Curious - how did the IRS figure out your lifestyle didn't match your income? I've always wondered how they catch that kind of thing if you're just spending cash.

They looked at my bank deposits compared to my reported income. Even though I wasn't depositing all the cash, enough of it was going into my account to show a pattern. Plus I financed a car with my "total income" (what I told the dealership I made) which was way higher than what I reported to the IRS. The audit process was brutal - they wanted documentation for EVERYTHING. They can also look at your rent/mortgage payments, car payments, credit card spending, etc. They have sophisticated methods to flag returns where the reported income doesn't support the person's known expenses. The stress and anxiety of going through that audit was the worst part - I wouldn't wish it on anyone.

You would report it on Schedule C (Profit or Loss From Business) as self-employment income. You'll need to fill out your employer's name and address in the appropriate sections. Even if they won't give you tax forms, you should still have their business name and location where you work. This means you'll be treated as an independent contractor rather than an employee. Keep detailed records of when you worked and how much you were paid. You'll also need to pay self-employment tax (Social Security and Medicare) using Schedule SE, in addition to regular income tax. While this means a higher tax burden than if you were properly classified as an employee, it's much better than not reporting and facing potential penalties later.

This is really helpful! I definitely haven't had any penalties before. Is First Time Penalty Abatement something I should specifically mention in my letter? Or should I try to call and request this directly?

You should definitely mention First Time Penalty Abatement specifically in your letter or phone call. Use those exact words. Many IRS agents are trained to check for FTA eligibility, but some might not think to offer it unless you ask directly. It's usually faster to call and request it, as they can often approve it immediately over the phone if you qualify. Just have your notice information ready when you call. In your case, since you've never had penalties before, there's a very good chance you'll qualify!

This is such good advice! I made the mistake of waiting to pay anything while I disputed the penalty, and the interest just kept growing. Ended up owing way more in the end.

Do you have a rough guideline for what percentage of profits should go toward reasonable compensation? I've heard everything from "at least 30% of profits" to "whatever the market rate is for your position regardless of profitability".

There's no fixed percentage rule that the IRS follows - it's more about what would be reasonable market rate compensation for the services you provide to the company. Different industries have different standards, and factors like your experience, time commitment, and responsibilities all matter. Document your research into comparable positions in your industry and region as justification for whatever amount you choose. The key is having a rational basis for the compensation level that you can defend if questioned. In my experience, trying to set compensation as a simple percentage of profits doesn't hold up well under scrutiny.

There's no specific exception for side businesses, but reasonable compensation is based on time spent and value added. If you're minimally involved (like just a few hours monthly), your reasonable compensation would be proportionally less than someone working full-time. The key is documenting your actual involvement and justifying the compensation level based on that.

That's really interesting, I hadn't come across Section 195 in my research. How would I "demonstrate" that I was still in startup phase? Would the fact that I only had one short-term guest who was a friend be evidence of that? And how does this interact with the depreciation requirements that seem to start once I had that first paying guest?

To demonstrate you were in startup phase, you would need to show that you were preparing to enter the rental business but not yet actively operating. Documentation is key here - keeping records of renovation work, marketing efforts in progress, business plan development, etc. The fact that you only had one friend stay for a fee that was likely below market rate could potentially support your position that this wasn't the start of regular operations. Regarding depreciation, there's an important distinction here. Section 195 applies to business startup costs (like market research, analysis, business formation costs, etc.), while depreciable assets like furniture and appliances follow different rules. Those depreciable assets would generally start being depreciated when placed in service, which would arguably be when your property was ready and available for rent - potentially when your friend stayed there. It's a complex area with some gray zones. The most conservative approach would be to start depreciation in 2024 for your assets while potentially treating certain qualifying expenses as Section 195 startup costs. This is definitely a situation where professional guidance specific to your circumstances would be valuable.

I went through an audit 3 years ago specifically about first-year rental losses. In my experience, the IRS was mainly looking at whether I had the "intent to profit" from the rental activity. They wanted documentation showing I was genuinely trying to rent it out at market rates and not just using it primarily as a personal residence with occasional rentals. They also scrutinized my depreciation start dates and whether I had properly segregated personal use vs. rental use time. As long as you have good documentation and weren't trying to claim personal expenses as rental expenses, you should be fine even with legitimate losses in the first year. Those startup costs and initial losses are normal in the rental business.

That's really helpful, thanks. I do have good documentation of all my expenses and definitely was trying to rent it out (have all my marketplace listings saved). I'm just nervous because the loss ratio is so high compared to income in that first year. Sounds like that might be normal and expected though if I can document everything properly.

Thanks for the insider perspective! Do you think I should say something to my friend? He seems so confident about all this, and when I expressed concerns he just laughed it off saying "everyone does it." I don't want to be preachy but also don't want him to get in serious trouble.

I would definitely say something, but approach it carefully. Instead of making it about him being wrong, maybe share an article about audit risk factors or a story about someone facing severe penalties. You could mention that you spoke with a tax professional who raised red flags about some of these deductions. If he's resistant, you could suggest he get a second opinion from another CPA - one who doesn't have a vested interest in keeping him as a client by promising aggressive deductions. Sometimes people need to hear the same message from multiple sources. Just remember that ultimately, it's his decision and his risk to take. You've done your part by raising the concern.

Did you have receipts for everything? I've heard if you keep perfect records they can't really say much even if the deductions are aggressive?