“Nothing is certain but death and taxes.” This quote credited to Benjamin Franklin is as true today as it was when he signed the U.S. Constitution over 200 years ago. When it comes to investing in real estate, taxes are often one of the least enjoyable tasks, especially the dreaded IRS audit.

An IRS audit is an examination of your accounts and financial information that ensures your taxes are accurate and comply with federal laws. While an audit doesn’t necessarily mean calamity, it can be a stressful, time-consuming, and expensive ordeal that’s best avoided when possible.

While there is no guaranteed way to completely avoid an audit, there are some steps you can take to reduce your chance of getting that feared notice that Uncle Sam wants to take a closer look at your taxes.

Basic Considerations

Whether you’re a full-time real estate investor or are simply exploring real estate as a side hustle, there are some general actions that can help you stay clear of an IRS audit. These principles apply regardless of what kind of income you report.

File a Tax Return Every Year

Even if you don’t think you made any money, owe taxes, or have much of an income, you still need to file a return. One of the biggest red flags for IRS audits involves missing returns. It will benefit you in the long run to have accurate records each year.

You also want to make sure you file on time each year. That doesn’t mean you can’t have a year or two when you need to file for an extension, but running late every year might raise some eyebrows at the IRS.

Stay Honest

It might be tempting to try to hide income or falsify information on your return. Not only can dishonesty make it more likely that you’ll get an audit notification, but you could face severe penalties.

According to Title 26 of the U.S. Tax Code, individuals or corporations that willfully commit tax fraud can be fined (up to $250,000 for individuals and $500,000 for corporations) or spend time in jail (up to five years).

Work with a Professional

There are tons of ways to manage your taxes each year. There are several tax preparers who claim they can reduce your taxes by a substantial amount.

Unfortunately, the IRS has a list of tax preparers who tend to push the limits year after year. These folks are more likely to trigger an audit than anyone else. Find a reputable tax preparer who understands the ins and outs of real estate investing.

Keep Accurate Records

It’s common knowledge that you should keep an accurate ledger of money spent and money earned from your investment property. While keeping these records is a critical part of preparing your taxes, a shoebox of receipts represents just the minimum effort.

Make a note in your accounting spreadsheet, on the receipt/invoice, or somewhere else in your records that helps describe the expense/payment.

Real Estate–Specific Considerations

Real estate lends itself to complex and somewhat confusing tax issues. That means real estate investors are under more scrutiny than other entrepreneurs and workers. There are several common tax situations for real estate investors to consider to help avoid an audit or at least be prepared if one comes your way.

Active vs. Passive

If your investment property or rental loses money, you may not be able to deduct those losses. Passive investors are those who don’t spend a lot of time participating in the property. This could be from the employment of a management company or in situations where you act as a silent partner in regular operations.

When an investor spends significant time managing and operating the property, they can earn the right to support deductions for real estate losses. To prove this to the IRS, you want to have a detailed log of the number of hours spent being involved.

Keep a daily calendar that outlines everything you do to show that your investment is full-time. Otherwise, you shouldn’t try to claim any losses.

The Sale Is in the Details

The goal of most investors is to buy low and sell high. If this happens and you have a gain on a real estate property, you must report this gain correctly. Of course, there are a host of tax deductions that you can make regarding your flipped property.

Some of the most popular are capital expenditures (expenses required to purchase the house, which can include closing costs, sales commission, etc.), renovation costs, business expenses (if you operate under an LLC or other business filing), and more.

Flipping a house often results in capital gains taxes. These special taxes are taxes on the profits made on the sale of your flip. There are numerous strategies to avoid or reduce capital gains taxes, including the following:

• Keep the house for more than a year. A fast flip is subject to short-term capital gains taxes, which start at 10% of the profits. Keeping the house longer helps reduce the tax.
• Document and claim expenses. The more expenses you have, the fewer taxes you’ll have to pay.
• Flip the home inside of a 1031 exchange. Within the strict rules and boundaries of a 1031 exchange, the IRS allows you to avoid paying capital gains taxes on the sale of your flip. Using a 1031 exchange is complicated and should involve a tax professional to ensure it is completed correctly.

