The Internal Revenue Service (IRS) employs a multifaceted approach to identify rental income, like utilizing audits, data matching, access to public and governmental records, advanced technology for pattern recognition, and information from property management companies.
Landlords should be aware that failing to report rental income accurately can lead to significant penalties and interest charges. Maintaining thorough documentation of all rental transactions and being transparent in financial reporting is crucial for compliance with tax regulations.
By keeping accurate records of rental agreements, income received, and expenses incurred, landlords can not only ensure they are meeting their tax obligations but also provide necessary documentation in the event of an audit.
Read on to find out "How does the IRS know whether I have rental income?"
What is Rental Income According to the IRS?
According to the IRS, rental income is any payment you receive for the use or occupation of a property. You may deduct the property's expenses from your gross rental income in the year you pay the expenses.
Here's an example: You rent an apartment for $800 per month. In addition, you receive a security deposit from the tenants for $800 and additional fees of $50 per month for maintenance.
Expenses related to this property include a mortgage payment of $400 per month, insurance, landscaping fees and property taxes. You may deduct the first three expenses from your rental income. For property taxes, you may deduct any property tax paid on the property during a vacancy period. If you also had to repair the furnace for $1,000, you may deduct this expense from your rental income as well.
How Does Rental Income Reporting Work?
Individual taxpayers must report rental income on their return for the year they receive it. That means you'll include rental income on your individual income tax return. While you can deduct appropriate expenses, it's your responsibility to report the rental income.
If you don't, the IRS can get rental income information from routing tax audits, real estate paperwork, public records and whistleblower information. If you don't report rental income, you could face accuracy-related penalties, civil fraud penalties or possible criminal charges.
How Does the IRS Track Rental Income?
The IRS tracks rental income from various sources and uses this information to verify your individual income tax return. Not claiming rental income on taxes is a reason to be flagged for an IRS audit, and if you report incorrectly, you'll have to pay fees or other penalties. How does the IRS catch unreported rental income? Common sources of rental income information for the IRS include:
Schedule E on Form 1040
You must report rental income directly to the IRS using Schedule E on Form 1040. The IRS matches data from these forms with other sources, such as landlord reports, third-party reporting services and real estate information.
Tax Audits
Failure to report income, including rental income, is one of the biggest reasons for a tax audit. During a tax audit, the IRS reviews and examines individual accounts and finances to ensure information is reported correctly according to the tax laws and to verify the reported amount of tax is correct. Of course, this will also turn up any unreported rental income.
IRS Automated Underreporter Program
As the name suggests, this partially automated program matches your tax return against information gathered by the IRS. This extensive information includes returns and schedules that are much more detailed than W-2 and 1099 forms.
Loan or Refinance Applications
Loan or refinance applications are available to the IRS. If you were approved for a loan, this could suggest an additional property purchase that may be used as a rental property.
Property Tax Records
If you own additional properties beyond your primary residence, this will show in property tax records and is available to the IRS. It will compare your individual income tax return with property tax records. If you don't report rental income, this can become a discrepancy.
IRS Whistleblower Office
According to the IRS website, its Whistleblower Office “pays monetary awards to eligible individuals whose information is used by the IRS.” This award varies but can equal 15% to 30% of the proceeds collected with the whistleblower's information. That is a big incentive for informants to suggest that the IRS check whether you report rental income. If your after-expenses rental income is $2,000 per month, the whistleblower could gain $3,600 to$7,200.
Common Mistakes to Avoid When Reporting Rental Income To The IRS
Ready to ensure you accurately report all rental income to the IRS? The consequences of these mistakes, including fines and penalties, can be avoided with accurate, careful reporting. Here are the most common mistakes taxpayers make when reporting rental income and how to avoid them:
Failing to Report All Income
The most obvious mistake is failing to report all income. You must include fees, deposits and all other income received related to the rental property. Then, double-check numbers to ensure you didn't miss a zero or accidentally only reported part of the year.
Deducting Expenses that Aren't Allowed
You may only deduct expenses that are exclusively related to renting out your property. You can't add on personal expenses. For example, you may deduct landscaping expenses or repair expenses of the rental property, but you cannot deduct the same expenses for your primary residence.
Failing to Keep Accurate Records
Failing to keep accurate records of rental expenses and income can make filing accurate tax returns difficult. You'll need to go back and gather all the correct information. Otherwise, taxpayers risk filing inaccurate returns and having to pay associated penalties and fees.
Misreporting Depreciation
Taxpayers may file an incorrect basis depreciation and calculate depreciation accurately on an annual basis. If you incorrectly report depreciation, you must file Form 3115 to correct the depreciation error and may need the help of a certified public accountant to ensure correct depreciation calculations.
Improperly Designating Personal Use
If you use the rental property for a vacation or other personal use, you cannot deduct any expenses from the time you occupy the property. In addition, according to the IRS, you use a rental property as a private dwelling if you use it for more than 14 days or 10% of the total days you rent it to others at a fair price in a given year. That means if you stay in the rental property for two months each summer, it's considered a private dwelling, and you won't be able to take the same deductions.
Reporting Rental Income Accurately
Rental income can be a powerful additional income stream that can give you financial freedom. Protect yourself and your income by setting up systems to report all income accurately. For those wondering, “Can I get away with not paying tax on rental income?” The answer is a strong no. But you can simplify reporting and management.
It's worth getting an app or tracking software to record all rental income and expenses to stay ahead of reporting rental income. When tax time rolls around, you're prepared. With a little planning, you'll be ready to avoid common rental income reporting mistakes while enjoying long-term financial growth from real estate investments.
Frequently Asked Questions
Where is rental income reported?
Rental income is reported on Schedule E on Form 1040 as part of your individual income tax return. You must report rental income annually as part of your total annual income.
Do you have to report rental income if there’s no profit?
Yes, you must report all income, including rental income. You can also report all expenses. If expenses are equal to income, you won’t have to pay tax on the rental income in most cases.
Is it possible to hide income from rental properties?
No, it’s never a good idea to attempt to hide income from rental properties. You could face significant penalties or fees if you fail to report rental income.