So you’re worried about being audited by the IRS. Or maybe you’re in the middle of an audit right now and aren’t sure what to do next. Being audited by the IRS is daunting and can feel scary, but all they’re really doing is asking for some clarity around your taxes.
If you’re a real estate investor targeting advanced tax strategies like real estate professional status (REPS) or short-term rentals (STR), your taxes have more moving parts than the average person, so your chances of being audited are higher.
The good news is that, you aren’t the first person to be audited, so we have guidance on how to approach specific situations and defend certain positions. More good news – you have this resource to help you know what to expect if you’re selected for examination.
Let’s take a look at all things audit: why they happen, what they look for, and how to prepare.
Why Real Estate Investors Get Audited
Anyone can be audited by the IRS. For some people, tax filings are as simple as reporting their W-2 wages. For others (you, the real estate investor), taxes are not simple –investors have multiple properties with various depreciation schedules, income sources, time tracking, and passive and nonpassive losses.
How does the IRS pick who they audit? The truth is, we don’t know exactly. Sometimes it’s random, other times we can identify when a tax return has a higher likelihood of audit. A general rule of thumb is that the higher the income is on the tax return, the higher the chances of audit are. What further increases the chance of audit is when higher income is offset or reduced by significant losses.
Tax strategies like REPS, STRs, and cost segregation can create big losses that offset high W-2 or other income. In addition, the data that supports these strategies (specifically time logs that show material participation hours) does not get reported on your tax returns. There is nowhere to report it on the return; you simply report that you materially participated, not how you materially participated. Instead, your time log and other documents are kept on file to prove the positions on the tax return in the event you are audited.
When the IRS sees high income and big losses that offset it without any proof on the tax return itself, it makes sense that they would want to ask questions.
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Common Areas the IRS Reviews
We’ve discussed at a high level why real estate investors get audited, but what are some of the specific things that might cause the IRS to take a closer look?
- Significant or recurring losses that offset other income.
- REPS, especially with W-2 income.
- Nonpassive STRs.
- Cost segregations that lead to a big amount of bonus depreciation.
- Repairs and improvements that are not categorized correctly.
- Partial asset dispositions (PAD).
- Incorrect reporting of passive or nonpassive activities.
Now let’s say the IRS comes knocking on your door, and all of your documentation is handwritten in a notebook, and you have countless receipts/invoices in a shoebox, you’re probably going to struggle through the audit. If your records are clean and organized, you’ve documented everything as you should, and you work with a specialized CPA team (ahem), you’re ready for battle. An audit becomes just another Tuesday for you.
What Happens During an Audit
It starts with an IRS agent knocking on your door, laptop in hand, ready to examine everything immediately.
Not really.
The audit process, in most cases, is far less invasive with much more time to prepare. Here’s what to expect:
| Step 1: You’ve got mail! | You receive a notice in the mail that your return has been selected for examination with an Information Document Request (IDR) outlining the scope of the audit and documents they are requesting and plan to review. |
| Step 2: Schedule the audit | Either you or your CPA (if you are being represented) contacts the auditor to schedule the initial audit interview. We’ve found that IRS agents are fairly flexible and will work with you to schedule several weeks out, giving you time to prepare. In our experience, the initial meeting usually lasts around an hour, but could be more or less depending on scope. |
| Step 3: Prepare, prepare, prepare | You can DIY this step, but a professional is worth their weight in gold here. Research and experience are important factors in building a solid defense and strategy. If you prepared throughout the year, this step is fairly easy; if not, retroactively building your defense can decrease your chances of winning. |
| Step 4: State your case | If you have a CPA representing you, the audit could be virtual or in person, depending on location. Either way, come to the audit prepared to defend your case. In addition to your documents, have authoritative guidance (IRC sections, Regulations, Tax Court Cases, etc.) to back up your positions. |
| Step 5: Follow up | After the initial meeting, there may be additional requests for documents or clarification. Communication with the auditor at this point could be via phone, email, fax, or snail mail. |
| Step 6: Receive the decision | Once all loose ends are tied up, the IRS will issue either a no change letter (this means you win) or a summary of changes with the revised results (and potential penalties and interest). If you still disagree with the results, you can appeal and continue to argue your case, but you’ll want to do a cost/benefit analysis here. |
One thing to keep in mind is that proactive preparation (before the audit) is extremely important, and timely and organized responses to the IRS’s requests help the audit go a lot smoother. As soon as you get that letter, reach out to your CPA ASAP. If you don’t have one, call us.
If you need support during an audit, contact our team and we can guide you through each step.
How to Prepare (Before and After You Are Notified)
The best way to prepare for an audit is to simply do things the right way as you go along. Document everything correctly and work with your CPA throughout the year, not just at tax time (and especially not after) – reconcile your books, track your time in real time, and digitally store receipts. Build that into your routine and it becomes second nature. Having said that, here is how to prepare before and after you are notified of an audit:
| Before | After |
| Reconcile your books monthly. | Review your books and financials to make sure they tie into the tax returns. |
| Track material participation hours contemporaneously. | Review your time log and ensure your entries have substantiation. |
| Store receipts and invoices digitally. | Review the IDR to see if any receipts or invoices need to be provided. |
| Keep detailed records (scopes of work, itineraries, etc.) for large expenses, improvements, and travel. | Review and refine your records to ensure they support your case. |
Documentation Every Investor Should Keep
- Reconciled financials – balance sheet, P&L, statement of cash flows.
- Depreciation schedules showing cost basis, in service dates, and accumulated depreciation.
- Receipts and invoices for repairs, improvements, travel, and other expenses.
- Travel and mileage logs with a clear business purpose.
- Time logs to support REPS or material participation.
- Closing statements and loan documents are tied to each property.
- Lease agreements for long or short term stays.
Summary
To sum up, an audit from the IRS really is just a request for more clarity. If you’ve been selected, it’s natural to be worried about it. You may not have been through that experience before and that can present challenges. However, with proper planning and representation from someone who has been there before (and won), it isn’t as stressful as it may seem.
Just remember, keeping your records organized and documented correctly is the best way to prepare for an audit. There is no time like the present to start proactive habits to protect yourself. If you’re looking for a CPA to help guide you through any of this, reach out to us – we are happy to help.
Continue Reading
- A Real Estate Investor’s Guide to IRS Audits
- Accounting for Real Estate Investors: Why Accurate Books Matter for Tax Strategy
- Understanding Partial Asset Dispositions (PADs) for Real Estate Investors
- How to Classify Repairs vs. Improvements
- Which Hours Count for Material Participation? A Guide for Real Estate Investors
