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Hey there, fellow real estate investors, FIRE enthusiasts, and tax aficionados! Welcome to "Real Estate is Taxing" – your go-to weekly podcast for all things real estate taxes, hosted by Natalie Kolodij, EA- Real Estate Tax Strategist and dry humor extraordinaire.
Each week, we're breaking down complex tax topics into bite-sized, understandable explanations, with no regard for how many obscure references it takes to get there.
Speaker: Welcome to Real Estate is Taxing,
where we talk about all things real estate
tax and break down complex concepts into
understandable, entertaining tax topics.
My name is Natalie Kalady, I'm
your host, and I am so excited
that you've decided to join me.
Microphone (Shure MV7): Hello.
Hello everyone.
Welcome to today's episode.
If you didn't have a chance to listen to
last week's episode on cost segregation.
I would recommend circling back and giving
that a listen first, because it's a little
bit of a precursor to today's episode.
What I want to chat with you
guys about today is the, a word
we're going to talk about audits.
And anyone who knows me knows that I
am not someone who fear mongers audits.
There's a super low risk of audit.
And if you're doing everything correct.
There's really no huge impact.
Just a little bit of time.
So they're not the terrifying
thing they're made out to be.
But what we're going to
do with today's episode.
Is talk about a handful of things.
That myself
And colleagues I have who do audit
representation have seen recently.
Related to audits.
In the real estate space.
So the point of today's episode
is not to scare you guys.
The point of today is to go
through and share what's going on
and to give you proactive steps.
So that you can avoid being
in these same positions.
A lot of the items that
get pulled for audit.
Are things that can be easily avoided.
Or things you might not
know you should be doing.
So hopefully this episode lets you
check a few of these things off your
list and just puts you in a safer spot
Microphone (Shure MV7)-1: The first item
on the agenda is the mileage deduction.
This is a really common item
to get pulled for audit.
'cause a lot of people do a really
bad job at keeping these records.
If you have a vehicle that you
use for business and personal use.
You need to keep track of your miles.
Whether you are taking the standard.
Cost per mile, which allows you to
deduct a set amount per mile you drive,
or if you are taking actual expenses.
For either option.
You need to keep track of
how many miles you drove.
So the first thing is you should
be keeping a log of these miles.
If you drive for business,
you should be recording this.
Either in a written ongoing log
or using an app like mile IQ.
The next thing.
Is that you cannot count.
Commuting miles.
If you are driving from home to a place
of business that is considered commuting,
and those miles are never deductible.
If you are going from business location
to business location, like you were
going from a rental property to home
Depot and then over to another property.
Those business miles would be deductible.
The workaround to commuting miles.
Is having a valid home office.
If you have a qualified, dedicated
space that you work from in your
home related to your business.
Then, if you are going from that location.
To the property.
That is now business mileage, because
you're going business to business.
It's technically not commuting.
So that is the workaround there.
Something, we are seeing.
In more recent audits.
Is that they're asking for
more than just this log.
So for example, If your log shows
certain amounts of miles to a
store or to a property or to
any of these different places.
If you also have a receipt from your
purchase there with a timestamp and
things like that, that can really
show those check-in points, that's
going to help substantiate your log.
The other big tip for this section.
At the beginning of each year.
You should do something with your vehicle,
that results in a third party, recording
the amount of miles on your odometer.
Whether this is renewing your
registration, where you have to
get an inspection or having a
service done on your vehicle.
What you want is just a
formal piece of documentation.
And even with some of the reports, they
even will list to something like a Carfax
report, something from a third party that
shows how many miles are on the vehicle.
January 1st.
And if you do that every year, now
you have this proof that during the
year you actually drove 50,000 miles.
So saying 20,000, our business.
Isn't super unreasonable.
If you didn't have that proof.
And you said you drove that
many business miles, which is
more than most people drive.
It becomes a harder burden to prove.
Microphone (Shure MV7)-2: So the recap
of action items for this section.
Is that you are going to keep a
log of the miles you have driven.
Going to keep records of items
that will substantiate those
locations, such as receipts.
And the last big tip
that you are going to do.
Is take your vehicle somewhere
at the beginning of each year.
To have a formal third-party record.
Of how many miles are on
the vehicle at that point?
Microphone (Shure MV7)-1: The next item
Is real estate professional status.
This is something that comes up.
All the time in court cases.
I talk about these quite a bit.
And what we're seeing.
And rep work.
I have a colleague who does a lot of
representation for taxpayers with the IRS.
And they are seeing an increased
and audits related to real
estate professional status.
For a few different reasons.
The first reason is people who
in no way, shape or form qualify.
These are people who work a full-time job.
They've got one or two properties.
There's just no universe where they're
anywhere close to meeting the criteria.
And they either don't know or don't
care where we're just taking the gamble.
