2. Tax Strategies for Your AirBnB Rentals
May 29, 2016

April 22, 2016

1. Documentation: The Key to Tax Savings

Introduction

So we’re gonna start off with an example, and it’s gonna help us illustrate why today’s topic of “document everything” is so important for the real estate investor and the business owner. At the beginning of this year, I had a new client come to me. He wanted help on tax preparation and then also wanted help getting his books in order from an accounting perspective. He was showing me all these expenses that he had incurred throughout the year, and I was asking for documentation, what was the process behind it, where the receipts? He didn’t have any of it because he didn’t have a process in place, so there was no documentation to support, sometimes, his several thousands of dollars of expenses. This creates a problem because as a CPA, while I’m not here to audit you, I also can’t sign off on a return unless I think that we can substantiate that expense or that income.

Potential Loss of Savings

Without documentation, there’s no way to substantiate any of that, so I’m now putting my name on the line essentially, and I didn’t want to do that. So I told him, “Hey, look, you know, I can prepare the returns for you, and I can help you going forward, but we’re not claiming these expenses because there’s nothing. You cannot come up with anything that proves to me that you actually incurred this expense.” And it was frustrating. I mean, he lost out on thousands of dollars of savings, and I’m talking savings, not just deductions. You know, he learned a painful lesson.

Setting Up Systems

Now, that said, we were able to go back and find a few things to help him out, but there were, I mean, there were plenty of expenses that he was just not able to substantiate, and there was just no way to go back and get the receipts for those expenses. But anyway, we set up a system for him, and going forward, he’s doing a great job of recording everything that comes as he actually sends it to me and allows me to take a look at it, asks my thoughts, and he’s doing a good job.

Documentation Tips

When new clients come to me, they always ask, “What is the number one thing that I can do to reduce my tax liability or to lower my taxes or to have more expenses?” The key is documentation, documentation, documentation. And why am I trying to drill this point home? Well, ultimately, you can’t get any tax deduction if you don’t have the supporting documents for it. The IRS may come in, audit you, ask for supporting documentation, and if you don’t have it, what do you think happens? You might end up in painful tax court cases or you might just end up with a lofty fine, or both. Not a fun position to be in. So just document.

Documentation Types

What should you document? Everything. Everything. Any sort of business receipt, any sort of expense, any activity related to your business, related to your rentals, you want to keep a receipt for, you want to keep an invoice for, or you want to scan it in. You can scan it in; that’s perfectly fine. The IRS allows digital receipts. Just make sure that you are keeping records of the expenses that you’re incurring.

Documentation Tools

So, things like business receipts, invoices, anything related to the mileage. I don’t know if you’re tracking your mileage, if you’re not, you need to start now, actually needed that you needed to start yesterday. Create a create an excel sheet that says where you’re coming from, where you’re going to, what the purpose of the trip is, how many miles round-trip it is, and what the date is, and that’ll work for a mileage log. They also have mileage trackers like MileIQ that work really well. I suggest checking it out.

Home Office Documentation

You should also be documenting your home office. So if you were to draw a floor plan, which you should be doing if you have a home office, draw a floor plan where in your floor plan is the home office. That area needs to be highlighted and marked off or whatever suits you to indicate that that’s where the home office is. You need to have the square footage measured, and the number, the dimensions there, and available on that floor plan. You should also have pictures of your actual home office because believe it or not, the IRS can walk through your house if you’ve claimed a home office deduction because they’re treating it just like any other commercial office building. So they can, they can walk through, and believe me, when they walk through, they’re gonna be looking at any other sort of furnishings that you have to see if what you’re reporting on your tax returns lines up with your standard of living. So, we want to keep the IRS out of the house. To do that, we can just take pictures of the home office. Generally, that will be plenty of proof to deter a walk-through if it even gets to that point.

Meals Documentation

The other thing that we want to really keep a good handle on, in terms of documentation, is meals. The IRS will drill in the meals if they were ever to scrutinize your returns or if they would ever audit you. So, make sure that you have documentation for meals. You certainly would not want the IRS to come back and disallow all of that.

What Does the IRS Scrutinize?

So what does the IRS scrutinize? The IRS scrutinizes travel, transportation, and meals primarily. The reason that I’m saying these three is because these are the three that can be most overstated in terms of expenses, and so the IRS is going to go in there and make sure that you have the documentation. If you don’t have the documentation, they’re gonna throw out as much of the write-off as they possibly can because you have to remember, they have a vested interest in getting rid of your deductions. It means more money in their pocket, and we really don’t want that to happen. So, travel, transportation, and meals, make sure that we’re recording, documenting as if your life depends on it because your financial life does.

