Reporting Rental Income: IRS Red Flags for Property Owners
Over the next decade, the IRS will receive $80 billion as part of the Inflation Reduction Act. A sizable portion of those funds is earmarked for tax enforcement and compliance. That means we can expect more thorough checks of our tax returns by the IRS in the upcoming years. For real estate investors, a focus on compliance may lead to agents examining your reported income more closely.
Calculating revenue is a hot topic for rental property owners, particularly since reporting too little or too much income comes with significant consequences. In this article, we’ll discuss the basics of reporting rental income, ways the IRS can learn about unreported revenue, and the potential results of incorrectly reporting your rental income.
Do I Need to Report Rental Income?
Short answer—yes.
According to the IRS, “any payment you receive for the use or occupation of property” is rental income. All income should be reported. Even if your real estate investments are operating at a loss, you’re still required to report the revenue.
How Does the IRS Know if I Don’t Report Rental Income?
If you’re ever tempted to skip reporting your rental income, just remember that the IRS has several ways of spotting understated or unreported income.
The IRS can check your return by using the Automated Underreporter program. It scans tax returns and looks for mismatched information. If your reported figures don’t agree with what banks or other payers report, the program flags the returns for further review.
Rental property comes with a paper trail. IRS agents can check real estate paperwork and public records to verify the information reported on your return. Some states require rental property owners to have licenses. Property tax records and reports about property sales include information about ownership and property use. Loan or refinance applications require income details. All of this information should support your reported revenue.
In the normal course of business, other companies will report information related to your rental property. Your mortgage lender will send both you and the IRS a Form 1098 showing your mortgage interest. If you don’t claim the interest on your return as an expense, that’s a red flag. Tenants may deduct rent as an expense on their returns if you rent commercial property. Property managers may report rental income to the IRS on your behalf.
Whistleblowers can provide information about your rental activities too. When certain criteria are met, whistleblowers may receive between 15 and 30 percent of the proceeds collected because of the tip.
Top IRS Red Flags Related to Rental Properties
Let’s not forget about routine tax audits. As your income increases, your chances of an audit also increase. During an audit, the IRS looks for common red flags, and several may apply to rental property owners:
Claiming 100 percent business use of a vehicle
Claiming rental losses
Engaging in cash transactions
Failing to report self-employment income
Running a business
Taking higher-than-average deductions, losses, or credits
Underreporting taxable income
Some of these situations are unavoidable in the rental property industry. But if you make an honest effort and provide supporting documentation, audits won't be an issue.
What Happens if I Fail to Report or Incorrectly Report Rental Income?
The funds from the Inflation Reduction Act may bring in an estimated $203 billion in additional tax revenue. That figure includes calculations for back taxes, fines, and penalties for unreported or incorrectly reported income. Even if an error isn’t intentional, inaccuracies in your reported revenue come with a price tag.
If the IRS discovers unreported or underreported income, that can lead to a complete review of your return. So you may face adjustments to your entire return, not just your income. At the very least, you’ll owe back taxes. That’s the remaining unpaid amount associated with your return. Besides back taxes, you may face fines, penalties, and criminal charges.
Accuracy-Related Penalties
These fines start at 20 percent of the understated amount. But for major misstatements, the penalty can go up to 40 percent. Any of these situations can trigger an accuracy-related penalty:
Ignoring IRS rules and regulations
Missing the payment deadline
Misstating the value of your property
Underreporting the tax due
Understating reportable transactions
Understating the value of a gift or estate
Civil Fraud Penalties
If you know you owe taxes and intentionally don’t pay them, that counts as fraud. The IRS can penalize you 75 percent of the federal tax that wasn’t paid.
Criminal Charges
Criminal charges result from less than 2 percent of IRS audits. But if you file false returns, commit tax evasion, intentionally do not pay estimated taxes, or willfully fail to keep records, the IRS may bring charges against you.
Is There a Limit on When the IRS Can Audit Me?
The limit for IRS audits is generally three years. However, if your return doesn’t include 25 percent or more of your gross income, that limit goes up to six years.
And if you file a fraudulent return—or fail to file—there isn’t a limit.
What if an Error on My Schedule E Was a Genuine Mistake?
It’s easy to transpose a digit or miscalculate, and the IRS understands that. A simple math error on a tax return is no reason to worry—the IRS will correct those when they review your return. If you forget to include a required form or schedule, they’ll request any missing information from you.
However, your return could include a mistake related to your filing status, dependents, total income, deductions, or credits. If you notice the error before the IRS does, file an amended return with Form 1040-X to correct any issues.
Even if the IRS catches the mistake before you do, don’t panic. You can cite the reasonable cause exception. If you can prove that you made a good-faith effort to report and pay the correct amount, you may avoid the penalties or interest. You’ll need to show that the mistake resulted from one of these situations:
A reasonable misunderstanding of the facts or laws
Dependence on the advice of a tax professional or CPA
Isolated errors in computation or transcription
Reliance on a third-party informational return, such as an employer’s Form W-2
The taxpayer’s experience, knowledge, and education
Use of erroneous information
You may disagree with the findings from an audit. If so, appeal the results by asking for an IRS review.
Takeaways
Rental income includes more than just a tenant’s monthly rent, but many real estate investors accidentally miscalculate their rental revenue. These errors come with significant costs, like interest, penalties, and audits. The IRS has multiple ways to double-check your returns, and if you intentionally don’t file a return, you’re always at risk—especially since we expect the IRS to increase its focus on enforcement in the coming years.
That’s why it’s more important than ever to stay on top of the books for your investment property. REI Hub’s specialized accounting software is designed for rental property owners. We help you keep track of reportable rental revenue, calculate income and expenses for your Schedule E, and organize your supporting documentation. Protect your business and get your books in order by signing up for our free 30-day trial today!
