When the IRS sees an opportunity to get more revenue they take it. As real estate investors we have an opportunity to itemize our deductions and enjoy some pretty great tax advantages. While it‘s great to take full advantage of these tax benefits and minimize our tax liability, we need to ensure that we are following the rules exactly and that we aren’t raising red flags for the IRS. IRS agents tend to focus on deductions that are most often taken advantage of inappropriately. The most common targets for the IRS are administrative expenses that are vague, entertainment and meals, and related party transactions. In the case of these three types of deductions it’s imperative that you document your expenses precisely in case there is an audit.
1. Administrative Expenses
When there are big expenses claimed on your taxes and there is not a clear logic trail or explanation as to what these expenses are it raises questions. These deductions are commonly categorized as administrative expenses and include credit card bills and other general expenses. Because these categories are rather all encompassing and vague IRS auditors tend to do a little more thorough look. This is an area where many businesses are guilty of deducting some expenses that are questionable at best.
When deducting administrative expenses on your tax return it’s best to break it down and be as specific as possible with a description of what the expense really entails. If you lump these expenses together in the “other expenses” category and don’t have an explanation you are asking for a closer look.
2. Entertainment and Meals
Deductions for entertainment and meals is often claimed a little (or a lot) more then is really intended in the tax law. Because the IRS realizes that businesses often overstate company parties and meals out it has become a target for further investigation. The rule is that a meal or entertainment expense can only be claimed if business occurs immediately before, during, or after the meal. Because the burden of proof is not with the IRS it is with the tax payer it is important to get a business card from who you were meeting with and take a few notes about what the meeting was about.
3. Related Party Transactions
Last but not least the IRS is taking a hard look at related party transactions. A related party transaction is simply doing business with someone that is part of your family, for example, loaning your sibling money, hiring a relative to do work, or selling assets to a family member. I’m not saying that you should avoid this tax advantage because it can be quite substantial it’s just important to properly document these types of activities and transactions.
So, now we need to be proactive about properly documenting and providing proof of all transactions that are deducted on our tax returns particularly in the target areas addressed above. Make sure to keep your files organized through out the year so your not scratching your head at tax time and not able to substantiate your claims. Having a simple and thorough system in place that you can quickly track and document all relevant data will keep you from scrambling when you get the audit notice in the mail. Remember, claiming these deductions will not automatically get you audited but it could and it’s in your best interest to be prepared for that or risk having to pay the IRS even more money.
What are some other audit risks? Any experiences bad or good with these audit targets?