Introduction

The tax code is full of deductions for landlords. Before you can start taking advantage of these deductions, however, you need a basic understanding of how landlords pay taxes and how tax deductions work. This chapter gives you all the information you need to get started, including:

• how the IRS taxes landlords
• how tax deductions work
• how forms of property ownership affect landlord taxes, and
• IRS audits -- how they work and how to avoid them.

How Landlords Are Taxed

When you own residential rental property, you are required to pay the following taxes:

• income taxes on rental income and profits from property sales
• property taxes, and
• Social Security and Medicare taxes (for some landlords).

Let's look at each type of tax.

Income Taxes on Rental Income

You must pay federal income taxes on the income (rent and other money) you receive from your rental property each year. When you file your yearly tax return, you add your rental income to your other income for the year, such as salary income from a job, interest on savings, and investment income.

This book covers rental property deductions for federal income taxes. However, 43 states also have income taxes. State income tax laws generally track federal tax law, but there are some exceptions. The states without income taxes are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. For details on your state's income tax law, visit your state tax agency's website, or contact your local state tax office. You can find links to all 50 state tax agency websites at www.taxsites.com/state.html.

Income Taxes on Profits When You Sell Your Property

When you sell your property, any profit you earn is added to your income for the year and is subject to taxation. Profits from the sale of rental property owned for more than one year are taxed at capital gains rates. These rates are generally lower than income tax rates -- usually 20% lower, except for taxpayers in the lowest tax brackets. (See Chapter 5 for an example of the tax effects of a rental property sale.)

However, you may be able to defer tax on your profits -- perhaps indefinitely -- by selling your property through a like-kind exchange (also called a section 1031 exchange or tax-free exchange). This kind of exchange involves swapping your property for similar property owned by someone else. These property swaps are subject to complex tax rules that are beyond the scope of this book, since they have nothing to do with income tax deductions. For more information, see IRS Publication 544, Sales and Other Disposition of Assets.

Social Security and Medicare Taxes

Everyone who works as an employee or who owns his or her own business must pay Social Security and Medicare taxes. These are two separate taxes:

• a 12.4% social security tax, up to an annual income ceiling or cap -- in 2006, the cap was $94,200 per year, and
• a 2.9% Medicare tax on all employee wages or self-employment profits.

Together, these amount to a 15.3% tax, up to the annual Social Security tax ceiling. Employees pay half of these taxes themselves and their employers pay the other half. Self-employed people must pay it all themselves.

You may have to pay (and withhold) Social Security and Medicare taxes if you hire employees to work in your rental activity -- for example, if you hire a resident manager. The employer's share of such taxes is a deductible expense. (See Chapter 12.)

Fortunately, the income you earn from your rental property is not subject to Social Security and Medicare taxes. (IRC sec. 1402(a)(1).) This is so even if your rental activities constitute a business for tax purposes. (See Chapter 2.) This is one of the great tax benefits of owning rental property. A person who owns a hot dog stand must pay the 15.3% self-employment tax on his or her annual profits, whereas a person who owns a rental house or other real estate need pay no self-employment taxes on his or her rental income.

There is one exception to this rule, which will not apply to many readers of this book: you must pay Social Security and Medicare taxes on rental income if you provide "substantial services" along with the rental. This exception would apply, for example, if you owned a boardinghouse, hotel, or motel and provided maid service, room service, or concierge services. The exception does not apply to services commonly provided for residential rentals, such as repairs, cleaning, maintenance, trash removal, elevators, security, or cable television.

In addition, if you qualify as a real estate dealer, you'll have to pay Social Security and Medicare taxes on your annual profits. (See Chapter 2.)

Property Taxes

Property owners in all states pay property taxes imposed by cities, counties, and other local governments. They are a tax on the value of your rental property. Property taxes are not covered in this book.

