IRS Audits for Real Estate Professional Status and Short Term Rentals

July 3, 2024 – This post has been updated with new information that goes beyond the scope of the podcast conversation.

Section 469 of the Internal Revenue Code (Real estate professional status and short-term rentals) is highly litigated. It’s important to understand how the IRS will audit positions you take so that you can proactively defend yourself against them.

Steps in an IRS Audit for Short-Term Rentals and Real Estate Professional Status

Step 1 – Receive an IRS Audit letter in the mail

The first step is perhaps what taxpayers fear the most. You will receive a letter in the mail notifying you that your tax return is being audited or examined.

The letter will state what tax year(s) the IRS is auditing and whether you are facing a correspondence audit (audit via mail) or an in-person audit (includes and on-site interview).

Step 2 – Contact your CPA

As soon as you can, contact your CPA. Though you will generally be given 30 days to respond to the initial audit notice, we have see taxpayers delay in contacting a professional service provider which will create pain the in the audit process.

Getting professional help is critical.

Professionals understand the audit process and will guide you through it. More importantly, professionals will keep the scope of the audit as narrow as possible which works to the benefit of many real estate professionals and short-term rental investors.

If you don’t have a CPA, schedule a consultation with us today.

Step 3 – Prepare requested documentation

The audit letter will request support for deductions you have taken.

For real estate investors, this generally includes expenses, such as repairs, maintenance, and labor, as well as depreciation.

If the auditor requests documentation for depreciation expense, prepare an asset report showing the cost of assets and when they were placed into service. If you ran a cost segregation study, review it with your CPA to determine if you will need more information from the firm who prepared the study.

Step 4 – Present your documents to the audit examiner

Once you have prepared your documentation, it’s time to present it to the auditor.

For correspondence audits, you will mail your documentation along with a memo summarizing your documentation and supporting authority for the positions you’ve claimed.

For in-person audits, you will walk the auditor through your documentation during the on-site interview.

The IRS examiner will then review your income streams and identify real estate activities. They will scrutinize your bookkeeping records and ensure you have proper support for deductions you have claimed. They will also review cost segregation reports and will likely have many questions about it.

As the auditor progresses through the audit, they may request additional documentation from you.

It is important to provide this documentation timely while ensuring it is exactly what the auditor requested.

Step 5 – Receive notification of the audit findings

After the auditor concludes their review, they will prepare and deliver to you a document that shows their findings and summarizes adjustments made to your income and tax liability.

At this point, you may have a limited opportunity to discuss with the auditor and help them come to a more reasonable conclusion.

Otherwise, your options may be limited to accepting the findings or formally appealing.

Note: IRS audits can be as short as a few months or much longer (think 12-18 months). Have patience as you progress through the process and make sure your CPA is with you every step of the way.

Why taxpayers lose IRS Audits of Real Estate Professional Status and Short-Term Rentals

Issue 1 – Under representation

Social media has exploded with inexperienced tax professionals mass marketing the STR Loophole and real estate professional status.

It’s a great tax strategy to get people excited about and it’s easy to teach.

But implementation and audit-readiness is not easy. And if you are battling the IRS, you will want a CPA team that fully understands the process, knows how to educate IRS auditors on the deduction, and can present your material participation case effectively.

You would think if you are working with a CPA you are covered, but unfortunately, we have found that not to be the case.

Some CPAs who are great at promoting the STR loophole and Real Estate Professional Status become hard to contact when their clients are audited by the IRS.

The “ghosting” leaves clients with high anxiety and feeling like they have no one to reach out to for help.

Worse still are CPAs who tell clients they can represent them but have no experience defending IRS audits. These CPAs make damaging mistakes that can expand the scope of an audit and put the taxpayer in a bad position.

Our team has experience assisting clients through real estate professional status and short-term rental audits. We can assist you and your CPA or attorney and we’ll advise on proper documentation and how to defend your positions related to Sec. 469 of the Internal Revenue Code.

