In recent years, the IRS has audited only about 0.5% of individual income tax returns. Their audit choices have been more high net worth returns and larger businesses with more tax issues. However, based on recent tax legislation, the government has provided more IRS funding to help close the tax gap — the difference between what taxpayers owe and what the IRS actually collects. In fact, several tax proposals rely on revenue received from unpaid taxes to minimize tax increases.
Since audit risk rises with the size of assets and income, it is not a surprise that real estate is often a factor in being part of an IRS audit with many larger taxpayers. The IRS generally uses data from third party information that helps them match smaller tax returns, so they tend to avoid auditing data they already have. Real estate is a long-term asset without much third party reporting nor tracking of deductions for real estate such as depreciation, maintenance and repair expenses. Regardless of the source of income, the tax issues for your return and the size of your assets, be prepared to act if you receive a letter from the IRS. The process can be drawn-out and tedious, so preparing for frequently audited issues with real estate may make this process much easier.
Related Read: Tips to Avoid an IRS Audit: Real Estate
Need to know audit topics
Your return may have been chosen for examination for many reasons. It could be chosen randomly, it could be a problem in accepting your tax return or it could be because the IRS needs additional information from you. Since your tax return does not include all details of your personal or business taxes, it is important not to assume what the specific reason is for being chosen. Even if the IRS suspects mistakes or misstatements, you should first review if you have properly prepared and filed the tax return, and then respond with appropriate data and support.
Real estate issues arise in many forms and categories. The ownership of real estate is often a combination of acquisition, improvement and development costs. The details of these steps should be maintained in a permanent file that shows support and funding for the overall cost.
When property is used in a business or rental activity, it is eligible for depreciation of the cost. The overall cost of the building and structures is generally a 27-year asset for residential costs and a 39-year asset for commercial costs. Any depreciation expense should be computed and deducted to be consistent with these asset lives. For many assets, the tax law has expanded the tax depreciation to deduct components of buildings over a shorter period or asset life. These categories include qualifying improvements, tangible personal property and building systems such as electrical assets, plumbing systems and HVAC, which provide a larger depreciation annually and are eligible for accelerated depreciation under bonus depreciation allowances. The documentation for categories is more detailed and may require a cost segregation report to make the proper calculation and allocation of grouped expenses and acquisition costs. It should factor in the cost of land which is generally not a depreciable asset for tax reporting purposes.
Real estate also requires accounting for maintenance, repairs and other annual costs of keeping the property in its current condition. In addition to the documentation of the assets, these recurring costs are deductible when they are tied to the use of the property in an income-generating rental or business activity. Many tax issues arise if property has temporary loss of revenue or rental, if property has mixed or personal use or if costs are not specific or clear.
Some of the common real estate issues apply specifically to investors. Although cash flow is a measure of the tax results of investing in real estate, the investment can often lead to tax losses. An investor may be limited to deducting real estate losses for several reasons. First, the investor can deduct losses to the extent of having sufficient tax basis in their investment, which generally includes their share of equity and debt that they are “at risk” for the losses. The financing of real estate may create qualified nonrecourse liabilities if secured by the property and allocated to the investors. Second, an investor may not be active in management, which makes them a passive investor in claiming losses that are carried forward until there is passive income or a disposition. Some investors are real estate professionals and spend sufficient overall time in real estate to avoid passive loss limitations. Finally, some investments are structured as partnerships or funds, which have group allocations and limitations. In some cases, an audit can focus on a partnership and only after the audit reviews the group issues can the audit results be applied to the investor.
In recent years, the tax law has encouraged like kind exchanges of real property by providing an incentive to defer taxable gain on the sale and using a replacement property to rollover gain. Some of the steps needed for a like kind exchange include a 45-day period to identify any replacement property, completing a reinvestment transaction within 180 days and using a QI (qualified intermediary) to maintain any proceeds from the property sale in an escrow account. The tax law also added another deferred gain option with investments in Qualified Opportunity Zone real estate. With the real estate market becoming volatile and mortgage rates increasing with inflation, it may not be a surprise it is becoming more difficult to complete an exchange with these limits. The IRS frequently will audit real estate transactions to determine if the tax reporting is consistent with the requirements to satisfy the tax benefits of these opportunities.
Related Read: Prepare for IRS Plans To Increase Tax Audits
Need to respond appropriately
Most IRS audit notices include a deadline by which you are required to respond or schedule an appointment. Since it takes time to begin gathering the information and preparing a response, you will need to manage the next steps appropriately. This may include invoices, canceled checks and receipts, as well as your tax return for the year(s) in question. If you maintain a file of your documentation, make duplicates of any documents you will need to provide to the IRS, so you can maintain a clear record of your communication and avoid losing your only copy of a record.
Although it is critical to provide all of the information requested, you should avoid volunteering additional records, such as tax returns from years falling outside the audit’s scope. Many returns have items that create a pattern for many years, and adding more information may prompt more questions and create a more extensive audit. The IRS often has three years from the tax filing date to begin an audit, and if any of these years are available, the audit could be expanded to more years.
Need to evaluate the cost of owing money
Most taxpayers assume that there are errors and the IRS process will end with them owing money. In fact, audits often conclude with a tax liability unchanged. In some cases, the IRS ends its examination concluding that it owes money to the taxpayer, which may include interest. However, if you do have proposed adjustments, how much should you expect to pay? The final answer varies widely. Keep in mind that, in addition to the extra tax owed, you may be assessed interest and penalties if the basis and size of the adjustment resulted from large and obvious mistakes.
Although many audited taxpayers agree to any changes proposed by the IRS, you may disagree on the basis for the audit results. There could be a unique story of facts in your favor, or the tax law may be unclear on your situation. If so, you can appeal the decision through the IRS’s Appeals Office which will offer a second opinion on the results. Alternatively, you can take your case to Tax Court, which offers additional rights to appeal and the proper procedures to do so. Again, the cost of challenging the results may be more than the benefit of accepting the final results.
Consider the scenarios and options
Of course, many audits are not complicated and can be settled outside of appeals or Tax Court. It is best to determine how much help is needed to work through the process, and whether you should accept or disagree with the results. If you have any questions or concerns, please contact your ORBA Advisor or Tom Kosinski at [email protected] or (312) 670-7444 to review your personal tax situation.