An audit can be initiated by random selection, computer screening and related taxpayers. Once you are selected for a tax audit, you will be contacted by mail to begin the process of reviewing your records. At that time, the IRS will determine if you have any unreported rental income floating around. In most cases, a taxpayer must report all rental income on their tax return.
Generally, they use Schedule E (Form 1040) to report income and expenses from rental real estate. If you earn income through self-employment or rental income, a red flag may be embedded in your return. Unlike wage earners, sole proprietors or landlords may report income and expenses at their discretion, especially in cases where individuals receive cash or undeclared payments from clients or customers. There are two sets of rental income tax implications that landlords should be aware of.
The first is how the IRS treats the rental income your property generates. The second is how it treats the eventual sale of your rental property. The IRS can impose penalties on landlords who fail to report rental income. If the underreporting is a legitimate error, the IRS will collect its underpayment penalty, which accrues at a rate of 0.05 percent per month up to a maximum of 25 percent of the total tax due.
However, if a homeowner intentionally omits income on their return, the IRS will collect their fraudulent filing penalty, which can include 20 percent of the unpaid amount along with a penalty of 75 percent of the total tax due. These penalties are in addition to the taxes still owed. If you do not claim depreciation on rental property, you will still be hit with depreciation recapture tax. The first question is whether your property is formally rental property or a personal residence that you sometimes rent out.
Under the new law, a real estate trade or business that elects out of the interest deduction limit must use the alternative depreciation system to depreciate any of its residential rental property. Property that you own and rent to tenants for 15 days or more each year is considered rental property by the Internal Revenue Service. Although the Internal Revenue Service sends relatively few people to jail, the penalties they impose accumulate very quickly, and their methods of collecting unpaid taxes and penalties can be crushing. After deducting all expenses and depreciation on a property, rental owners can get another tax break.
In this situation, the taxpayer does not report rental income and does not deduct rental expenses. Publication 527, Residential Rental Property (Including Rental of Vacation Homes) has more details on personal use. If you buy residential rental property, you can divide the acquisition cost of the property (minus the value of the land) by 27.5 to determine your annual depreciation deduction. It will also count as income if the tenant pays for a repair or utility not required by the lease and then deducts that payment from his or her rental payment.
If the IRS audits your return, you need to fully document the rental income you have received, as well as every dollar of expenses you claim on your tax return. If you run into a rental property tax problem and are not sure what to do, consult a professional. To make sure you provide the IRS with the correct information, you will want to keep records of the management of your property. If you are only an individual with a rental property, you will probably use the cash basis method.
By using leverage wisely, you can use your investment capital to purchase more than one rental property while deducting the mortgage interest expense.