Boston Real Estate Investors Association

Critical Areas IRS Will Watch Out For with Real Estate Investors

Approximately 1.5% of all taxpayers are audited every year. Despite this relatively small number, the IRS still causes many people to shake in their boots when contemplating the chance of an audit. The odds are low that you would be picked for an IRS audit because the IRS does not have enough personnel and resources to examine every tax return. Your chances of being audited are higher depending on income levels, profession, transactions, and tax deductions. Here are some tips on high-risk areas for audits, so you can ensure you are not on that list.

High-Risk Tax Audit Areas

High Income

Your chance of being audited rises as your income increases. Here are some red flags to the IRS:

  • You have large amounts of itemized deductions on your tax return that exceed IRS targets.
  • You claim tax shelter investment losses on your tax return.
  • You own or work in a business which receives cash and/or tips in the ordinary course of business.

  • You have rental expenses on your tax return.

  •  A prior IRS audit resulted in a tax deficiency.

  • You have complex tax transactions without explanations on your tax return.

  •  You are a shareholder or partner in an audited partnership or corporation.
  • You claim large cash contributions to charities in relation to your income on your tax return.
  • An informant has given information to the IRS.
  •  Your business expenses are large in relation to your income on your tax return.
  • You have complex investment or business expenses on your tax return.

Don’t let these factors influence how you file your tax return. You must report all income and take all your deductions to ensure you prepare your tax return accurately and completely.

Large Amounts of Itemized Tax Deductions

If your tax deductions exceed a target range set by the IRS, this will increase your chance of an audit. You should of course take the deductions that you are entitled to, but beware that if they exceed the averages for your income level, this will increase the chances for an audit

High DIF

IRS computers compare all tax returns to the national Discriminate Information Function (DIF) system average. The IRS calculates the DIF score by using a closely-guarded formula. Tax returns with the highest DIF scores are scrutinized by experienced IRS examining officers who determine which tax returns provide the best chance for collecting additional taxes, interest, and tax penalties.

Unreported Taxable Income

This is a very common red flag for an audit. If the IRS finds unreported taxable income by matching income from your tax return with information from banks and other financial institutions, this will increase the chance of an audit. You must ensure that you report all 1099 forms from bank savings accounts, mutual funds and others.

If you hold rental real estate or know someone who holds rental real estate. This is a must Read. IRS has decided to target returns with rental real estate for audit this year.

Rental Income

The IRS recently released a report indicating their intent to perform more examinations of individual tax returns that report losses from rental real estate activity. The increased scrutiny was triggered by a 2008 report that found at least 53% of individual taxpayers with rental real estate activity for the tax year 2001 misreported their rental real estate activity. The report appears to direct the IRS to focus on those taxpayers claiming real estate professional status

Thus, similar to documenting expenses, documenting your time devoted to real estate-related activities is extremely important given the IRS’s intent to look more closely at real estate activities.


Other Areas for Critical Review


Self Employment (Schedule C Filers)

Self-employed people come under more scrutiny for an audit because the IRS believes most under-reporting of taxable income and abuse of tax deductions occurs among those who are self-employed. Unfortunately, these individuals are audited by the IRS far more frequently than employees collecting a salary. The IRS publishes manuals to familiarize its auditors with about 100 different businesses, particularly ones that have a high number of self-employed individuals. You can get copies of these guides to further learn how to protect yourself from an audit at:

Audit Guides or call the IRS Freedom of Information Act Reading Room at (202) 622-5164, or write Box 795, Ben Franklin Station, Washington, DC 20044.

Home Office Tax Deductions

Home office tax deductions have been targeted by the IRS. Since the tax rules for deducting home office expenses on your tax return are complicated, you should consult a tax expert, such as a CPA, to determine whether you qualify to deduct home office expenses on your tax return.

Unreported alimony

Not all taxpayers report alimony receipts as taxable income. Therefore, the IRS now matches tax deductions for alimony payments by one former spouse with the taxable alimony income reported by the other.

Automobile Logs

This is a commonly audited item for business owners and real estate investors. It’s important to keep good records of your mileage log. An easy way to do this is to show the date, beginning and ending odometer readings, the location, the business purpose, and the client.

Defend Yourself!

You are entitled to take every tax deduction that you qualify for and you should never be scared by the potential of an IRS tax audit. You must use common sense when making decisions about deductions and hire a qualified CPA to help you through the minefield of taxes

A recent question from my blog:

QUESTION: This year I bought my first house, a duplex. I live in the lower, and the upper is rented. I’m claiming half of the mortgage interest on schedule A, and half on schedule E. Same with the taxes, and PMI. I write off half of the water bill. I put about 5 grand into the house. I have every single receipt for that 5 grand. Most items were buying supplies to repair the house myself. Paint, little tools, gutters.. Do I claim these items under “supplies” or “repair”? I bought about 1900 dollars in new appliances for the rental unit. I am on the page where I depreciate the items.

Can I just lump the 5 appliances together, and call them “appliances” for 1900 dollars, or do I need to do them one piece at a time… For Example Stove for 350 dollars or whatever, then depreciate that over 5 years..My final and most important question…I understand that I can depreciate the rental unit. Would I put the purchase price for the rental unit to be exactly half of what I paid for the house? As it turns out, I’m going to be claiming a loss of about 1200 dollars for this year on the unit. This was because I only got 5 months of rent out of it, and we totally refurbished the entire place.

ANSWER: First of all, congratulations on the purchase of your first rental. I will try to answer most of your questions. Owning a duplex and living in one unit while renting out the other offers numerous tax advantages over owning and living in a single-family home. The rent should offset at least part of the mortgage payment, and many of the home’s expenses are deductible that would not be deductible for a single-family, owner-occupied residence.

All the mortgage interest is deductible — your half on Schedule A of your 1040 and the rented portion half on Schedule E (the rental income and expense schedule on your 1040). The same is true for city and county property taxes supplemental taxes and any special tax assessments. The cost of a business license is fully deductible since the license is only for the portion that is business property — the part your renter occupies.

Repair and Improvement

All the repairs and maintenance costs to the property are proportionately deductible. Take the percentage of the rented portion (usually 50 percent) of all these expenses against the rental income on Schedule E. This includes gardening, exterior painting, plumbing and electrical repairs, pest control, and any other expenses or regular maintenance that affect the entire property. Any work done on the rented unit itself is 100 percent deductible.

Larger projects, such as major improvements, fences, landscaping, and other projects that add significantly to the property’s value, are deductible at the same percentage as repairs and maintenance, but they are usually capitalized and depreciated over time. Calculate the allowable depreciation expense each year and take it as an expense against the rental income on Schedule E.

Calculating Depreciation

The rented portion of your duplex is fully depreciable. This means you must calculate the basis (your purchase price plus expenses of the purchase) of the building portion of your duplex, then calculate the percentage of the rented portion. For example, assume a purchase price of $400,000. Check your property tax bill to determine the percentage that applies to the building. Let’s say it is 75 percent of the value, or $300,000. If the rented portion is the same size as your personal living space, you can take half of the value on the depreciation schedule ($150,000). The rental potion is depreciable over 271/2 years, so your depreciation deduction is $5,454 annually. Calculate major improvements to the entire property at the same percentage. Improvements that affect only the rental unit portion are 100 percent depreciable.

I address many of these issues in my Wealth Building Plan. Make sure you are getting the best tax advice. Let me evaluate your financial and tax situation, then develop a customized tax strategy just for you. Together, we will come up with a strategic plan designed to answer your questions as you build your own customized wealth-building plan. You can get more information at WealthBuildingPlan

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