It is now just a few days before the tax deadline! If you have not already started on your taxes or if you are still gathering your documentation, I highly recommend you consider filing tax extensions. Remember, the IRS allows extensions so you can have more time to gather up your tax information and tax deductible expenses, so why not take advantage of it?
If you want to know how to use your real estate to significantly reduce your taxes, be sure to check out our book The Book on Tax Strategies for the Savvy Real Estate Investor.
Now let’s go back to our topic this week on tax savings and audit protection. During tax season one of the things that’s on our mind is what is the best way for me to minimize my taxes? At the same time another thought often creeps into our mind is what can I do to minimize my risk for an IRS audit?
Let’s face it, we all want to avoid audits if at all possible. Just the thought of having to deal with IRS can really put an investor in an unhappy position. So is there actually a way for us to avoid an IRS audit? Unfortunately, the answer is no. There is no way that we can definitively eliminate the possibility of an audit. However, there are simple things we can do when we are preparing our tax returns to make sure that our audit risk is significantly minimized. Let’s take a look at some of these easy things that help us do that.
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Match Up the Numbers
It is widely known that every single tax return goes through an automatic audit with the IRS computer system. What does that mean? Well, it simply means that there is a computer system that automatically matches up the tax documents that have been reported to the IRS with the actual tax return that you submit.
For example, if a management company issued a 1099 to your name showing $5,000 of rental income, the IRS system will match up that 1099 to your tax return to make sure that the gross rents you report match the 1099 that the property management company provided them with. One of the ways to minimize your tax audit is to make sure that you receive a copy of all the 1099s that were issued to the IRS. If you are unsure whether one has been issued to you, you can simply contact your management company to find out.
Make Sure the 1099 Amount is Correct
Another way is to make sure that the 1099 amount is actually correct. Oftentimes the property management company might issue an incorrect 1099 to include security deposits or other “reserve” items. These should generally be excluded from your 1099s because they are usually not taxable in the current year. If you find yourself in a situation where the 1099 amount does not match your records, you may want to contact your property management company and request that they issue a corrected 1099. The 1099 amount should match the gross rental income you received plus any other types of income, such as income from the laundry machines or other income your rental property generates.
Now, what if the 1099 issued by your management company is wrong but they refuse to issue corrected ones? Believe it or not, we do see this quite often. For example, say your property management issued you a 1099 for $5,500, of which $500 was actually a security deposit from your tenant. If they refuse to issue a corrected 1099 to show $5,000, what you may want to do is show gross rent of $5,500 on your tax return. Then on a line underneath that, indicate an expense amount of $500 labeled as “security deposit amount not taxable.” This way, the gross number on your tax return will match the 1099 sent to the IRS by your property management company.
Reporting Property Sales
Another common way to get tripped up for an audit as a real estate investor is when it comes to the sale of a property. Whether you are someone who does fix and flipping or someone who is selling a rental property, one of the ways that people often get selected for an audit is the sales price reported on the tax return not matching the 1099s issued to the IRS.
How does this happen? What people often do is rather than reporting the gross sales price of the transaction, they incorrectly report the net sales price on a particular property. For example, say you had a property that you sold for $200,000, but after selling costs and closing costs, the net you received was $180,000. In that example, the IRS has likely already received a form 1099 from the issuer showing gross sales proceeds of $200,000. As such, if on your tax return you’re only reporting $180,000 of net sales price, then the chances of you getting an audit or other IRS correspondence may be high because your sales price may be lower than what the IRS is expecting to see on your tax return.
In this example, the correct way to report it on your tax return is to show a gross sales price of $200,000. This way, that top-line on your tax return matches the 1099s that the IRS has on file for you. Then below you would show the $20,000 as selling costs or other expenses so that your net sales price is the correct $180,000.
Personal Versus LLC or Corporation
Another common mistake that creates a tax audit could be with respect to the 1099 names simply not matching up.
Let’s say, for example, that during the year you move your rental property from your personal name into your newly formed LLC. If you forgot to tell your property manager that this happened, they may incorrectly issue the rental 1099 to your personal name instead of your LLC name, which can lead to a potential audit.
In this situation, the IRS is expecting to see the rental income reported on your personal tax returns, when in fact you might be reporting it on an LLC tax return. This oftentimes can create an audit risk due to the fact that the IRS is not seeing the expected rental income show up on your personal 1040 income tax return.
To avoid that, first try to contact your property management company to see if they can issue corrected 1099s. If they can issue a corrected 1099 to have that rental income appear in your LLC’s name and tax ID, that might help you to avoid this potential IRS inquiry. Alternatively, if the property management company refuses to issue a corrected 1099 for some reason, then one of the ways you can protect yourself is to show the rental income on your personal income tax return, then put a negative rental income in the same dollar amount. Indicate on the negative income line something like, “Income attributable ABE Real Estate, LLC EIN 12-34567.”
Although this seems like a redundant item to show on a tax return, it does proactively tell the IRS what happened with that income and the reason why it was not showing up on your personal tax return. Simply having that one additional statement or disclosure can help you to significantly decrease your audit risk.
I’m sure you will agree that an IRS audit is one of the last things that anyone wants to deal with. Even if the IRS doesn’t find any errors on your tax return, the audit process itself is usually not pleasant and can often take away valuable time and resources for all of us as real estate investors. So this tax season, take some small steps and be proactive. Work carefully with your tax advisor on your tax returns to make sure that you are doing the simple things to significantly minimize your audit risk.
What steps do YOU take to guard against audits?
Leave your comments below!