How Income Tax Deductions Work

The tax law recognizes that you must spend money on your rental properties for such things as mortgage interest, repairs, maintenance, and many other expenses. The law allows you to subtract these expenses, plus an amount for the depreciation of your property, from your effective gross rental income (all the money actually earned from the property) to determine your "taxable income." You pay income tax only on your taxable income, if any. Expenses you can deduct from your income are called tax deductions or tax write-offs. These deductions are what this book is about.

Although some tax deduction calculations can get a bit complicated, the basic math is simple: The entire tax regimen for rental real estate can be reduced to the following simple equation:

Effective Gross Rental Income

minus Operating Expenses (including mortgage interest)
minus Depreciation and Amortization Expenses
= Taxable Income

(People who analyze real estate investments don't include mortgage interest as a real estate operating expense, but it is an operating expense for tax purposes.)

EXAMPLE: Karen owns a rental house. This year, her effective gross rental income (all the income she actually earned from the property) was $10,000. She doesn't pay tax on the entire $10,000 because she had the following expenses -- $5,000 in mortgage interest, $1,000 for other operating expenses, and $2,000 for depreciation. She gets to deduct these as outlined in the above equation:

Effective Gross Rental Income	$10,000
- Operating Expenses	6,000
- Depreciation and Amortization	2,000
Taxable income	$ 2,000

Karen only pays income tax on her $2,000 taxable income.

Many landlords have so many deductions that they end up with a net loss when they subtract all their deductions from their effective gross rental income. In that situation, they owe no tax at all on their rental income. This is especially common in the early years of owning rental property, when you haven't had time to raise the rents much. Indeed, it is common for landlords to have a loss for tax purposes even if they take in more in rental income than they pay in expenses each month.

Having a tax loss on your rental property is not necessarily a bad thing. You may be able to deduct it from other income you earn during the year, such as salary income from a job or income from other investments. However, there are significant restrictions on a landlord's ability to deduct rental losses from nonrental income. Many small landlords can avoid them, but not all. These restrictions -- known as the passive loss rules and at-risk rules -- are covered in detail in Chapter 16.

What Can You Deduct?

All tax deductions are a matter of legislative grace, which means that you can take a deduction only if it is specifically allowed by one or more provisions of the tax law. You usually do not have to indicate on your tax return which tax law provision gives you the right to take a particular deduction. If you are audited by the IRS, however, you'll have to provide a legal basis for every deduction you take. If the IRS concludes that your deduction wasn't justified, it will deny the deduction and charge you back taxes and penalties.

Landlords can deduct three broad categories of rental expenses:

• start-up expenses
• operating expenses, and
• capital expenses.

This section provides an introduction to each of these categories (they are covered in greater detail in later chapters).

Keep track of your rental expenses. You can deduct only those expenses that you actually incur. You need to keep records of these expenses to know for sure how much you actually spent and prove to the IRS that you really spent the money you deducted on your tax return, in case you are audited. Accounting and bookkeeping are discussed in detail in Chapter 17.

Start-Up Expenses

The first money you will have to shell out will be for your rental activity's startup expenses. These include most of the costs of getting your rental business up and running, like license fees, advertising costs, attorney and accounting fees, travel expenses, market research, and office supplies expenses. Start-up expenses do not include the cost of buying rental property. Up to $5,000 of start-up expenses may be deducted for the year in which they're incurred. The remainder, if any, must be deducted in equal installments over the first 180 months you're in business -- a process called amortization. (See Chapter 8 for a detailed discussion of deducting start-up expenses.)

Operating Expenses

Operating expenses are the ongoing, day-to-day costs a landlord incurs to operate a rental property. They include such things as mortgage interest, utilities, salaries, supplies, travel expenses, car expenses, and repairs and maintenance. These expenses (unlike start-up expenses) are currently deductible -- that is, you can deduct them all in the same year when you pay them. (See Chapter 3.)