Documentation Methods

Alright, so how do we actually go about documenting everything? There are a couple of methods. I’m sure everybody’s heard of the classic envelope method. It’s not fun to be a CPA and to dig through somebody’s to dig through a client’s documents, so I’m actually a virtual firm. I don’t take paper, paper receipts, paper documents, paper forms in, and that really helps me avoid the whole having to sift through somebody’s envelope. I don’t want to deal with that.

My philosophy is if you don’t care enough about your business to set up systems that work, to be reconciling income and expenses every month or every quarter, then, you know, we’re just not a good fit. And, you know, I have some clients that come to me with the envelope system, and I help them get set up on systems that work better and are ultimately gonna add more value to them anyway.

Cloud-based Tools

So, something like moving to digital, we can take it to the cloud. We can download a scanner on your iPhone or your Android phone, and you can actually scan receipts as you go, and you can then upload it to your favorite cloud system, whatever that might be. I personally use Expensify as my scanner. It allows me to scan a receipt in, record the expense details, so what the amount was, who I met with, or what it was for, and then also add a little note, which is really helpful because ultimately, the documentation that we’re doing needs to be contemporaneous, which means it needs to be continuous. So we can’t go, like, we can’t go back five years, once we’re being audited and try to recreate five years of documentation. The IRS sees right through that. It’s very easy to see who is doing it as they go and who is doing it retroactively. So we want to be on the as-you-go side.

So yeah, for my cloud-based storage system, I use ShareFile, and actually have a client portal for all of my clients, and they’re all on ShareFile. Awesome system, very, very easy, a lot easier than a lot of CPAs and even my old system was. You can download a desktop app, I believe that they also have an iPhone app, and you can just upload right to your personal file, your client file. So it’s great.

So, you want to figure out tools that are gonna work for you, that are gonna help you maintain the documentation on a consistent basis. So in terms of receipts, like I said, I scan mine in, I encourage clients to scan theirs in because it’s just a whole as-you-go thing. But we want to have two key details, actually three key details on that receipt: you want to have who you met with, what you discussed, and the date, and then obviously the expense.

Now, whenever you’re out with a client, or whenever you’re out with an investor, or a real estate agent, or property manager, or whoever you’re meeting with for business purposes, whenever you’re meeting with them, and you get that check at the end of the meeting or the end of the session or whatever, write down who you met with on top of the receipt, what you discussed, and then just take a picture of it and scan it in, and it’s easy, and you’re done. You know, you might need to go and book it on your actual bookkeeping system, whether it’s a spreadsheet, or whether you just wait till the end of the year, but at least you’ve captured the receipt, and you’ve captured it as you go, which is the key to maintaining good documents.

Digital Calendars

Another tip is to schedule meetings, lunches, and check-ins on your digital calendar, and then you can print that calendar off at the end of the year, or whenever you need it. But being on the digital calendar gives you an advantage because if the IRS ever came back and started questioning you, you would have records of who you met, when you met them, and what you met them for, and it’s right there, readily available. The IRS likes to see that type of thing, and if you can show them that type of thing, then obviously the inquiry is going to go more so in your favor than not.

Business Travel Planning

We also want to be planning ahead whenever we’re traveling. So we want to ask ourselves a question of, who is traveling? Do they have a business need to travel? So sometimes what will happen is two spouses will go to a new rental market, and they’re sourcing properties, they’re looking at deals, and they want to deduct both of the business expenses. They want, they want stood up the travel for both of them. Unfortunately, it doesn’t really work like that because the IRS is always gonna come back and say, “Hey, one of you might have had a business need to go, but we highly doubt both of you had a business need to go.” And it’s really as simple as that. If you can’t prove that both people had a business reason to go, then you can’t take the deduction.

And so when I talk clients through something like this, I tell them to kind of think about if they were actually running a big-time business or something, and an employee or two employees came up to them and wanted to go on a trip, what would be their criteria to determine whether or not there is a business need for each one of them to go? One, we would look at budget, financial standing; two, we would want to look at the workload; three, what are the objectives, what are they gonna come away from that travel, that trip with? And then four, is both of them really necessary?

