IRS Plans to Double in Size - What That Means for Investors

[Joe Splitrock]

More tax news out of Washington. The administration announced doubling the size of the IRS over ten years. This reverses the trend during the last administration of reducing IRS staff and scaling back the number of audits. They are also pushing for banks to increase transaction reporting efforts. Currently banks are only required to report suspicious activity or large cash transactions, but they are hoping for more transactional detail. The end goal is to crack down on people who are evading taxes. This covers three main areas; unclaimed income, illegitimate deductions and unpaid taxes. They are also concerned that crypto is a tax evasion vehicle. 

As with all proposals, the stated aim is "high income earners", which is an attempt to placate the masses, by convincing them that they will not be affected. In reality this is likely to affect small businesses and real estate, more than any other category. Even if you think you are doing things legitimately, it doesn't mean you can't get pulled into an audit or have your business questioned. Legitimate things can appear sketchy or you could be accidentally making errors. Here are a few ways it could affect real estate investors:

1. There are countless contractors out there offering "cash discounts", which is secret code for I don't pay taxes. You may pay with cash or with a check. Often those transactions go unreported to the IRS, because the investor doesn't send a 1099 and the bank has no reporting requirement due to the amount or type of payment. When more returns are audited and more bank information is available, it is easier to identify the fraud. A landlord could get pulled into an investigation. One way landlords can protect themselves is always send a 1099 when required. Avoid ever paying cash because it is not traceable and hard to prove you actually paid the money. If you believe the contractor is asking for cash to avoid taxes, make it clear you want the transaction legitimate. A landlord may say, "not my problem", but in some circumstances the IRS can collect taxes from you or fine you if the receiving party didn't pay them. There can be an argument if a rental business is passive or active and if 1099 is required, but why fight that fight?

2. Real estate has as many or more deductions as any other business. Landlords don't always know the difference between legitimate and illegitimate deductions. It is sometimes a grey area, so people use the rationale, "how can the IRS prove it isn't legitimate?" The answer is simple. The IRS has access to every return filed from every landlord. They know what deductions are typical based on size and type of property. For example, you may be house hacking and renting out rooms. You claim your cell phone, home office deduction and 100% of your utilities. The IRS knows that is not reasonable. You can't justify needing a dedicated office for one property. You can't justify the full expense of a cell phone when tenants live down the hall. You can't expense all your utilities, when you enjoy personal use of the space. New investors get excited about "all the deductions", but forget you must have legitimate business need before you claim something. Anything you use for personal use must have expense split with personal. If you are claiming mileage or car expenses, you need to have travel logs that show miles driven and business use. Document the purpose of every expense. Remember that the expense needs to be necessary and reasonable. Hiring a tax professional to guide you is an absolute must, because software like Turbotax only tells you HOW to claim the expense, not IF you actually should. 

3. Bank reporting could be used as a way to trigger audits in the future. As a landlord, make sure your business uses separate accounts from personal. Make sure every deposit is logged, stating which tenant, which property and the purpose of the payment like "June Rent". Make sure every payment logs the business use, not only in your check book log, but in your accounting software. All expenses should have a matching receipt. Keeping good records is the best way defuse any questions in an audit. Consider sending 1099 to contractors as a way to substantiate your expenses.

4. How you claim expenses could be scrutinized too. Be aware what expenses need to be depreciated, versus expensed. Follow bonus depreciation rules. If using cost segregation, make sure you have good documentation to support your claims (work with a professional). I have seen people claim massive first year losses by accelerating depreciation. When done legally, it is fine. Just realize any tax returns with high income, heavy expenses that result in low to no tax burden may stand out. The IRS isn't interested in scrutinizing people who pay taxes, just those who don't. 

5. Be careful of edgy strategies. This could be things like excessive deductions or I have heard people claim they did a 1031 exchange after only three months of owning a property. They say that their tax professional tells them they could "defend it and win in court". I would argue a better tax strategy would avoid the need to defend yourself. If you end up in court, you have already lost. If you are working extra hard to defend what you are doing as legitimate, that is an indicator you may be pushing it too far. 

I support everyone paying their taxes, but there are countless examples of the IRS bullying legitimate businesses. Throughout history the IRS has even been weaponized for political reasons, targeting specific groups for audits. Call me paranoid, but there is a high level of "real estate loophole" frenzy and "landlord hate" going on right now. Just be careful, because as much as tax strategies can help your business, it is not worth pushing the boundary to attract unwanted attention.