Your job is to keep accurate records. The best method is to keep records knowing that an audit could come your way. One popular method is to use the “Four Ps” of expense tracking:

• Place: where the money was spent. This information is typically on your receipt.
• Price: how much was spent.
• Players: who was involved in the transaction: contractors, marketing teams, landscapers, etc.
• Purpose: why the expense was made. This information isn’t necessary for taxes, but it will come in handy if you go through an audit. Keeping this kind of record can also ensure you remember the important details years later.

Your tax professional can help ensure you claim everything correctly to stay off the IRS’s radar.

Don’t Be Suspicious

There will be years when the cost of maintaining your rental properties, making repairs, paying the mortgage and property taxes, and operating your investment business is more than what you bring in from the property. While the goal of these kinds of investment properties is to create enough cash flow to cover all your expenses, that may not always be the case.

There may be a year when your property needs major repairs or upgrades, like a new roof or complete remodel. Reporting a loss on your taxes isn’t necessarily a red flag by itself. There are cases, however, when an investor continues to lose money year after year. This activity may raise a few eyebrows, especially if it’s a small loss each year.

The reality is that you may have a few years of small losses, but even real situations can look suspicious. There may be times when it behooves you not to report a loss. You are legally required to report all your income, but you don’t have to report all your expenses.

You might find that omitting a few expenses now and again and showing a small net profit will take some pressure off of you. Of course, discuss this with your tax professional to ensure you make the right decision.

Dealing with an Audit

If you happen to have an audit come your way, don’t panic! An audit doesn’t necessarily mean you are guilty of anything or will be penalized. It does, however, mean a ton of hassle and the risk that the IRS will catch any mistakes.

The first thing to keep in mind is that you will only be notified of an audit via a letter in the mail. The IRS does not make phone calls to discuss taxes. There are quite a few scams out there where people try to take advantage of those who don’t understand the rules.

If you’ve kept good records, you can soar through your audit smoothly. If you don’t have the proper documentation for the deductions being questioned, the situation could turn messy. This is when you review bank statements to find the appropriate transactions.

Once you locate these expenses, you might be able to get official receipts. This isn’t something you’ll want to do alone, so make sure you work with a tax pro who offers audit programs.

Assuming you kept great records, just make sure you respond to the audit questions in a timely fashion. It’s also wise to request delivery confirmation from the post office to record that everything was delivered.

Prevention Is Key

The most sure-fire way to survive an audit is to avoid it in the first place. While there is no way to guarantee that an audit never comes your way, there are ways to reduce your risk. Keep in mind that your chances of being audited are somewhat low. According to CNBC, your chances of being audited are only about 1 in 220 (roughly 0.45%).

The exact things that can trigger an audit vary from year to year, but the IRS tends to keep an eye out for excessive deductions, misfiled capital gains, and repeated losses. These things may happen naturally, but they can be a little suspicious.

To avoid looking like you’re hiding something, it is paramount that you keep detailed and accurate records. This is a time when it’s better to overshare than to be concise. Audits can happen years after taxes are submitted. You don’t want to rely on your memory alone to explain why a certain deduction was necessary. Instead, you’ll have notes, receipts, and other supporting documentation that justifies an expense.

Ultimately, it’s worth the cost to hire an experienced tax professional who understands your investments and how to best leverage your situation for an excellent outcome. It’s worth considering purchasing a quality fast doc scanner and expense-tracking software for your receipts and other important paperwork. Some of the most popular options are Quickbooks, Expensify, and Zoho.

While no one wants to go through an audit, if you keep great records and work with a certified professional, an IRS audit will be nothing more than a minor inconvenience.