Microphone (Shure MV7)-3: Whatever the
reason for people in this situation.
The proof doesn't come down
to not having good records.
It's just literally not
qualifying to begin with.
So the action step for this section.
Is if you have a full-time W2
job, go ahead and assume that you
can not qualify for real estate
professional status at the same time.
There's always unique circumstances,
but out of all of the court cases
on this, I believe there's only been
one where it was allowed and it was
a very obscure working situation.
So typically, because you have
to spend more time on real
estate than anything else.
If someone has a full-time job.
It doesn't get very far in tax court.
The next part with real
estate professional status.
Is people who do qualify, but
have kept really bad records.
If you are claiming real
estate professional status,
you have to claim your time.
Your hour spent.
On your real estate activities.
You have to count your hours for
material participation on your rental
grouping or each rental activity.
And if you have an additional job
or business, You also need to track
your time there because you need to
prove that you spent more time on
real estate than you did on that.
So the first item here.
Is make sure you are keeping good logs
of these separate buckets of time.
That detail out.
Where you were, what you were
doing the times you were doing it.
And anything else that might be relevant
and just add a little more context.
If you are looking for a good
way to keep track of this time.
I do have a free real estate
professional time log.
That you can download from my website.
If you just go to natalie.tax.
And you can grab that free time log.
While you're keeping track of your time.
You want to be really mindful that
what you're recording is accurate.
Is not overinflated and
that it makes sense.
A common thread with tax court.
Is if they have reason to believe
part of your evidence is unreliable or
can't really be used or isn't accurate.
They now kind of doubt all of it.
So if you have part of your hours that
are inflated, or it's clear that you're
really pushing to like make up time.
If they see that now, even the valid
hours, they're going to start to question.
If you are looking for more context.
On what time should be included in this.
And how to set up your log
and what they want to see.
There is a passive activity,
audit technique guide.
And again, I'm a big fan of these.
The IRS is literally saying here's the
guide to how we're going to audit you.
Why wouldn't you look at that?
So check that out.
Look over their examples.
They even have lists of
questions for the auditor to ask.
Things that they're going to use
to try to poke holes in your story.
See, if you don't actually qualify,
kind of catch these specific things
that are often that string, that
they can pull to unravel the entire
claim that you would qualify.
Currently that audit log
isn't listed on the website.
They are in the process of updating it.
So it should be listed again
soon, once they finish.
Revamping it.
So keep an eye out for that.
And once it's back, download it,
familiarize yourself with it.
And make sure that if you are claiming
real estate professional status,
the way you are tracking your hours
and what hours you are counting.
Align with what you are allowed to do.
Per that audit technique guide.
Microphone (Shure MV7)-4: And the last
area we are going to touch on today.
Is cost segregation.
This is where it all ties together.
So this has come up pretty frequently
lately from a few different sources.
And there's a few reasons why.
The first thing is just
overall, the number of cost
segregation reports has gone up.
And these large amounts being written
off has gone up because cost segregation
has become much more affordable.
Over the last few years
than it used to be.
In addition to that between 2017 and 2022.
We had 100% bonus depreciation.
Which was a huge incentive
for getting a cost segregation
So that's the first reason.
The second reason is we've all
heard about how the IRS has
been hiring tons of new people.
They got all of this funding.
As a starting point, I'm not mad
about it and you shouldn't be either.
If you remember during COVID where
if you filed anything by paper.
It might just now be getting processed.
They were wildly understaffed.
We would try to call for clients
and literally could not get a human.
It was impossible.
They would just be like,
sorry, there's too many phone
calls, I guess, deal with it.
While simultaneously having the automated
system continue to send notices.
So that was a really fun time.
I'm glad we got to go on
that journey together.
But I am pretty glad that they do
have a little bit of staffing now.
The downside is part of that staffing.
Is people who are going to work in audit.
So there's a little bit of a trade off.
That being said, I'll
reiterate this again.
The point of the episode
isn't to scare you guys, audit
risk is still incredibly low.
The point is just to take these
proactive steps, to avoid the common
things that are easy to get dinged for.
In an audit.
So as part of that hiring
process, Where the IRS was getting
to bring on more employees.
Part of that was more engineers.
Historically, they didn't have a ton of
engineers on staff, which are the experts
who would do cost segregation studies,
Or who could analyze a study that
was done by a taxpayer and say, if
it was reasonable, under audit.
The IRS did not have a ton
of these qualified employees.
So historically the ones they
did have, they would spend.
Their time on larger projects on
conservation easements, cell phone
easements, things that if under
audit, they found things they could
disallow would result in a greater.
Collection of tax.
So they were just going where
their highest and best use was.
As part of this hiring process,
they're bringing on a few hundred
more engineers and they're about
two thirds through that hiring.
