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When it Comes to Your REI Taxes: Does Crime Pay?

by Amanda Han on April 3, 2014 · 18 comments

  
REI Taxes: Does Crime Pay?

I was fortunate enough to be interviewed by real estate expert Bruce Norris for his radio show recently and I have to admit, I was a nervous wreck.  To make things worse, one of his opening questions to me was “Amanda, does crime pay?” At first I did not understand exactly what his question was and, as such, I didn’t know how to answer that. So I asked him to clarify it for me.

Bruce said “I talk to some of my friends and sometimes, they tell me some outrageous stuff that they do to avoid paying taxes.  I have friends who make a lot of money but have not filed tax returns years. I have also heard other investors who tell me they write off every penny that they spend regardless of whether it’s allowed or not. So I want to know….does crime pay?”

Once I understood his question, I felt my face turning hot from my nerves as I internally pondered the “correct” answer to provide.  You see, as a CPA and being on a broadcasted radio show, I can’t legally or ethically say that I recommend someone use tax avoidance techniques. But at the end of the day, the answer to Bruce’s question really depends on the risk tolerance level of each taxpayer.

Does it Pay?

For example, I have a lot of clients who want to do everything exactly by the book. They want to make sure they have every single receipt before they write-off an expense. They want to make sure that nothing they claim on a tax return would even remotely be connected to an “audit red flag” item.  So, as a tax advisor, I do my best to make sure that we keep this client’s audit exposure to a minimum even though I sometimes may disagree with an over-conservative position. For example, I still have clients who refuse to claim a home office deduction because of hints from an old tax preparer over 10 years ago that it could be an audit risk. So each year, I explain to the client that this is no longer an audit risk and that I suggest they take the deduction.  I try to quantify the potential loss of tax savings as a result of this but in the end if the client is not comfortable taking that deduction, then it is my job to make sure that my client’s tax return reflects their wishes exactly as they wanted.

Related: Do You Hate Paying High Taxes? Me Too. Here’s the REAL Problem…

On the Flip Side…

I also have a lot of clients who want to be more aggressive on their tax returns (some more so than others).  My job in this example is to let them know of the exposure and potential outcome in case of an IRS audit. For example, I have a client who has a very high W-2 income working a full time job. Back a few years ago, he got into real estate and promptly acquired 13 rental properties in one year. After we maximized all of his write offs with business expenses and accelerated depreciation, the rentals ended up with a huge loss on the tax returns. But because of his high income, he would have needed to claim real estate professional status in order to use all those losses on an unlimited basis to offset his W-2 income. Now, with his time log, he was most likely going to be able to support that he spent more time on his 13 new rentals during the year then his time at his job, but nonetheless, his tax return would be one with very high IRS audit exposure simply due to the fact that he had a large W-2 income showing.  So, my role in this example was to quantify the tax savings that he would get by claiming the real estate professional status. But I also needed to inform him that this tax savings comes with an elevated audit risk and explained what the potential process could look like if he were to ultimately get audited. After understanding the risks and the potential time commitment that he may need to deal with audit issues, this client made his decision to still claim the real estate professional status because he was comfortable with that risk. So, just as in the last example, we filed his tax returns exactly as he wished for it to be reported.

Related: Investors Beware: 8 Warning Signs You May be Overpaying Your Taxes

At The End of The Day…

It’s not a matter of whether I think crime pays or not.  It’s about each person’s risk tolerance level and where they fall within that spectrum. Just like one investor may find a tear-down shack to be a great fix and flip opportunity, another investor may run for the hills. The same goes for tax returns. Since the taxpayer is the one who ultimately signs on the dotted line, we need to file a tax return based on that taxpayer’s wishes.

Don’t forget, proactive tax planning can go a long way. I always say that when you are doing your taxes in April, there may be few strategies that can be used to offset taxes. But planning proactively with your CPA throughout the year is a great way for you to identify safe and legitimate ways to reduce your taxes. So my advice is to be “strategic” rather than “aggressive.” And remember….don’t wait for your CPA to call you, be proactive and call your CPA if you ever have any questions or think you may need help.

How are your taxes coming along?

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{ 18 comments… read them below or add one }

Adrian Tilley April 3, 2014 at 2:14 pm

Great article. As you said, the question is really “how much risk do you want to take”? Everyone has a different comfort level.

