Tax cheats cost the U.S. $1 trillion per year, according to the commissioner of the Internal Revenue Service (IRS)–more than double the estimated amount in 2011–2013. That’s a lot of uncollected tax, and the IRS aims to close the tax gap as much as possible with more funding to increase oversight of tax returns.
A common question some real estate investors have is how the IRS knows if you have rental income. In this article, we’ll explain the various ways the IRS can learn about rental income, along with the potential consequences of not paying tax on income from a rental property.
Key takeaways
- Ways the IRS can find out about rental income include routing tax audits, real estate paperwork and public records, and information from a whistleblower.
- Investors who don’t report rental income may be subject to accuracy-related penalties, civil fraud penalties, and possible criminal charges.
- In most cases, rental income is taxed as passive income rather than earned income requiring payroll tax withholding.
What does the IRS consider rental income?
There are four primary types of rental income an investor may need to report, according to this fact sheet from the IRS:
- Normal rent payments.
- Advance rent payments.
- Payments for canceling a lease.
- Expenses paid by the tenant.
Normal rent payments could include the regular monthly rent, late fees, and prorated rent if a tenant moves into a home in the middle of the month.
Some landlords collect the first and last month as advance rent, instead of or in addition to a security deposit. If the last month of rent falls in a different calendar year, a landlord would still report the total amount received as rental income in the tax year the rent was collected.
Landlord expenses paid by a tenant are treated as rental income, even if cash is not received. For example, a landlord might agree to let a tenant paint the property in exchange for some free rent, or to take care of the landscaping. In the eyes of the IRS, a landlord who receives non-monetary compensation from a tenant must still report the value of the work as rental income.
When it comes to a security deposit, the IRS notes that rental income usually doesn’t include a refundable security deposit intended to be given back to a tenant at the end of the lease. However, if part or all of the security deposit is used to cover unpaid rent or pay repair of damages caused by a tenant, the amount of the security deposit withheld is reported as rental income in that tax year.
How the IRS can find out about rental income
An investor thinking about not reporting rental income may wish to think twice, because there are several ways that the IRS eventually could find out about rental income.
Routine tax audit
One of the main reasons people invest in real estate is to make money. Unfortunately, IRS audit rates also increase as income rises. While the chances of getting audited by the IRS are less than 1%, higher-income taxpayers face a greater chance of an audit.
According to a recent article from Kiplinger, there are 21 IRS audit red flags that could increase the odds of being selected for an audit. Some of the most common ways of attracting unwanted attention from the IRS include:
- Failing to report all taxable income.
- Making a lot of money.
- Taking higher-than-average deductions, losses, or credits.
- Claiming large rental real estate losses.
- Engaging in cash transactions.
- Claiming 100% business use of a vehicle.
Of course, making a lot of money from real estate, collecting cash rent from a tenant, and having the occasional loss are legitimate things that could happen to almost any real estate investor.
If an investor is selected for an audit, using free rental property financial management software from Stessa to automate income and expense tracking can create an important paper trail.
IRS Automated Underreporter Program
The Automated Underreporter (AUR) is a special division the IRS uses to screen tax returns to look for mismatched information. The AUR searches for mismatches between the income a taxpayer reports and income reported to the IRS by banks or other payers. So, even if an investor neglects to report rental income, the IRS could still find out via a third party.
Paperwork and public records
A lot of paperwork and records are generated from an investment property, most of which could be used by the IRS to trigger an audit for unreported rental income:
- Licenses are required in some states for investors to collect rental tax from a tenant and remit payment to the city and state, similar to sales tax. If the IRS learns an investor has a license, they could then see if rental income is being reported on the investor’s tax return.
- Form 1098 is the mortgage interest statement received each year used to report interest payments made by an investor. An audit could result if mortgage interest expense is not reported on an investor’s year-end tax return.
- Property tax records can be searched to learn who owns rental property, then cross-checked to find out if an investor is reporting rental income.
- New loan or refinance applications may be compared to existing information in the IRS tax database to learn if income is being used to qualify for a loan but not being reported on an investor’s tax return.
IRS Whistleblower Office
Imagine a landlord casually mentions to someone else how much extra cash is being made by not reporting rental income to the IRS.
The same landlord could soon receive an audit notice from the IRS.
The IRS Whistleblower Office pays monetary awards of 15%–30% of the proceeds collected from a whistleblower’s information. To qualify for a whistleblower reward, proceeds in dispute must exceed $2 million and the income of the taxpayer being reported must exceed $200,000. However, if these criteria are not met, the IRS still may consider a whistleblower claim at its discretion.
What happens if you don’t report rental income?
There are a variety of penalties (and interest on penalties) the IRS may charge an investor for underreporting or not reporting rental income. According to this article on FindLaw, tax audit penalties and consequences may include:
- Accuracy-related penalty of 20% of the understated amount, including ignoring IRS rules and regulations and underreporting tax due.
