The United States IRS loses an estimated $1 trillion annually due to tax evasion, a figure disclosed by the commissioner of the Internal Revenue Service (IRS) that has more than doubled since 2011-2013. Because of this the IRS has begun intensifying efforts to reduce this gap with additional funding established under president Biden to be spent on increasing employees and enhancing oversight of tax returns.
Even so, there is one common question many real estate investors have and that is how does the IRS actually know if i have rental income? In this article, we will delve into the various methods employed by the IRS to identify rental income, shedding light on the potential repercussions individuals might face for failing to report income from rental properties.
What Does the IRS Consider Rental Income?
The IRS outlines four primary categories of rental income that investors are required to report, as detailed in their fact sheet:
- Normal Rent Payments: This encompasses regular monthly rent, late fees, and prorated rent if a tenant moves in or out mid-month.
- Advance Rent Payments: Landlords sometimes collect first and last month's rent as advance payment. If the last month's rent falls in a different tax year, the total received amount is still reported in the tax year when the payment was collected.
- Payments for Canceling a Lease: Any payments made for canceling a lease agreement fall under taxable rental income.
- Expenses Paid by the Tenant: Non-monetary compensations, such as a tenant providing services like painting or landscaping in exchange for reduced or free rent, are considered rental income. Even if no cash changes hands, the value of these services must be reported as income.
Regarding security deposits, the IRS generally excludes refundable security deposits from rental income, as they are intended to be returned to the tenant at the end of the lease. However, if a portion or the entire deposit is used to cover unpaid rent or repair damages caused by the tenant, the withheld amount is considered taxable rental income for that specific tax year.
How Does The IRS Know If I Have Rental Income?
There are a few ways the IRS can find out if you have rental income. This could be from a routine tax audit or it could be because an error or abnormality in your tax filing has triggered an audit.
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Below we outline some of the key ways the IRS will know if you have rental income.
Routine Tax Audit
While the probability of an IRS audit is generally low (less than 1%), individuals with higher incomes are more likely to be audited. Certain red flags, such as failing to report taxable income, substantial earnings, unusually high deductions or credits, significant rental real estate losses, engaging in cash transactions, or claiming 100% business use of a vehicle, could attract IRS attention. These factors, although potentially legitimate for real estate investors, might trigger audits.
IRS Automated Under-reporter Program
The IRS utilizes the Automated Under Reporter (AUR) division to detect inconsistencies between reported income and information provided by banks and other payers. Even if an investor fails to report rental income, the IRS can identify discrepancies through third-party sources.
Paperwork and Public Records
Various paperwork generated by investment properties can trigger an audit if not accurately reported:
- Licenses required in some states for collecting rental tax can alert the IRS to unreported income.
- Form 1098, the mortgage interest statement, must be reported accurately; inconsistencies may lead to an audit.
- Property tax records can be cross-referenced to identify unreported rental income.
- Loan or refinance applications may reveal discrepancies between reported and qualifying income, triggering IRS scrutiny.
IRS Whistleblower Office
Informants who report tax evasion to the IRS Whistleblower Office can receive monetary rewards ranging from 15% to 30% of the collected proceeds. To qualify, disputed proceeds must exceed $2 million, and the taxpayer's reported income must exceed $200,000. The IRS may still consider claims at its discretion, even if these criteria aren't fully met.
In light of these methods, maintaining accurate records and reporting all rental income truthfully is crucial to avoid legal consequences and penalties imposed by the IRS.
What Happens if you Don’t Report Rental Income?
The IRS can impose a range of penalties, including interest on these penalties, on investors who underreport or fail to report rental income. According to an article on FindLaw, tax audit penalties and consequences may involve:
- Accuracy-Related Penalty: This penalty amounts to 20% of the understated tax, covering situations where IRS rules are ignored or tax obligations are underreported.
- Civil Fraud Penalty: In cases of intentional fraud, where an investor knowingly avoids paying owed taxes, the penalty equals 75% of the federal tax that was not paid due to fraudulent actions.
- Criminal Charges: While criminal charges are rare (affecting less than 2% of IRS audits), they can be levied if a taxpayer files a false return, engages in tax evasion, or intentionally neglects to pay estimated taxes or maintain proper records.
It's essential to note that these potential penalties are additional to the original tax amount that the investor should have paid.
How Is Rental Income Taxed?
Investing in real estate involves managing risk against potential rewards. "It's evident that the risk of not reporting rental income far outweighs any potential benefits, especially given the tax implications associated with rental income," says says Jasen Edwards, chair of the Agent Editor Board at Agent Advice.
Typically, rental income is treated as passive income, similar to how stock dividends and real estate investment trust (REIT) distributions are taxed. Instead of dealing with Federal Insurance Contributions Act (FICA) payroll taxes, the tax on net rental income is calculated based on the investor's tax bracket.
To illustrate this, let's consider an example where an investor owns a single-family rental home generating an annual rental income of $18,000. After accounting for operating expenses totaling $6,200, deductible mortgage interest of $4,500, and depreciation of $5,000, the net taxable rental income stands at $2,300.
For an investor in the 24% tax bracket, the federal income tax owed on this rental income would amount to $552. Most investors would likely agree that this is a relatively small tax payment compared to the substantial penalties the IRS could impose for not reporting rental income accurately.
Related: Everything You Need to Know About Rental Income Tax
Where and How to Report Rental Income
Most real estate investors will report their rental property income and expenses on Schedule E (Form 1040) which is the designated section for reportingl income and losses from a rental property to the IRS.
The majority of investors follow a "cash basis" accounting approach, wherein rental income is documented when received, and expenses are deducted when the associated bills are paid.
Landlord Studio is a specialized property management and accounting software, with default expense categories in line with Schedule E requirements. Simply generate a Schedule E report at tax time and copy the details across.
With simplified income and expense tracking paired with powerful real estate accounting and automation tools, including a GPS mileage tracker, smart scan receipt scanner, and bank feeds you’ll be able to ensure every available deduction is claimed.
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