Issue 2 – Poor recordkeeping and bookkeeping

Both real estate professional status and the STR loophole require that you prove material participation in the rental activity.

To prove material participation, you need a time log.

Your time log can’t have “BS” hours like education, research, and travel. And the time log needs to match your AirBnB/VRBO calendar and credit card statements.

If you said you were at the rental working, you’ll need to prove it.

Issue 3 – Logging time that does not qualify

Everyone wants to claim education, research, and travel time on their time logs.

It’s easy!

Unfortunately, that time won’t count. And it makes sense – imagine how many people would “materially participate” from the comfort of their own home if they could just listen to 100 podcast episodes about real estate investing.

If your accountant told you the hours count, it’s time to find a new one.

Issue 4 – Unable to substantiate participation in the rental activity

The IRS knows you can write down whatever you want in your time log.

So expect them to take steps to verify your time log’s legitimacy.

You said you were at your rental painting? You need to have receipts showing you bought paint and supplies.

You said you out worked your cleaners? You need to track their time (as you do any vendor).

Make sure your paper trail is 100% in line with what your time log claims.

IRS Audit Technique Guide for Passive Activities

The IRS Audit Technique Guide is guidance given by the IRS to IRS auditors. It’s their structural framework for conducting an audit. They include the relevant steps and questions.

Here are some assumptions from the guide:

• Rental activities, by nature, usually do not require significant day-to-day involvement
• For any taxpayers using outside property management, the only material participation test available is the 500-hour test
• In many circumstances, an individual rental activity will not require 500 hours of material participation
• Will the taxpayer have sufficient time available to spend at least 50 hours on each rental activity?

The guide also mentions the massive incentive for taxpayers to claim real estate professional status.

Specifically, the guide warns auditors about manipulated time logs.

Included in the ATG is a list of indicators that the taxpayer did not materially participate in the rental activity:

• The taxpayer was not compensated for services
• The taxpayer’s residence is hundreds of miles away from the rentals
• The taxpayer has a W2 wage requiring 40+ hours per week
• There is paid on-site management
• The taxpayer is elderly or has health issues
• The majority of hours claimed do not materially impact operations
• Business operations would continue uninterrupted if the taxpayer did not do the activities they logged

IRS Auditor Interview

“One of the first questions they’re going to ask you is to describe the work you perform as a real estate professional.”

The IRS examiner will try to gain clarity about all jobs you perform, including your W2. They will ask questions regarding whether you or your spouse is the real estate professional and what daily activities they have that may prevent them from working on the rentals. They will ask for the percentage of the real property trade or business that you own and, if you own 5% or less, your time working in real estate will not count.

For example, if you work for a property management company as a W2 employee, you aren’t a real estate professional unless you own 5% or more of the property management business.

“They’re trying to build a case, they’re trying to understand: do you actually spend what you say you spend in the rental real estate activity? If you’re keeping a time log, it should say the date, hours spent, services, performed, which property, and detailed notes of the activity. Your entries of notes need to be specific and unique to that day.”

“This is not an easy thing to achieve. If you want to achieve this, you really have to take it seriously. At the end of the day, it’s a business that you’re running. If you want real estate to be passive and hands-off, then that’s what it will be – a passive activity.”

If you’re not a real estate professional, it’s a better use of your time to embrace this fact and pursue other ways to generate tax-free cash flow.

“There are ways to create passive income and then use the rental passive losses to offset that passive income. Many of our clients are not real estate professionals, yet they have a portfolio that creates enormous cash flow, and they don’t pay tax on the cash flow. That’s the Warren Buffet approach: over time, I’m going to generate cash flow that I don’t pay tax on because everything offsets, so my effective tax rate on my total income goes down.”

For our next podcast series, Brandon and Thomas will dig into short-term rentals. Short-term rentals have exploded on the real estate scene lately, many of our clients are taking advantage of the short-term rental loophole. Yes, a loophole! Unlike REPS, there are characteristics of short-term rentals that could be considered a loophole!