when it comes to reporting all of your income definitely falls under the category of what not to do.  Doing so will almost certainly get you invited to the audit party.  Though it may be tempting to exclude that part-time job or other source of extra income, the IRS can easily track income for which you receive a 1099 or W-2.  Disturbingly, the IRS also has increasing access to individuals' bank account histories for comparison, even when no 1099 or W-2 is issued.

Being too generous with charities may also pose a problem for you with Uncle Sam.  An easy red flag for the IRS to spot is charitable contributions that are not consistent with income levels.  If you report earning $50,000 but claim to give $20,000 away annually, you are probably going to be audited.

Claiming losses on a hobby is a definite Don’t and will land you on the IRS guest list.  You can, however, deduct expenses related to the hobby up to a point (to offset money earned from it), but claiming losses is not allowed.

As with most things, using common sense and following the "what is reasonable" rule will go far and keep you far away from the party.  Also, keep in mind receiving an invitation to an audit doesn’t have to end in fines, penalties or six months in jail, as long as you keep good records and have played by the rules.

Do you know of other audit triggers?  Tell us about any experiences or close calls you have had with the IRS.

More information about the IRS's approach to auditing real estate professionals can be found here.

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Categories: Tax Strategies

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