IRS Audits on Landlords
IRS Audits
Most landlords filed their 2012 income tax return months ago and have since forgotten about the matter. For some landlords, especially those who push the limit regarding their rental business, the 2012 return won’t be forgotten for at least many months because as everyone knows, the IRS can pursue issues for three years after the April 15th filing date or, if filed during an extension period, for three years after the date the return was filed. Of course, if there is any fraud involved, there is no statute of limitations.
A letter from the Internal Revenue Service creates a lot of anxiety for most taxpayers, particularly prior to opening the mail and reading the notice. Many, perhaps the majority of letters are actually quite benign – you forgot to sign your return or two digits of your social security number were interchanged. Sometimes the letter is actually good news – the IRS recalculated your data and found you’d made a math error and will be receiving a refund.
Often, there is a simply a question regarding an issue that you must respond to. Perhaps the name used for an expense of your business is unusual and an explanation is required. Sometimes, however, the letter questions income,
deductions or both or an explanation regarding some other entry is required.
The IRS defines an audit as “a review-examination” of a return “to verify the amount of tax reported is accurate.” If you are selected for one, the agency has on its website a video guide to the process.
In 2011, the IRS audited nearly 1.6 million individual returns, slightly more than 1 percent of the total filed. About three-quarters were done by correspondence, the rest through field examinations done in person by an IRS agent. Only 1 percent of people with incomes under $200,000 had their returns audited; the audit rate for those with incomes of $1 million and higher was about 12.5 percent.
The IRS says that the vast majority of taxpayers fills out their returns accurately and has nothing to worry about. However, they also remind us that they have a variety of screening processes to make sure they catch the people who are cutting corners.
There’s no magic equation for knowing which returns the IRS will select for a major audit – i.e., your chances of getting the scary letter. Some returns are selected for audit through computer screening. The IRS is looking for unreported income. Accordingly, the IRS often focuses on taxpayers with cash earnings.
An IRS computer simply compares data from your return to average numbers for that data from people in similar types of business or at income levels. Your return could be flagged for further action if your numbers are significantly different than “normal.”
The computer may also compare your most recent return with your returns for previous years, looking for different types of entries compared to other years and/or for large variances from other years. Things that are reviewed include charitable contributions, interest income, and whether there are variations from averages in your income bracket or zip code. The computer will flag each significant variance.
The computer will also compare various types of reported income items – e.g., interest, dividends, wages, and self-employment – with W-2s and 1099s that were submitted to the government by those making payments to you. It’s important that you think through those items reported by third parties and make sure those are going to match up. This means that you have reported at least as much income within each category as will be reported by the payers. Reporting less than
that reported by payers is certain to trigger questions. Reporting more than will have been reported to the government may actually be of benefit in avoiding audits.
Assuming that you can forget about income for which you received no W-2 or 1099 is both dishonest and risky. It’s risky because there might be some reason why you didn’t receive a copy rather than the payer didn’t follow the rules in submitting the proper reports to the government – perhaps your copy was lost by the Post Office.
There’s yet another category of things that can trigger an audit of your return called “related examinations” by the IRS. Returns may be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for audit for some reason.
Some potential issues are of similar risk for a large percentage of taxpayers. Others are more of a problem for self-employed individuals, including landlords.
The IRS is well aware that landlords might be tempted to forget about some of the rents received in cash and/or to write off personal expenditures as rental expenses. In order to avoid additional scrutiny rents, including cash, should be
deposited into a bank account other than other business or employment receipts and expenditures not made by check from that account should be via a credit card or other business credit lines dedicated to the rental business.
Many landlords claim deductions for a home office and this expense often attracts IRS scrutiny. However, if you qualify for the deduction, don’t be afraid to claim it. To qualify to claim expenses for business use of your home you must use part of your home:
(1) exclusively and regularly as your principal place of business (as defined by the IRS),
(2) exclusively and regularly as a place where you meet or deal with patients, clients, or customers in the normal course of your trade or business,
(3) in the case of a separate structure which is not attached to your home, used in connection with your trade or business, or
(4-6) three other uses that are not usually of concern to landlords.
All landlords utilize one or more motor vehicles in managing their income properties. However, many small business owners, including landlords, do not fully comply with the IRS requirements regarding the deductibility of vehicle use and many do not even come close. Claiming significant business auto expenses may result in a request that you furnish a copy of the mileage log that you were supposed to maintain contemporaneously with the business driving.
There’s no particular amount for charitable contributions guaranteed to catch the IRS’ attention, but inordinate amounts relative to income might do so. However, you shouldn’t shortchange yourself. As for most issues, it’s all in the
documentation. Find out what donated items sell for, at a thrift store, for example, or check valuation tools on the Internet.
The IRS will notify taxpayers of an impending audit by telephone or mail. E-mail is not used. Just because your return has been selected for an audit doesn’t suggest you made an error or you’re dishonest. Audits can result in acceptance of the tax return without change or even result in an unexpected refund.
The IRS has a Declaration of Taxpayer Rights that sets forth what you can expect from an audit, ranging from privacy and confidentiality to professional and courteous service. Taxpayers have the right to be accompanied at an audit by anyone of their choosing or to have someone else represent them rather than even appear at the audit. Taxpayers or their representative also have the right to make an audio recording of the session.
They may appeal the judgment, either to the Appeals Office or to a court, and can request that penalties and interest be waived.
Being accurate and having the records to confirm the accuracy is the best defense in an audit. Using tax preparation software gives significant protection against mistakes in tax code interpretation if you prepare your own returns rather than have a licensed professional do so.
Again, don’t increase the odds of being audited by making careless mistakes..
Summary
The bottom line is that the most important thing in an IRS audit will be paper. Maintain good records. Keep your receipts. If you maintain good records and have receipts, you should win.