Can the IRS Find Out About My Second Rental Income?

If you’re a new real estate investor, you might ask yourself, “Can the IRS find out about my rental income?” The answer is simple: Yes, the IRS will know if you have rental income. And, if you try to avoid reporting it, you could face financial and criminal penalties.

According to the IRS, the tax gap in the United States is $696 billion. That’s the difference between Americans’ actual tax liability and the income taxes they end up paying.

Due to this significant loss in tax revenue, the U.S. government is taking additional steps to ensure everyone pays their fair share.

So, how does the IRS know you have rental income? Keep reading as we break it down and help you understand how to report your rental income accurately on your tax return.

What does the IRS consider rental income?

The IRS has published a helpful fact sheet for real estate investors to clarify what counts as rental income. Here’s what they include:

Normal rent payments: These are the regular monthly rent payments you receive from your tenants. They also include late fees and any prorated rent if a tenant moves in during the middle of the month.

Advanced rent payments: When a new tenant moves in, you might collect the first and last month’s rent upfront. Doing so is considered collecting advanced rent, and the entire amount is taxable in the year it’s received.

Payments for canceling a lease: If you receive a payment because a tenant cancelled a lease, you must report that amount to the IRS as rental income.

Expenses paid by the tenant: Non-cash compensation — such as a tenant providing services, like mowing the lawn or painting, in exchange for reduced or waived rent — counts as rental income. Even if no cash changes hands, you must report the fair value of the services as income.

Finally, tenants usually pay a security deposit when they move into a property, and landlords typically do not count it as income because they plan to return it at the end of the lease. However, if they use any part of the deposit to cover expenses or unpaid rent, that amount instantly becomes rental income.

How does the IRS find out about my rental income?

If you don’t report rental income to the IRS, how might they find out? It could happen through a random tax audit, a tip from someone who knows you’re hiding income, or IRS tools designed to detect tax evasion.

IRS Automated Underreporter Program

The IRS created the Automated Underreporter (AUR) to spot irregularities in tax returns. It compares what taxpayers report with what banks and other financial institutions submit. Even if you leave income off your return, the IRS can use third-party sources to uncover it.

Routine Tax Audit

According to the Tax Policy Center, the IRS audits about 0.3% of all annual tax returns. In the big picture, that represents a relatively small percentage of the American population. Still, routine (and, for the most part, random) tax audits are another way the IRS can uncover unreported rental income.

It’s also worth noting that the IRS focuses more on higher earners, meaning the more you make, the higher your chances of being audited.

According to TurboTax, here are some red flags to avoid if you want to avoid a tax audit:

• Failing to report income
• Taking the home office deduction
• Reporting business losses
• Reporting unusually large business deductions
• Making a lot of money or very little
• Making errors on your tax return

IRS Whistleblower Office

The IRS Whistleblower Office pays out rewards of 15% to 30% to people who report potential tax evasion, meaning if you cheat the IRS and confide in someone, they could profit from turning you in.

For the IRS to consider a whistleblower’s claim, the disputed amount must exceed $2 million, and the taxpayer must have reported at least $200,000 in income.

Paperwork and Public Records

Owning an investment property involves a significant amount of public records and paperwork, and the IRS has access to all of it. These documents can reveal unreported income and trigger an audit.

• Form 1098: Each year, you’ll receive a Form 1098 showing how much mortgage interest you paid on the property. If you don’t report this interest on your tax return, it could raise a red flag and trigger an audit.
• Licensing: As with sales tax, some cities and states require property investors to pay a rental income tax and, in some cases, obtain a license before doing so. If the IRS sees that you hold this license, they’ll expect you to report rental income each year.
• Property tax records: The IRS can cross-check property tax records to see who owns rental property and whether they’re paying taxes on that income.

How is rental income taxed?

The IRS taxes rental income in the same manner as it taxes other earned income. Your tax rate depends on which tax bracket you fall into. Below is a table to help you determine your bracket.

As an example, let’s pretend you have $4,000 in net rental income. This amount is what you earned from an investment property after deducting operating expenses, mortgage interest, and depreciation.

If your total income places you in the 24% tax bracket, you’ll pay $960 in income taxes.

How do I report rental income to the IRS?

Reporting rental income to the IRS isn’t difficult, but it requires accurate bookkeeping and the proper forms. Here’s a basic walkthrough of how to report rental income to the IRS:

1. Gather Documents and Update Your Bookkeeping

Before you file your tax return, ensure all your records are accurate. Doing so includes calculating your rental income and expenses from the past year. You’ll also need to understand the property’s cost basis, since that’s what you’ll use to calculate annual depreciation.

Using TurboTenant’s integrated accounting tool can help you keep your bookkeeping accurate and reduce stress during tax season.

2. Fill Out Schedule E

As a real estate investor, you’ll need to fill out a Schedule E form, which includes details about the property, such as the address, property type, and total rental days for the year.

You’ll also use Schedule E to report rents received and all related expenses. With that information, you can calculate the property’s net profit or loss, which you’ll then transfer to your Form 1040.

Remember that most investors report income and expenses using the “cash basis” method, meaning they report income in the year it is received and expenses when they are paid.

3. Fill Out Form 4562

When you claim the depreciation deduction on a rental property, you must also fill out Form 4562, which will let you deduct a portion of the property’s cost over a 27.5-year period.

4. File All Forms

Once you’ve completed your documentation, you’ll file Form 1040, Schedule E, and Form 4562 with the IRS.

If you live in a state that collects income tax, you must also file a state return. Requirements vary depending on the state.

What happens if I don’t report rental income to the IRS? 

The last thing you want to do is fail to report rental income to the IRS, even if you’ve done so unintentionally. If the IRS discovers unreported income, it can initiate a full audit of your tax return. You could end up owing back taxes, facing penalties, and, in some cases, doing jail time.

Here’s a closer look at the penalties you could face for not reporting rental income:

• Civil fraud penalties: If you knowingly owe taxes but fail to report them, the IRS considers it fraud. You could face a penalty of 75% of the amount owed.
• Accuracy penalties: If an audit reveals errors on your return, the IRS can impose penalties ranging from 20% to 40%, depending on how severe the issue is.
• Criminal charges: Fewer than 2% of audits result in criminal charges. But if you commit tax evasion, file a false return, fail to file, or intentionally avoid paying estimated taxes, you could face criminal prosecution and jail time.

The Bottom Line

If you have rental income, the best thing you can do is make sure you report it accurately on your tax return. TurboTenant’s rental property accounting software syncs your rent payments, expenses, and bank accounts, helping you avoid unexpected errors.

TurboTenant will also help you with many other parts of your rental property business, including:

• Property advertising
• Rental applications
• Tenant screening
• Lease agreements
• Rent collection

Sign up for a free TurboTenant account today to immediately streamline your property management operation.

Disclaimer: This blog is for informational purposes only and is published by TurboTenant. It is not legal, financial, or tax advice. Laws and regulations for landlords vary by state and locality and may change over time. Always consult a qualified attorney, accountant, or local housing authority before making decisions related to your rental property. The publisher and authors assume no responsibility for actions taken based on the information provided.

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