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I actually did exactly what you're considering about 3 years ago with our rental business. We switched from taking mostly W2 to a smaller salary with quarterly distributions. BIG MISTAKE. We got audited the following year, and the IRS determined our W2 salaries were unreasonably low compared to our responsibilities and distributions. They reclassified about 70% of our distributions as wages subject to employment taxes, plus penalties and interest. Our tax bill ended up being much higher than if we'd just maintained appropriate W2 compensation in the first place. Don't get greedy trying to avoid FICA taxes - the IRS has seen every trick in the book with rental businesses.
Wow that's scary. What was your W2 to distribution ratio that triggered the audit? Were there any warning signs before they came after you?
We went from 100% W2 to about 25% W2 and 75% distributions, which was way too aggressive. There weren't any specific warning signs before the audit notice arrived. They simply selected our return for examination. During the audit, they looked at our involvement in the business, the services we performed, and comparable salaries in our area for property managers. They determined that our "reasonable" salary should have been around 65-70% of what we were taking out of the business.
Has anyone considered the potential impact on mortgages and loans when switching from W2 to distributions? I made this switch with my property management company and then tried to refinance my primary residence. The bank gave me a MUCH harder time qualifying with distribution income versus W2 income. They wanted 2 years of tax returns showing consistent distributions and still counted it as less reliable than employment income. Just something to consider if you're planning to apply for any financing in the next couple years!
This is such an important point! I had the same issue when trying to get a construction loan for a new property development. My lender basically ignored my S-Corp distributions as qualifying income and only counted my W2 earnings, which made my debt-to-income ratio look terrible.
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Has anyone considered the potential partial interest rules here? If the property has a mortgage or if the OP is only donating a portion of the property rights, that complicates things significantly. The charitable deduction could be limited in ways beyond just the AGI limitations others have mentioned.
Good point! I donated a fractional interest in a property once and it was a paperwork nightmare. The IRS scrutinizes partial interest donations very carefully. OP, do you own the property outright or is there still a mortgage?
Don't forget about state tax implications too! Depending on your state, the rules for charitable deductions of property might differ from federal rules. Some states limit itemized deductions or have different AGI percentage limitations. In my state (CA), they have additional documentation requirements beyond what the IRS asks for.
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Make sure to send your response via certified mail or some international equivalent that gives you tracking and delivery confirmation! I had a similar situation and the IRS later claimed they never received my response. Without proof of delivery, I had to go through the whole process again.
That's a great tip! Do you know which international shipping methods the IRS accepts as proof of delivery? I'm in Germany so I assume Deutsche Post has some options, but not sure which ones the IRS recognizes.
Any service that provides tracking and delivery confirmation should work. DHL, FedEx, and UPS are all recognized by the IRS. Deutsche Post's registered mail service (Einschreiben) should also work fine. The key is getting a tracking number and delivery confirmation you can save. The IRS doesn't specify which carriers they prefer - they just need verifiable proof you sent it by a certain date and that they received it.
Just want to point out - since you already PAID your taxes, this is mostly a paperwork issue and not something to panic about. The IRS cares most about getting their money, which they already have. I had a similar situation (though domestic) and just sent in the signed form with a brief explanation. Never heard anything else about it. They just needed to check the box that they had my signature.
This isn't entirely accurate. An unsigned return is technically not a valid return, even if taxes were paid. The IRS can assess failure-to-file penalties in some cases if they don't receive a valid signed return, regardless of payment.
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Always request a transcript of your account directly from the IRS before assuming payments have been "lost." You can get this online by setting up an account at irs.gov or by filing Form 4506-T. This will show all payments received and credited to your account. In your case, both payments should show up on the transcript. The IRS will eventually figure out the overpayment and either refund it or apply it to next year, but you can expedite this by filing Form 843 (Claim for Refund) along with proof of both payments. Include copies of both canceled checks or bank statements showing the withdrawals.
Does this work for state tax overpayments too? I overpaid New York state by about $3k and wondering if there's an equivalent process.
For New York State overpayments, the process is different. You'll need to contact the NYS Department of Taxation and Finance directly. They don't have a direct equivalent to the IRS transcript system, but you can request an account statement by calling 518-457-5181. For a $3k overpayment to NYS, you should file Form DTF-973 "Request for Refund of Overpayment or Credit Balance." Include all documentation showing both payments (bank statements, canceled checks, confirmation numbers). New York is generally faster than the IRS in processing these requests - typically 4-6 weeks rather than 8-12 weeks.
Isn't there a way to prevent this from happening in the first place? My CPA always sends me a detailed "action required" email before submitting any payments. I have to explicitly approve any payments through a secure portal. I thought this was standard practice?
That's how my accountant works too. We get a secure message that says "APPROVAL REQUIRED" in the subject line with a breakdown of what's owed and a checkbox to authorize payment. Nothing happens automatically.
Thanks for confirming! I'm going to stick with my current accountant then, as that process seems much safer. I think the takeaway here is that we should all clearly establish payment procedures with our tax preparers at the beginning of the engagement, and get it in writing. As tax preparation becomes more digital, these authorization processes need to be more explicit, especially when we're talking about potentially large sums of money being transferred. I'd recommend everyone have a specific conversation about payment authorizations with their accountant before tax season next year.
Marcelle Drum
Everyone's giving great advice about qualifying as a real estate professional, but let's not forget about the basis limitation and at-risk rules. Even if you qualify as a real estate professional, you can only take losses to the extent of your basis in the partnership. Since you mentioned it's a new investment with bonus depreciation, make sure you have enough basis to actually claim the losses. Your initial capital contribution plus your share of partnership liabilities minus any distributions determines your basis. If the depreciation exceeds your basis, you'll have to suspend the excess losses until you have enough basis.
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Tate Jensen
•This is really important! I qualified as a real estate professional but still couldn't take my losses because I didn't have enough basis. The K1 box 20 will usually have a code that tells you your adjusted basis at year end. Double check that before counting on those deductions.
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Adaline Wong
Slightly off topic but has anyone used cost segregation with bonus depreciation for apartment buildings recently? My K1 shows huge depreciation but I'm worried about depreciation recapture when we sell the property in 5-7 years. Especially since bonus depreciation is phasing down now (80% for 2023, 60% for 2024, etc). Seems like it just creates a tax time bomb for later.
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