So just over the past couple of years, The
number of qualified people who are at the
IRS to look at cost segregation studies.
Has increased.
So those are the two biggest reasons for
seeing this increase in these audits.
Even though it's still not many.
They just used to be so, so low.
What I heard from a larger firm
was that where they'd see one
a year related to real estate.
Now they're seeing three.
And this is a firm with
thousands of clients.
So it's still not a huge risk.
You just want to be aware.
Microphone (Shure MV7)-7: The final
part of this episode is going to be
what we're seeing related to these
audits on cost segregation studies.
And what you can do to
avoid hitting these targets.
The first item is those DIY costs eggs.
Where you enter your own
information online and an
algorithm creates a report for you.
If at all possible, you want to get an
actual engineered cost segregation report.
They're going to cost a little bit more,
but they're going to be more reliable.
And in my experience that often
results in a bigger write off anyway.
So rather than taking the
risk, I would recommend getting
the full study to begin with.
Once you have a full study.
Be mindful that not all firms are created
equal and even the better firms out
there can make mistakes or do things that
might not be so buttoned up under audit.
Microphone (Shure MV7)-8: The
next pieces of information.
R what I've put together
after getting to review.
An audit report.
From a colleague who just had
a client audited for two of
their cost segregation studies.
So I had an opportunity to
look over that redacted report.
And here are a few of the common themes
and items that to me were the stand out.
Red flags the first thing was
that at a starting point, this
client had left off income.
On a couple of the years.
So again, that same theme where if the IRS
has reason to believe you're unreliable
or they can't count on your information.
They're going to continue
with that mindset.
So that was the first thing was
just, they started off inaccurate.
The next thing that the taxpayer was
dinged for was land and building value.
Talked about this a few episodes ago.
They had two studies done by different
firms, but both used a standard 85, 15 for
building and land versus an actual value.
So when the auditor saw this, they
said that is not a reasonable method.
And that was another ding against them.
Or the auditor could now go in
and readjust their land value.
The third item.
That was a picking point for the auditor.
Was some of the amounts from the
allocations into those shorter life
assets, just weren't reasonable.
There was a circumstance where
on one of the properties.
There was a single asset, something like
a fence or driveway, one single thing.
That was like 30% of all of the
building and improvement value.
So your action point here is
when you get this report, even
though you are not an expert.
You should still look at it because
you know what your property has
and what would be reasonable.
If you get this report back and
they list half of the value of what
you paid as the fencing, but you
know, this property only has a small
picket fence around part of the yard.
Red flag, ask more questions.
So just look over the reports for what
seems reasonable based on what you do now.
And ask questions if you're not sure
you don't need to know all of the
technical, just kind of common sense.
The next thing.
was lack of detail on additional items
added to the depreciation schedule.
This is something I see really often.
Where we just receive one lump sum
for something titled renovations
or improvements or kitchen remodel.
And it's just one price for everything.
One cost.
And so they were dinged for not
having more detail on what those
were, what the assets were that
were included in this $20,000 item.
So when you are doing a renovation,
You want to break out as much as
possible about those renovation details?
To give to your tax professional.
What I mean is if you are doing a kitchen
remodel, don't just say $30,000 kitchen.
You are going to break out
appliances and you were going to
break out farther refrigerator,
$1,200 stove, $800 listed all out.
For cabinets and countertops.
You're going to list
that out for flooring.
You're always going to
note what type of flooring.
What value of each type of
flooring you put into a property.
So if it's all flooring that is hardwood.
One price for all the hardwood.
If the property has some carpet,
some hardwoods, some tile.
You'll want an amount for each of
those because different flooring can
have a different depreciable life.
Depending on if it's
permanently a fixed or not.
And if your tax professional doesn't
know that your 10 grand a flooring
has actually three different types.
Than if you're audited, you
don't have the correct detail.
So always break out that detail.
The last thing that came up as
part of this audit and has actually
come up in conjunction with a
prominent court case on this that
I'm going to touch on real quick.
His kitchen fixtures.
All right.
So your kitchen cabinets,
countertops and sinks.
These were always a more aggressive item.
They started related
to commercial kitchens.
So the concept was if your rental
property was now a business asset,
similar strategy should apply here.
But bathrooms are specifically excluded.
So bathroom counters and sayings
and cabinets, that's not allowed.
Kitchens were allowed based on
this commercial use definition.
Dan still kind of a unique crossover,
cause we're still in a single family house
or an apartment, not like a restaurant.
So this has always been something.
That could be one of those
strings that an auditor pulls on.
So the advice here.
Is that if your return is
already more aggressive from
other strategies you're using.
Or if you are very risk adverse.
If you do a cost segregation
or you do a renovation.
Don't separate out those kitchen
components into five-year lives.
Go ahead and leave them on that full
life of 27 and a half years or 39.
If it's commercial.