Capital Expenses

Capital assets are things you buy for your rental activity that have a useful life of more than one year. A landlord's main capital asset is the building or buildings he or she rents out. However, capital assets also include such things as equipment, vehicles, furniture, and appliances. These costs, called capital expenses, are considered to be part of your investment in your rental activity, not day-to-day operating expenses.

The cost of your capital assets must be deducted a little at a time over several years -- a process called depreciation. Residential rental buildings are depreciated over 27.5 years. Capital assets other than real estate are depreciated over a much shorter period -- for example, vehicles and furniture are depreciated over five years. The cost of land is not deductible -- you must wait until land is sold to recover the cost. (See Chapter 5 for more on this topic.)

How Your Tax Status Affects Your Deductions

Owning rental property can be a business for tax purposes, an investment, or, in some cases, a not-for-profit activity. Landlords whose rental activities qualify as a business are entitled to all the tax deductions discussed in this book. However, those whose rentals are an investment lose certain useful deductions, such as the home office deduction. Tax deductions are extremely limited for landlords who, in the eyes of the IRS, are operating a not-for-profit activity.

Your tax status is determined by how much time and effort you put into your rental activity, and whether you earn profits each year or act like you want to. Most landlords who manage their property themselves qualify as for-profit businesses. (See Chapter 2 for more on determining your tax status.)

The Value of a Tax Deduction

Most taxpayers, even sophisticated businesspeople, don't fully appreciate just how they save with tax deductions. Only part of any deduction will end up back in your pocket as money saved. Because a deduction represents income on which you don't have to pay tax, the value of any deduction is the amount of tax you would have had to pay on that income had you not deducted it. So a deduction of $1,000 won't save you $1,000 -- it will save you whatever you would otherwise have had to pay as tax on that $1,000 of income.

To determine how much income tax a deduction will save you, you must first figure out your income tax bracket. The United States has a progressive income tax system for individual taxpayers with six different tax rates (called tax brackets), ranging from 10% of taxable income to 35% (see the chart below). The higher your income, the higher your tax rate will be.

You move from one bracket to the next only when your taxable income exceeds the bracket amount. For example, if you are a single taxpayer, you pay 10% income tax on all your taxable income up to $7,550. If your taxable income exceeds $7,550, the next tax rate (15%) applies to all your income over $7,550 -- but the 10% rate still applies to the first $7,550. If your income exceeds the 15% bracket amount, the next tax rate (25%) applies to the excess amount, and so on until the top bracket of 35% is reached.

The tax bracket in which the last dollar you earn for the year falls is called your "marginal tax bracket." For example, if you have $60,000 in taxable income, your marginal tax bracket is 25%. To determine how much federal income tax a deduction will save you, multiply the amount of the deduction by your marginal tax bracket. For example, if your marginal tax bracket is 25%, you will save 25¢ in federal income taxes for every dollar you are able to claim as a deductible business expense (25% x $1 = 25¢). This calculation is only approximate because an additional deduction may move you from one tax bracket to another and thus lower your marginal tax rate. For example, if you're single and your taxable income is $75,000, an additional $1,000 deduction will lower your marginal tax rate from 28% to 25%. The first $800 of the deduction will save you $224 in tax (28% x $800 = $224); the remaining $200 will save you $50 (25% x $200 = $50). So your total tax saving is $274, instead of the $280 you would get if, say, your taxable income had been $76,000.

The following table lists the 2006 federal income tax brackets for single and married individual taxpayers and shows the tax savings for each dollar of deductions.

Each year, the federal government adjusts income tax brackets for inflation. For current brackets, see IRS Publication 505, Tax Withholding and Estimated Tax.

You can also deduct your rental activity expenses from any state income tax you must pay. The average state income tax rate is about 6%, although seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) don't have an income tax. You can find a list of all state income tax rates at www.taxadmin.org/FTA/rate/ind_inc.html.

