We military landlords tend to want to maximize deductions and minimize taxes. That is probably true of all taxpayers. I know I haven’t had a client yet who said they wanted to pay more in taxes than was required. For the purposes of this article, surviving an audit means walking away without any additional taxes, penalties, or interest when audited by the IRS.
I”ve had potential clients ask me if I was a conservative or an aggressive tax professional. I’ve been asked if I do “creative tax preparation and planning”. I don’t know what those things mean, way too broad to individual interpretation. My goal with tax preparation is to be right and to minimize tax liability. My goal with tax planning is to defer taxes and to minimize taxes. And I’ll use every valid and legal method I can to do those things. But I’m not putting things on a tax return that I don’t view as legitimate or that I don’t think will survive an audit.
Putting things on your tax return that won’t survive an audit can result in taxes, penalties, and interest if audited. In some cases it is worse, you may be committing fraud, being negligent, or significantly underreporting income. All of those three things can result in high penalties and in some cases criminal charges. Here are 5 signs that you may not survive an audit:
- Having a business asset that really isn’t a business asset. Bought a $5000 computer that is only used to manage your 2 single family home rental properties. Doesn’t pass the smell test. But my friend bought a truck and fully deducted it for his ONE rental property. The probability that this truck was used for 100% business use with one rental property is low. In many cases even with 50 properties the truck isn’t 100% business use. Maybe it is though. If audited the IRS doesn’t just take your word for it. They want records. How does the IRS (and the taxpayer) determine the percentage of business use? Mileage and mileage logs. Which brings us to the next sign.
- You don’t have adequate mileage records. An estimate is just trouble. A nice even 10,000 miles for 3 rental properties screams “audit me”. Mileage needs to be done right (just like every other part of tax prep). If it is inconvenient, then tough, get out of the real estate business or figure out a way to do it without driving your own vehicle. One thing to note is that while the IRS doesn’t require odometer readings for each trip, they do want the miles traveled. However, they do offer an acceptable example log in Pub 463 and it does have columns for starting and stopping odometer readings. This is what ensures you can pass the audit in regard to mileage:
- Odometer readings at the beginning and end of each year. I recommend recording for any vehicle that may end up being used for business (rental property) purposes.
- Record the date, the purpose, the location (at least the town/city), miles of the trip -with start & stop odometer readings if you would like to impress the IRS if audited.
- Also track any commuting miles.
- Track actual expenses too.
- Keep any official documents verifying mileage. Maybe maintenance records. If your state has annual inspections, often mileage is recorded as part of the inspection.
- An example log can be found in Publication 463.
- There are apps that can be helpful and the IRS does permit mileage records to be reconstructed.
- You have an expense deducted on your Schedule E without having any proof. As a tax preparer I am permitted to take your summary statements regarding expenses -as long as I don’t suspect there are errors and as long as I don’t have reason to doubt their validity. It is on the taxpayer to retain the proof. If you have a tax preparer and want more surety that your proof is adequate -then provide the proof even if the tax professional is accepting your summary. There is often a tendency to want to rely on credit card statements and bank account statements. While they can be part of the proof, relying on these alone have resulted in failed audits. Those statements are not enough. Straight from the IRS website: Your supporting documents should identify the payee, the amount paid, proof of payment, the date incurred, and include a description of the item purchased or service received that shows the amount was for a business expense. Have all of these elements and you should be good assuming it is an ordinary and necessary business expense.
- You haven’t filed and issued any 1099-NEC forms for unincorporated independent contractors. If you pay an unincorporated independent contractor $600 or more for work performed (and expense deducted) for your rental property, you are supposed to issue a 1099-NEC to that individual. The IRS does not like it if you forget to do that. If you pay Joe $1000 to paint a fence, 1099 him. If you don’t, and the IRS figures it out there are penalties for you. Also, if you have taken the Qualified Business Income (QBI) deduction, which most military landlords probably qualify to do, that deduction may be disallowed and that can be costly. Obviously if you didn’t make any payments that required 1099-NEC forms be filed and issued, then this one isn’t a problem.
- You only have one item on your depreciation schedule, but you have had the rental property for many years. The first and usually the biggest item on a depreciation schedule is usually the original property purchased -the structure value (often a house). Costs come up over the years that may be required to be depreciated. Often these are assets or improvements. Some may be depreciated quickly, even in one year (Section 179 items for example), but they will still show on a depreciation schedule. If you refinance your rental property there may be amortized refinance costs, which would show on the depreciation schedule. Now you could be more fortunate with having additional asset or improvement costs, but generally speaking the longer you hold a rental property, the more items that show up on your depreciation schedule.
Why did I write this? Most of us won’t get audited. But there is audit risk and there is the tax code and there is doing what is right. What is right is to comply with the law and to make sure if you are audited that you can back up what you claimed. If you do have a tax professional, it doesn’t matter how much you paid that person, YOU are still responsible for what is on that return. So make sure the input for that tax return is right and ask your tax preparer questions when things don’t make sense.
Please note: the intent of this article is to provide some guidance on what to consider for tax questions on this topic. It is not intended to be the final authority on a given tax situation or to provide tax advice for your specific situation. I certainly haven’t covered all scenarios. You need to consult the applicable IRS publications and possibly the IRC and the CFR to sort out your particular tax situation. And/or consult a tax professional with experience in both rental properties and military tax provisions.