#8: Tips To Avoid An Audit If You Do A Cost Seg

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

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.

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.

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.

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.

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.

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.

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.

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.