The IRS recently did an audit of previous years tax returns and found out that landlords are cheating their taxes, whether they know it or not. This audit was conducted because in August 2008, the Government Accountability Office stated that “at least 53 percent of individual taxpayers with rental real estate activity for Tax Year 2001 misreported their rental real estate activity, resulting in an estimated $12.4 billion of net misreported income.”
The Treasury Inspector General for Tax Administration issued a report in December 2010 recommending increased scrutiny of tax returns with rental real estate activity, estimating that the change could recover over $27 million in lost revenue over 5 years.
No matter how honest you are on your taxes, owning rental property is an audit trigger since these reports were issued. Another area of high scrutiny by the IRS this year is landlords who are claiming to be a "real estate professional", which allows one to take the maximum passive activity losses. This type of classification requires more than 50% of a landlord's working hours and 750 or more hours each year materially participating in real estate as developers, brokers, landlords or the like. Look for the IRS to begin verifying these hours.
The federal government is starving, and they are looking for new income sources anywhere they can. Increasing IRS audits has proven to be highly lucrative for the IRS in the past, and this year and future years it's extremely likely they will continue to expand the scope of what they are auditing. If you do your taxes yourself and it doesn't appear to be crystal clear, I'd recommend consulting an experienced CPA. If your CPA seems OK with "grey areas", be very cautious. Don't risk it, audits are expensive even if you've done everything right.
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Nathan is a member of Rentec Direct who provides property management software, tenant ach payment processing, and tenant credit and criminal reports for property managers and landlords.
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