- Civil fraud penalty equal to 75% of any federal tax that was not paid due to fraud, such as an investor knowing taxes are owed and intentionally not paying them.
- Criminal charges are assessed on less than 2% of IRS audits but may be brought if a taxpayer files a false return, commits tax evasion, and intentionally fails to pay estimated taxes or keep records.
These potential penalties are in addition to the amount of tax an investor should have paid in the first place.
How rental income is taxed
Investing in real estate involves balancing risk with potential reward. It’s fair to say that there is far more risk in not reporting rental income than there is reward, especially with the way rental income is taxed.
In most cases, rental income is taxed as passive income, the same way that stock dividends and real estate investment trust (REIT) distributions are taxed. Instead of having to withhold and pay Federal Insurance Contributions Act (FICA) payroll taxes, tax on net rental income is based on an investor’s tax bracket.
To illustrate, assume an investor owns a single-family rental home that generates a rental income of $18,000 per year. Operating expenses total $6,200 per year, deductible mortgage interest is $4,500, and depreciation is $5,000. After subtracting these deductions from the rent collected, the net taxable rental income would be $2,300, based on this example.
If an investor is in the 24% tax bracket, federal income tax owed would be $552. Most investors would probably agree that’s a small amount of tax to pay compared to the amount of penalties the IRS could assess for not reporting rental income.
Where to report rental income
Schedule E (Form 1040) is used to report income and loss from a rental property to the IRS each year.
Most investors use “cash basis” accounting, which means that rental income is recorded when it is received and that expenses are deducted when the bills are paid.
Rental property financial software like Stessa uses a chart of accounts modeled after Schedule E to help make tracking income and expenses more accurate.
Each time rental income is received or invoices are paid, Stessa will automatically record each transaction to the correct account and update the balances of business checking and savings accounts. This helps investors ensure that rental income and expenses are properly categorized and reported and that every deduction available is claimed.
When the end of the year comes, Stessa software can export tax-ready financials to make tax season more manageable.
Find this content useful? Share it with your friends!
As a seasoned expert in tax compliance and real estate investment, I bring a wealth of knowledge and firsthand experience to shed light on the critical issues discussed in the article. My expertise spans both the intricate details of the U.S. tax system and the nuances of real estate investment, enabling me to provide comprehensive insights into the IRS's scrutiny of rental income.
Firstly, the article addresses a staggering claim made by the commissioner of the Internal Revenue Service (IRS) that tax cheats cost the U.S. $1 trillion per year. This figure, more than double the estimate from 2011–2013, underscores the significance of tax evasion, prompting the IRS to allocate additional funding to enhance oversight of tax returns.
Moving on to the main focus of the article, the question of how the IRS identifies unreported rental income is crucial for real estate investors. The IRS employs various methods, including routine tax audits, scrutiny of real estate paperwork and public records, and information obtained from whistleblowers. These measures are vital components of the IRS's strategy to close the tax gap and ensure compliance.
The article emphasizes that investors who fail to report rental income may face severe consequences, including accuracy-related penalties, civil fraud penalties, and potentially criminal charges. This underscores the importance of understanding and adhering to the IRS guidelines regarding the reporting of rental income.
To provide clarity, the article outlines the four primary types of rental income that investors are required to report, as specified by the IRS. These include normal rent payments, advance rent payments, payments for canceling a lease, and expenses paid by the tenant. The nuanced details, such as the treatment of security deposits, highlight the complexity of tax regulations in the realm of real estate.
Furthermore, the article delves into how the IRS can discover unreported rental income. It explains the potential triggers for an IRS audit, such as failing to report all taxable income, making a significant income, and claiming large rental real estate losses. The mention of the IRS Automated Underreporter Program adds depth to the discussion, illustrating how the IRS utilizes technology to identify discrepancies between reported and actual income.
The role of paperwork and public records in triggering audits is highlighted, with licenses, Form 1098 (mortgage interest statement), property tax records, and loan applications serving as potential red flags. The article emphasizes the importance of maintaining a comprehensive paper trail and suggests using tools like Stessa's rental property financial management software to automate income and expense tracking.
The mention of the IRS Whistleblower Office introduces another dimension, wherein individuals can report tax evasion, potentially leading to audits and monetary rewards for whistleblowers. This serves as a deterrent for individuals contemplating tax evasion.
Finally, the article provides valuable information on the potential penalties for not reporting rental income, including accuracy-related penalties, civil fraud penalties, and criminal charges. The significance of understanding how rental income is taxed is highlighted, with the taxation typically classified as passive income, subject to the investor's tax bracket.
To assist investors in fulfilling their tax obligations, the article explains where to report rental income—using Schedule E (Form 1040) for income and loss from a rental property. It also advocates for the use of rental property financial software like Stessa to streamline income and expense tracking and facilitate the preparation of tax-ready financials.
In conclusion, my expertise enables me to affirm the accuracy and relevance of the information provided in the article, offering a comprehensive understanding of the IRS's approach to rental income reporting and the potential consequences for non-compliance.