When you add up your savings in federal and state income taxes, you can see the true value of a tax deduction. For example, if you're in the 25% federal income tax bracket, a deduction can be worth 25% (in federal income taxes) plus 6% (in state income taxes). That adds up to a whopping 31% savings. (If you itemize your personal deductions, your actual tax savings from a business deduction is a bit less because it reduces your state income tax and therefore reduces the federal income tax savings from this itemized deduction.) If you buy a $1,000 computer for your rental activity and you deduct the expense, you save about $310 in income taxes. In effect, the government is paying for almost one-third of your rental expenses. This is why it's so important to know all the deductions you are entitled to take and to take advantage of every one.

You should get into the habit of thinking about your rental expenses in terms of "after-tax dollars" -- what the item really costs you after you deduct the cost from your income taxes.

Don't buy things just to get a tax deduction. Although tax deductions can be worth a lot, it doesn't make sense to buy something you don't need just to get a deduction. After all, you still have to pay for the item, and the tax deduction you get in return will cover only a portion of the cost. If you buy a $500 lawn mower to use for your rental properties, you'll be able to deduct less than half the cost. That means you're still out over $300 -- money you've spent for something you may not have needed. On the other hand, if you really do need a new lawn mower, the deduction you're entitled to is like found money -- and it may help you buy a better lawn mower than you could otherwise afford.

How Property Ownership Affects Taxes

How you own your residential rental property affects the tax returns you must file each year. The main ownership options for a small landlord are:

• sole proprietorship
• general partnership
• limited partnership
• limited liability company (LLC)
• corporation
• tenancy in common, or
• joint tenancy.

These can be sorted into two broad categories: individual ownership and ownership through a business entity. If you don't know how you hold title to the rental property you already own, look at your property deed.

Individual Ownership

Most small landlords (owners of from one to ten residential rental units) own their property as individuals -- either alone, or with one or more co-owners.

One Property Owner

If you own the property by yourself, you can take title to the property in your own name and be a sole proprietor for tax purposes. This is by far the simplest and easiest way to own residential rental property. Any rental income you earn is added to your other income, such as salary from a job, interest income, or investment income. Losses you incur can be deducted from your other income, subject to the restrictions discussed in Chapter 16. You report your rental income and losses on IRS Schedule E and attach it to your individual tax return. (See Chapter 18 for a detailed discussion of Schedule E.)

Two or More Co-Owners

If you own the property with one or more co-owners, you can take title in your own name as a tenant in common along with your co-owners. Each co-owner owns an undivided interest in the entire property. The interests can be equal or divided in unequal amounts, however the owners agree. The ownership interest of each owner should be listed on the property deed.

EXAMPLE: Al and Alice, brother and sister, buy a rental house together, taking title as tenants in common. They decide that because Al put more money down on the property, he should own a 60% interest and Alice 40%. This means that Al is legally entitled to 60% of the income the property generates and is supposed to pay 60% of the expenses. Alice gets the remaining 40%.

Each cotenant reports his or her share of the income and deductions from the rental property on his or her own tax return, filing Schedule E. Each owner's share is based on his or her ownership interest -- for example, Alice in the example above lists her 40% share of the income and deductions from the co-owned rental house on her Schedule E and pays tax on that amount. Al lists the other 60% on his own Schedule E.

If one cotenant pays more than his or her proportionate share of the expenses, the overpayment is treated as a loan to the other cotenants and may not be deducted. The cotenant who overpays is legally entitled to be reimbursed by the other cotenants. (IRS Reg. 301.7701-3(a).)

EXAMPLE: Alice from the example above pays 80% of the annual expenses for the rental house this year, instead of the 40% she should pay based on her ownership interest. She may not deduct her overpayment, which amounts to $10,000. Instead, it is treated as a loan to her cotenant Al. Alice is entitled to be repaid the $10,000 by Al. If he doesn't pay, she can sue him to collect. If he does pay, he can deduct the amount as a rental expense.

