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There are many ways to reduce your chances of being audited by the IRS. As we've discussed in previous articles, the IRS has red flags for certain industries and tax filing behavior. Unfortunately, real estate investors and business owners stand a far greater chance of being audited than their salaried counterparts. In this article we will look at some tips on how you can avoid these red flags:
• Try not to use whole numbers on your return such as $15,000. This can look suspicious and raise a red flag. Always file the exact amount spent.
• Avoid using a Schedule C for your business. This is a huge red flag because business owners can hide income and claim personal expenses as business expenses. If you file as a partnership or S corporation, you will reduce your chances of being audited considerably. Partnership tax returns are the least audited type of tax return. LLCs are usually taxed as partnerships and are a great option as they also offer limited liability and flow-through taxation.
• Home office deductions can raise suspicion, but this can be avoided by filing a partnership or corporate tax return instead of using Schedule C.
• Ensure that your return numbers match the 1099s you receive from your broker, employer etc.. For example, if your 1099 from the broker shows $26,987 in proceeds from stock sales, the proceeds on your Schedule D of your tax return should be $26,987.
Tax returns are flagged for IRS audits for a number of reasons. They can be picked at random, or set apart by discrepancies in the numbers (your clients report $96,709 in gross income but you report only $65,000), or they can contain certain warning signals. Although the IRS doesn't disclose exactly what signals send up the red flag, here are a few ways to lower your chances of being audited.
Keep your deductions in line with your industry
The IRS rule of thumb allows you to deduct the cost of items commonly used by others in your profession—"reasonable" and "customary" are the keywords. It's perfectly reasonable for consultants to deduct cell-phone service—your clients need to be able to reach you, and you wouldn't otherwise have a fixed office number. If you have your own office, supplies are also common, but a second cell phone for your teenager is clearly not deductible, and a new stereo system for your office is questionable.
Deductions that exceed your business income, even in a start-up year, raise a red flag. Of course, if you're losing money, you'll want to take every possible deduction you can. Just be conservative with your deductions, especially if you can't avoid some of the other red flags.
Avoid sudden decreases in income
Unfortunately, a real estate investor's income can fluctuate wildly. Just beware that if you lose on a lot of deals or take some time off – a big drop in income will get the IRS's attention. If you report $200,000 in income one year and $53,000 the next, the IRS might come looking for the missing money. If you report a loss, the IRS may suspect that your business is a front for a hobby or other nonbusiness activity.
Although you can't guarantee all your deals will be a success, you can at least do the following when you know your income is going to drop:
• Try to avoid taking large deductions or shift them to a year of higher income. For example, if you know by April 15 that you won't make as much this year as last, you could decrease last year's net income by making a much larger retirement contribution than you had planned—perhaps even the maximum amount allowable. In effect, make both this year and last year's contribution now, decreasing last year's net and increasing this year's. Similarly, postponing large equipment purchases can help.
• Be prepared for an audit and ensure you have excellent record-keeping in place
***NEW CHANGES RE: REAL ESTATE REPAIRS***
New rules have made it more difficult to take a repair deduction if you fix something on an investment property. If you don't get the repair deduction, you have to capitalize the expense as an asset and then depreciate it over time. You may spend $10,000 to repair something, only to find out you can only take a deduction for a few hundred dollars. For obvious reasons, this couldbe very expensive for your business or real estate.
The IRS now dictates 8 different separate components of the property. An improvement/repair is determined based on the overall value of the specific component.
New regulations require you to divide up your property along the lines of a cost segregation study. You will be able to front-end load your depreciation, if you want, to create more of a tax loss. But this only works if you're able to take advantage of the loss against other income. This is important because not only does it take away the past potential issue with component segregation, but it is actually required to break down your property with something like a cost segregation study.
Here are some recent questions from my blog:
QUESTION: The other day I stumbled upon articles on segmented depreciation and how it increases the depreciation in early years by doing this. It sounds like little bit of work to segment the depreciation amounts but seems worth it if we have positive cash-flow. I am trying to reduce my positive income on schedule E and this seems like good way to do it at least for few properties
ANSWER: It can be a pretty simple or completed process. The main task is to look at the rental property and to see if you have any items in the property that are considered personal property or leashold improvements. Personal meaning moveable, does not cause structural damage, etc. Items like Fridge, Stove, cabinets would qualify.
Leasehold improvements are alterations to a building to make the space more usable. Some examples of leasehold improvements include: painting, installing retail counters, partitioning, replacing flooring, and building dressing rooms, among many other things.
If you determine that you have the above two items, you can now depreciate the personal property over 5 or 7 year and the leasholds over 10-15 years. This accelerates the depreciation because before now, the whole property cost was being depreciated over 27.5years.
I have also had clients who have used reasonable methods such as allocating a % to personal property like 20% and 20% to land and the 60% to the building. Then any rehab is considered improvements.
There is also a website that can help you gather your data if you want to be more sophisticated and they charge you for that.
QUESTION: I am a 60% owner of an LLC with 20 or so rental units in it. If this LLC were to buy a property and rent it to me, would this be a problem tax wise?
ANSWER: Because you own the LLC, it will be considered a personal use dwelling and subject to limits. Bottom line is that if you rent to yourself, you are not allowed to deduct expenses in excess of income
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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