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Kimberly H. April 3, 2014 at 2:24 pm

Great article. We *just* switched to a CPA/attorney/real estate investor who totally understands this and makes sure what he is doing is within our risk tolerance. Interesting on the W2 and professional real estate status being an audit risk, was not aware of that, but in our case my husband has the W2 and I am the real estate pro so I’m thinking that is not of concern for us.

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Amanda Han April 3, 2014 at 10:45 pm

Yes…if only one of you is full time then your audit risk goes down significantly on the REP status. I am not the IRS but that is my theory at least. =)

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Kimberly H. April 3, 2014 at 10:55 pm

Thank you.

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Dennis April 3, 2014 at 6:03 pm

If crime didn’t pay we would have to beg citizens to run for public office.

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Amanda Han April 3, 2014 at 10:44 pm

lol

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Eric April 3, 2014 at 7:03 pm

It’s really not that hard. Claim the income, save every receipt, deduct the proper expenses. I can sleep at night knowing that I have all my receipts. Of course online purchases require payment of the state sales tax.

Why have a sleeping issue when for ~$200 you can be 100% legit?

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Sharon Tzib April 4, 2014 at 9:48 am

I’ve always expected my CPA to find me every single legal tax deduction possible – kind of feel like that’s what I’m paying her for lol! Thanks, Amanda!

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Amanda Han April 9, 2014 at 10:13 am

Thanks Sharon. You are exactly right…..what you pay for is the advice to get every legal deduction possible. Its the “grey” areas that typically need a risk tolerance check.

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Shaun April 7, 2014 at 12:34 pm

I personally feel it is more risk than it is worth to straight up lie or not file. Being aggressive on some stuff is a different matter.
I’m sure that I could maybe have some things I deduct disallowed if I went though an audit, but nothing is unjustifiable and the things are relatively small for the most part.

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Kimberly H. April 7, 2014 at 1:02 pm

Same here. I don’t mind being aggressive where there is no case law out there defining the rule. But if the rule is clearly defined, we abide by it.

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Amanda Han April 9, 2014 at 10:15 am

Great comment Shaun. Sometimes it makes sense to pass on the small stuff and focus on getting the strategies to deduct the larger items legitimately.

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Brett Synicky April 7, 2014 at 10:37 pm

I can’t imagine the IRS will look the other way with your client claiming RE pro when he has a full time job. I was under the impression that’s a huge red flag, as in automatic audit…better to just carry over the losses until you can actually use them…thanks for another great post Amanda!

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Shaun April 7, 2014 at 10:52 pm

Amanda indicated he can prove that he qualifies with his time.
Might be hard to believe that one can put in >2000hrs on RE while also working full time, but it is possible.
If he has high income then that is exactly why he should claim it if he can qualify. Unlimited losses against that other income being taxed at high rates (since she indicated he had a high W2 income).
Now I would make damn sure that I could justify and verify every single line of my return perfectly in the likely outcome of getting audited. But I’d run that risk if it was going to save me (I’d guess) like 5-figures on my taxes, legitimately.

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Amanda Han April 9, 2014 at 10:17 am

Great comment Brett. Yes audit risk is significantly higher for high w- earners however it is not a guaranteed audit. Also , we do have clients who have been able to legitimately claim real estate professional status…it all comes down to documentation. Someone who works full time and owns one rental property out of state with a management company is a lot less likely to pass the test than someone who works part time and owns a handful of local properties that they self manage.

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Andrew April 17, 2014 at 10:06 am

I really enjoyed your article, Amanda. One question though…if you take all the deductions you’re legally allowed to and you have all the supporting documentation, could your upcoming audit prove to the IRS that you’re playing by the rules and become a benefit instead of a risk?

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Amanda Han April 21, 2014 at 1:35 pm

Hi Andrew: Yes if you are ever under audit and it turns out that you had more deductions that you missed out on then the IRS will give you a refund on that money. They are generally very goof about that and if they find something that indicates you should get a refund they will generally let you know that.

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Andrew April 21, 2014 at 4:19 pm

Really? I wouldn’t have expected them to offer a refund. I just thought a tax return verified by an audit might put you in good standing with them and reduce the likelihood of another one down the road. Thank you!

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