Co-Ownership by Spouses

Spouses who own rental property together typically take title as joint tenants -- rather than tenants in common. Joint tenants are treated exactly the same as tenants in common for tax purposes, but there are significant nontax differences. Joint tenants must own the property 50-50. In addition, joint tenancy always includes "the right of survivorship." When one joint tenant dies, his or her share automatically goes to the survivor. This is not the case with tenants in common, who can leave their share of the co-owned property to anyone they want. Unmarried people can also be joint tenants, but this isn't commonly done.

If a married couple who jointly own rental property file a joint income tax return, as most do, their joint ownership produces the same tax result as individual ownership by one of the spouses. This is because the spouses' shares of the income and deductions from the rental property are combined on the joint tax return.

EXAMPLE: Sam and Samantha are a married couple who jointly own an apartment building. They file a single joint tax return, so all their income and deductions from the apartment building are listed on a single Schedule E they file with their joint return.

Ownership Through a Business Entity

Instead of owning your rental property in your own name, you can form a business entity to own it, and own all or part of the entity.

EXAMPLE: Vicki and Victor, a married couple, own a small apartment building. Instead of taking title in their own names as joint tenants, they form a limited liability company (LLC). The LLC owns the building and they, in turn, own the LLC.

The tax deductions available from rental property are the same whether you own it in your own name or through a business entity.

This section provides only the briefest possible introduction to business entities. To learn more, refer to LLC or Corporation? How to Choose the Right Form for Your Business, by Anthony Mancuso (Nolo).

Type of Entities

There are several different business entities that can own rental property:

Partnerships. A partnership is a form of shared ownership and management of a business. The partners contribute money, property, or services to the partnership; in return, they receive a share of the profits it earns, if any. The partners jointly manage the partnership business. Although many partners enter into written partnership agreements, no agreement is required to form a partnership. A partnership can hold title to real estate and other property.

Limited partnerships. A limited partnership is a special type of partnership that can only be created by filing limited partnership documents with your state government. It consists of one or more general partners who manage the partnership and any number of limited partners who are passive investors -- they contribute money and share in the partnership's income (or losses) but do not actively manage the partnership business. Limited partnerships are especially popular for real estate projects that are owned by multiple investors.

Corporations. A corporation can only be created by filing incorporation documents with your state government. A corporation is a legal entity distinct from its owners, who are called shareholders. It can hold title to property, sue and be sued, have bank accounts, borrow money, hire employees, and perform other business functions. For tax purposes, there are two types of corporations: S corporations (also called small business corporations) and C corporations (also called regular corporations). The most important difference between the two types of corporations is how they are taxed. An S corporation pays no taxes itself -- instead, its income or loss is passed on to its owners, who must pay personal income taxes on their share of the corporation's profits. A C corporation is a separate taxpaying entity that pays taxes on its profits. C corporations are rarely used to own rental property.

Limited liability companies. The limited liability company (LLC) is like a sole proprietorship or partnership in that its owners (called members) jointly own and manage the business and share in the profits. However, an LLC is also like a corporation because its owners must file papers with the state to create the LLC and it exists as a separate legal entity.

Tax Treatment of Business Entities

Partnerships, limited partnerships, LLCs, and S corporations are all pass-through entities. A pass-through entity does not pay any taxes itself. Instead, the business's profits or losses are passed through to its owners, who include them on their own personal tax returns (IRS Form 1040). When a profit is passed through to the owner, the owner must add that money to any income from other sources, and pay tax on the total amount. If a loss is passed through to the owner, he or she can deduct it from other income, subject to the restrictions on deducting rental losses discussed in Chapter 16. Because pass-through taxation permits property owners to deduct losses from their personal taxes, it is considered the best form of taxation for real estate ownership.

Although pass-through entities don't pay taxes, their income and expenses must still be reported to the IRS as follows:

Partnerships and limited partnerships. These must file an annual tax form with the IRS (Form 1065, U.S. Return of Partnership Income). Form 1065 is used to report partnership revenues, expenses, gains, and losses. The partnership must also provide each partner with an IRS Schedule K-1, Partner's Share of Income, Credits, Deductions, etc., listing the partner's share of partnership income and expenses (copies of these schedules must also be attached to IRS Form 1065).