Don't separate these out.
they're low hanging fruit
for the auditor to grab.
Microphone (Shure MV7)-10: And
the final connection on why all of
these breakouts of assets matter
and figuring out different flooring
types and all of these things.
It's because whether something is
permanently affixed to the property
and structural and a key component.
Or if it is somewhat tangentially
attached and is something that can be
replaced and separated, this is what
determines the useful life of that thing.
So there are several factors
called the Co-factors.
That are what make this determination.
And these look at how easily something
is to be moved, how much damage it
would cause how much time it would take.
How often just looking at like
common industry expectations, how
often would this item be replaced?
So all of these things are
looked at in conjunction.
To determine if something is permanently
affixed, in which case it would stay
on that 27 or 39 year life, or if it's
not, and it could be removed and would
be, or could be pretty frequently
without too much damage or cost.
So an example of this would be tile
floors versus floating LVP, right?
Tile, you can't really just pop it out and
swap it out without doing damage to the
flooring underneath it's a whole project.
It is pretty permanently attached.
Floating LVP is a different story.
Not nailed down, not mortared down,
it's a whole different circumstance.
So that's really what they're looking at.
And those factors are what you should
look at when you're being mindful of this.
And you can find them in
that audit technique guide.
These factors.
Also reference back to
a prominent court case.
That was referenced in that audit
report that we just talked about,
but comes up pretty often in
conjunction with cost segregation.
So this is the America south
case, and this was back from 2012.
But basically the ruling on this case
was that a cost segregation on an
apartment building wasn't allowed.
They looked at.
The parts of the apartment as
what would be required for it
to operate as an apartment.
Versus kind of the historical stance of
there being an overall building and what
was needed for the building to operate
and then separate components within it.
So this case kind of went against.
All prior guidance for the most part,
it was a whole different mindset.
This auditor really went in
on this and it was a multitude
of problems with this case.
The first one, being that the
original cost segregation report
that they had done kind of sucked.
Wasn't a good report.
It was inaccurate.
They claimed things that weren't
reasonable and they even pulled in
things like costs for utility lines and
electric lines that weren't the taxpayers
that weren't part of their property.
So the overall quality of the report.
Wasn't good to start with.
And this property was larger apartments.
So they had paid $10 million
for this apartment complex.
So this was almost 400 apartments.
This wasn't like a small study.
So that study moved.
Three and a half million dollars worth
of assets into those shorter life assets.
And these were five and 15 year assets.
The auditor disagreed with this.
And.
Said they were disallowing it, they
went through and they said most of
these assets didn't qualify and they
didn't agree with the allocation.
So the tax payer filed a
petition to challenge this.
But the problem was then the taxpayer
kind of S stopped participating.
They didn't send in any evidence.
They didn't go forward
with any of their argument.
So they kind of just dropped off and
then they just dropped discussion.
With both the IRS auditor and
also their legal counsel on this.
So it's a really unique case.
Because it just didn't actually go
through the way a case should've happened.
And then the court went ahead and
ruled, even though there wasn't.
Any further evidence
provided by the taxpayer.
They didn't have to do this.
They could have dismissed the case But
they didn't, they went ahead and ruled
and said they agreed with the IRS.
And that you couldn't do a cost
segregation report on apartments.
Microphone (Shure MV7)-11: So the big
problem with this America south case.
Is that.
It is something auditors can
now basically hang their hat on.
So if you have a cost segregation
study done, and there is any amount of
messiness to it, there's any string,
they can pull to unravel it a little bit.
They are basically coming in and
just straight up saying Amera,
south bitch and disallowing it.
That is their Trump card.
They're just throwing that down on
the table and using that overlying
guidance, just this one court case.
So the final takeaway, the final
action item for this episode.
Is.
Don't be terrified about it.
Don't not do cost segregation.
Just make sure that if you are
doing it, that you're using a
good firm, you're separating out
your land and building value.
You are doing all of these things that
are easy to get dinged for so that
an auditor doesn't come in and throw
down that America south card on you.
And just create a whole
headache related to your taxes.
So that's what I've
got for you guys today.
I hope you found it valuable.
I hope you're not terrified.
I hope you go read this audit technique
guide and I hope you read through
that America south case or some.
Reviews on it.
Some interpretations of it.
Cause it's incredibly valuable to
know if you are a tax professional
or a taxpayer who might do or be
involved with a cost segregation.
You want to know what auditors are going
to look for and you want to avoid the
low hanging targets for being audited.
So as always, if you guys have enjoyed
this episode, please subscribe,
share it, leave a review, and don't
forget to join us in the Facebook
groups linked in the show notes.
And if you want that real
estate professional time log.
Just hop on the website@natalie.tax
and you can download it there.
I hope everyone has a
fantastic rest of their week.
And I will chat with you guys next week.