Consider the first three items. In general speaking, when it’s two spouses going, two spouses are not going to be needed on a business trip. So what this means is that only one spouse’s travel expenses are going to be deductible. But that’s okay because it’s still something, right?

Tax Deductions from Travel

So some other things we want to do with travel: we want to plan meetings in advance, to schedule them on your calendar in advance. You can show the IRS this if you’re ever questioned, it will really help your case. Another thing that we want to do is plan for personal days if we’re traveling somewhere that is near vacation spots and tourist attractions, or near family members. We want to strategically plan for personal days so that we can still take the travel expenses that we’ve incurred.

So, at the end of the year, what should you be providing your CPA with in terms of documentation? First off, it’s important to understand that we are not here to audit you, so we don’t want to see all of your expense documentation. I mean, I don’t really want to see 100 receipts for $30 expenses or $80 expenses. We want to see receipts for substantial or abnormal expenses, something that’s going to be material to all of the expenses or material to your financial position or your tax position.

End of Year Checklist

So basically, what I want to see is a profit and loss statement for your businesses or for your rentals, I want to see mileage logs, I want to see meals and entertainment expense details, I want to see travel details, and I want to see an expense report, or if you have an app that works similar to that, then I want to see something like that. And what I’ll do is go through all that and pick out expense items that I want to follow up on because at the end of the day, I’m putting my name, my business name, on your returns, so I need to make sure that it makes sense for me to sign off on those returns. One of the checks is to just look for those material or those abnormal expenses.

But the key is going to be to have the documentation ready to go because if I follow up with you, and I say, “Hey, you spent $1,500 at XYZ restaurant meeting with a client, can you provide that documentation for me?” and you say, “Oh yeah, well I have it, and I think I have it somewhere, let me go try to find it,” and it takes you two weeks to get it to me, now I’m going to be thinking, does this guy really have the documentation? Should I start asking about other expenses to make sure that he does have the documentation?

So just have the documentation readily available and ready to hand off to a CPA at a moment’s notice if you are asked for it. And remember, we’re on your side, so when we ask for documentation, we’re really just trying to protect you as much as we’re trying to protect ourselves.

Contractor Documentation

Alright, and then last thing real quick, let’s talk about contractors. Documentation surrounding contractors: many of you own investment property, many of you also run businesses, you likely use contractors in some way, shape, or form. If you pay a contractor over six hundred dollars annually, you need to issue them a 1099-miscellaneous. What this does is it sends information to the IRS that says, “We paid this person this amount of money,” and then the IRS is going to be looking for that income to show up on that person’s tax return.

Contractor Pitfalls

Through my clients, I’ve been hearing that many contractors are a little shady. So what’s happening is contractors either just want cash so that they don’t have to report it, or they just think that receiving cash is easier, maybe they have a working capital problem, they need, they need the money today rather than waiting on credit. So they want to be paid in cold hard cash instead of, you know, via credit card or check or anything like that.

Before you do that, you need to get a W-9 from the contractor. The W-9 is going to tell you who the contractor is, what their Social Security number or EIN number is, and that’s gonna be the information that you need to issue a 1099 at the end of the year. And don’t try to make excuses saying, “Well, he’s a great contractor. I’m just gonna go ahead and pay him cash,” because at the end of the day, this is your business, and this is your portfolio, and you need to protect it as much as you possibly can. And issuing 1099s is an excellent way to protect your business, to protect the write-offs that you’re claiming, in the event that you were ever audited.

Because ultimately, if you are audited by the IRS or if the IRS is scrutinizing your return and they’re asking about expenses like rehab expenses or contract service expenses that you’ve written off, but they don’t have a 1099 for, whose fault is it? The contractor’s not gonna care. He’s already gone. The IRS isn’t gonna go after the contractor, but ultimately, it’s your business that you need to protect. So make sure that we’re issuing 1099s.

Podcast Conclusion

Alright, well, that’s about it. Thanks for listening to the show. If you have a few minutes and you like the show, please leave a rating on iTunes and SoundCloud. I’d really appreciate it. This will help the show climb in rankings and gain some exposure. And ultimately, I want to help everybody better run their real estate portfolio and their real estate businesses. If you have any questions or topics that you’d like to discuss, feel free to email me at contact@therealestatecpa.com. That’s contact@therealestatecpa.com. I’m pretty responsive, and I’m always, always looking for feedback, so feel free to send me an email.