The partners must then file IRS Schedule E, Supplemental Income and Loss, with their individual income tax returns, showing the income or losses from all the partnerships in which they own an interest. Partners complete the second page of Schedule E, not the first page, which individuals use to report their income and deductions from rental property. (See Chapter 18.)

S corporations. These entities must file "information returns" with the IRS on Form 1120s, U.S. Income Tax Return for an S Corporation, showing how much the business earned or lost and each shareholder's portion of the corporate income or loss. (An information return is a return filed by an entity that doesn't pay any taxes itself. Its purpose is to show the IRS how much tax the entity's owners owe.) Like partners in a partnership, the shareholders must complete the second page of Schedule E, showing their shares of the corporation's income or losses, and file it with their individual tax returns.

LLCs. LLCs with only one member are treated like a sole proprietorship for tax purposes. The member reports profits, losses, and deductions on Schedule C, Profit or Loss from a Business. An LLC with two or more members is treated like a partnership for tax purposes, except in the unusual situation where the owners choose to have it treated like a C or S corporation.

Landlords who own their properties through business entities don't use individual Schedule Es to report their rental income or losses. Instead, the partnership, limited partnership, LLC, or S corporation files IRS Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation to report the income and deductions from the property owned by the entity. This form is very similar to Schedule E.

Why Form a Business Entity?

The primary reason small landlords form business entities to own their property has nothing to with taxes. Rather, they use business entities to attempt to avoid personal liability for debts and lawsuits arising from rental property ownership.

When you own rental property in your own name, alone or with co-owners, you are personally liable for all the debts arising from the property. This means that a creditor -- a person or company to whom you owe money for items you use in your rental activity -- can go after all your assets, both business and personal. This may include, for example, your personal bank accounts, your car, and even your house. Similarly, a personal creditor -- a person or company to whom you owe money for personal items -- can go after your rental property. The main creditor that rental property owners worry about is the bank or some other financial institution from which they have borrowed money to purchase their property. If they default on their loan, they could be personally liable for the debt. (However, this isn't always the case. It depends on the nature of your loan and how your state law deals with real estate foreclosures.)

If you own property in your own name, you'll also be personally liable for rental-related lawsuits -- for example, if someone slips and falls at your rental property and sues for damages.

In theory, limited partnerships, LLCs, and corporations provide their owners with limited liability from debts and lawsuits. (Only the limited partners in a limited partnership have limited liability. General partners are personally liable for partnership debts and lawsuits.) Limited liability means that you are not personally liable for the debts incurred by your business entity, or for lawsuits arising from its ownership of rental property. Thus, your personal assets are not at risk; at most, you'll lose your investment in the business entity (which, of course, is often substantial).

In real life, however, limited liability is often hard to come by, even when you form a business entity. Lenders may require small landlords who form business entities to personally guarantee any loans their entities obtain to purchase property. This means the landlord will be personally liable if there is a default on the loan. in addition, you'll always be personally liable if someone is injured on property due to your personal negligence. For example, if someone slips and falls on your property, they can sue you personally by claiming your own negligence caused or contributed to the accident. This is so even though your property is owned by a business entity, not you personally. You can far more effectively protect yourself from such lawsuits by obtaining liability insurance for your rental property. The cost is a deductible rental expense. (See Chapter 14.)

However, if you're dead set on owning your rental property through a business entity, the entity of choice is the LLC. It provides the same degree of limited liability as a corporation, while also giving its owners pass-through taxation -- the most advantageous tax treatment for real property. As a result, LLCs have become very popular among real property owners in recent years.

For detailed guidance about LLCs, refer to How to Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo).

