I would talk to your CPA because in the event you are audited, they are the one that needs to explain.

If I got audited, the poor little IRS agent gets to go through the boxes and they can sort them out for the source documents, I wouldn't let them see my photocopies!

Keep in mind that the deepest purpose of these records is a trail of evidence for you to use in the event of an audit. 

And if you go ahead and report it as an investment property on Schedule E anyway, and the IRS audits you and finds out it was a personal use property (which it sounds like it is), you had better have some money saved up for penalties and interest. 

I then asked the date of their last audit by the custodian. 

In general, smaller buildings in NYC are difficult to manage as they entail a slew of services (rent collection, bookkeeping, maintenance visits, tenant disputes, leasing, local law compliance, payroll, insurance, insurance audits, etc.) that aren't cost effective for the owner of a small building, and the fees aren't enticing enough to afford the best talent in property management space.

If you are audited, you may be requested to show that you’ve been renting the correct percentage of the new property.

My EA for my Audit says unless expenses for looking at an investment turn into an actual investment, the IRS does not consider them an expense.   

I've heard of audit cases from the California Dept of RE to ensure PM's, but yeah, the insurance seems steep so I wouldn't be surprised if they didn't have insurance.All that aside, ridiculous that they're suing both.

When properly established and utilized, a self-directed IRA or Solo 401(k) should not have any issues in the event of an IRS audit.