The IRS and the Landlord

I-R-S. For generations, these three letters have struck fear into the hearts of Americans. Some landlords don't take deductions to which they are legally entitled because they are afraid of being audited. Others believe that the IRS has become a toothless tiger -- and take questionable tax deductions hoping that the IRS won't catch on. Which group is right? Is the IRS a clear and present danger or a phantom menace? Here are the facts.

For a detailed discussion of IRS audits, see Stand Up to the IRS, by Frederick Daily (Nolo).

Anatomy of an Audit

You can claim any deductions you want to take on your tax return -- after all, you (or your tax preparer) fill it out, not the government. However, all the deductions you claim are subject to review by the IRS. This review is called a tax audit. There are three types of audits: correspondence audits, office audits, and field audits.

Correspondence audits. As the name indicates, correspondence audits are handled entirely by mail. These are the simplest and shortest type of IRS audits, usually involving a single issue. The IRS sends you written questions about your tax return and may request additional information and/or documentation. If you don't provide satisfactory answers or information, you'll be assessed additional taxes.

Office audits. Office audits take place face-to-face with an IRS auditor at one of the 33 IRS district offices. These are more complex than correspondence audits, often involving more than one issue or more than one tax year. If you make less than $100,000 per year, this is the type of in-person audit you're likely to face.

Field audits. The field audit is the most comprehensive IRS audit, conducted by an experienced revenue officer. In a field audit, the officer examines your finances, your landlord and other business activities, your tax returns, and the records you used to create the returns. As the name implies, a field audit is normally conducted at the taxpayer's place of business, which allows the auditor to learn as much about you as possible. Field audits are ordinarily reserved for taxpayers who earn a lot of money. You probably won't be subjected to one unless you earn more than $100,000 per year.

How Landlords Get in Trouble With the IRS

When auditing small landlords, the IRS is most concerned about whether you have:

• underreported your rental income
• claimed tax deductions to which you were not entitled
• properly documented the amount of your deductions, and
• complied with the passive loss rules and other restrictions on deducting rental losses.

Records Available to Auditors

An IRS auditor is entitled to examine the records you used to prepare your tax returns, including your books, check registers, canceled checks, and receipts. The auditor can also ask to see records supporting your tax deductions, such as a mileage record (if you took a deduction for business use of your car). The auditor can also get copies of your bank records, either from you or your bank, and will check them to see whether your deposits match the income you reported on your tax return. If you deposited a lot more money than you reported earning, the auditor will assume that you didn't report all of your income, unless you can show that the deposits you didn't include in your tax return weren't income. For example, you might be able to show that they were loans, inheritances, or transfers from other accounts. This is why you need to keep good financial records.

The IRS: Clear and Present Danger or Phantom Menace?

In 1963, an incredible 5.6% of all Americans had their tax returns audited. However, by 2004, an IRS audit had become a relatively rare event and only .62% of all Americans were audited. There are several reasons for the change:

• The IRS workforce declined -- between 1995 and 2004, the IRS workforce declined by 16%; the number of revenue agents dropped by 35%.
• The IRS workload increased -- at the same time the IRS workforce was declining, its workload was increasing. Between 1995 and 2004, the number of tax returns filed increased 12%, reaching 174 million.
• Starting in the mid-1990s, the IRS began to emphasize taxpayer service, rather than enforcement. Staff work shifted from audits to service functions, such as answering taxpayer questions.
• Congress enacted new laws in 1998 that were intended to prevent perceived abuses by IRS agents and auditors. These new protections also made it more difficult for the IRS to go after tax cheats.

Both the IRS and the Congress are aware of the IRS's enforcement problems and have taken some steps to ameliorate them. The IRS has received moderate budget increases in the past few years and has placed a renewed emphasis on enforcement. The precipitous decline in audit rates that began in the mid 1990s has stopped, but audit rates remain at very low levels. However, the IRS commissioner promises that audit rates will go up in the next few years. With huge federal budget deficits yawning as far as the eye can see, it seems likely that this is one government promise that will be kept.

Audit Rates for Landlords

Are small landlords a target for the IRS? No one knows for sure, but the answer appears to be no. An analysis of over 1,200 tax returns conducted by a professor of statistics in the mid-1990s could find no correlation between filing Schedule E (the tax form used to report rental income and losses) and an increased risk of an audit. (See How to Beat the IRS At Its Own Game, by Amir D. Aczel (Four Walls Eight Windows, 1995).)

The IRS does not release any statistics on how many Schedule E filers are audited. However, it does release detailed audit statistics for individuals who are not in business and for business filers -- sole proprietors who file Schedule C, partnerships, and corporations. Given the fact that landlords don't appear to be an IRS audit target, it's not likely that small landlords are audited any more often than sole proprietors filing Schedule C -- they are probably audited less often.

Six Tips for Avoiding an Audit

Here are six things you can do to minimize your chances of getting audited.

Tip #1: Be Neat, Thorough, and Exact

If you file by mail (as you should) and submit a tax return that looks professional, this will help you avoid unwanted attention from the IRS. Your return shouldn't contain erasures or be difficult to read. Your math should be correct. Avoid round numbers on your return (like $100 or $5,000). This looks like you're making up the numbers instead of taking them from accurate records. You should include, and completely fill out, all necessary forms and schedules. Moreover, your state tax return should be consistent with your federal return. If you do your own taxes, using a tax preparation computer program will help you produce an accurate return that looks professional.

Tip #2: Mail Your Return by Registered Mail

Mail your tax return by registered or certified mail, return receipt requested. In case the IRS loses or misplaces your return, your receipt will prove that you submitted it. The IRS also accepts returns from four private delivery services: Airborne Express, DHL Worldwide Express, Federal Express, and United Parcel Service. Contact these companies for details on which of their service options qualify and how to get proof of timely filing.

Tip #3: Don't File Early

Unless you're owed a substantial refund, you shouldn't file your taxes early. The IRS generally has three years after April 15 to decide whether to audit your return. Filing early just gives the IRS more time to think about whether you should be audited. You can reduce your audit chances even more by getting an extension to file until August 15 or October 15 (the latest extension you can obtain). Note, however, that filing an extension does not extend the date by which you have to pay any taxes due for the prior year -- these must be paid by April 15.

Tip #4: Don't File Electronically

The IRS would like all taxpayers to file their returns electronically -- that is, by email. There is a good reason for this: it saves the agency substantial time and money. Every year, the IRS must hire thousands of temp workers to enter the numbers from millions of paper returns into its computer system. This is expensive, so the IRS only has about 40% of the data on paper returns transcribed. The paper returns are then sent to a warehouse where they are kept for six years and then destroyed. The IRS makes its audit decisions based on this transcribed data. By filing electronically, you give the IRS easy electronic access to 100% of the data on your return instead of just 40%. Moreover, if you file electronically, you cannot add written explanations of any deductions the IRS might question (see Tip #5). No one can say for sure whether filing a paper return lessens your chance of an audit, but why make life easier for the IRS if you don't have to?

Tip #5: Explain Items the IRS Will Question

If your return contains an item that the IRS may question or that could increase the likelihood of an audit, include an explanation and documentation to prove everything is on the up and up. For example, if your return contains a substantial casualty loss deduction, explain the circumstances. This won't necessarily avoid an audit, but it may reduce your chances. Here's why: If the IRS computer determines that your return is a good candidate for an audit, an IRS classifier screens it to see whether it really warrants an audit. If your explanation looks reasonable, the screener may decide you shouldn't be audited after all.

Tip #6: Report All Your Rental Income

You should always report all the income you receive. The IRS has a pretty good idea how much money rental properties ordinarily bring in. If the income you list on your Schedule E looks disproportionately low for the size, location, or value of your rental property, your return may be tagged for an audit.