Partnership Audits in Real Estate: What Investors and Sponsors Need to Know

In this episode of the Major League Real Estate Podcast, Nathan Sosa and Matt Hamilton break down what a partnership audit actually looks like, how it differs from a typical individual audit, and why real estate investors should still take audit risk seriously—even if partnership audits remain relatively rare. They also discuss common IRS notices, the evolving partnership audit regime, and why aggressive tax positions should always be evaluated through a risk-reward lens.

The Most Common IRS Notices Investors Receive

Nathan and Matt begin by pointing out that most IRS notices are not full audits. In many cases, investors or partnerships receive notices related to late filing penalties, missed extensions, or small modifications the IRS makes to a return. For partnerships, one of the most common issues is a late-filed return triggering penalties and interest. For individuals, it is often a simple notice reflecting a minor adjustment that is not significant enough to contest.

They also note that some penalties can potentially be removed through first-time penalty abatement, while certain small partnerships may qualify for relief under separate reasonable cause standards. The bigger point is that not every IRS notice signals a major problem—but every notice should still be handled carefully.

Why Partnership Audits Are So Rare

A major focus of the episode is the reality that partnership audits are still relatively uncommon, especially compared to how often investors worry about them. Matt explains that the IRS has historically avoided auditing partnerships because partnerships themselves generally do not pay tax. Even if the IRS successfully adjusts a partnership return, it still has to trace those changes through the partners, which creates a lot of work for relatively limited return.

That lack of efficiency has made partnership audits less attractive from an enforcement standpoint, particularly when compared to audits of taxpayers where the IRS can assess tax more directly.

What Changed Under the New Partnership Audit Rules

Although partnership audits have historically been rare, Nathan and Matt explain that the rules did shift under the newer partnership audit regime established several years ago. Those rules were meant to make partnership audits more practical by allowing the IRS, in some cases, to assess tax at the partnership level instead of chasing adjustments through every partner individually.

That change led many tax professionals to expect a much larger increase in partnership audits. Later, when the IRS received additional funding and expanded enforcement efforts, there was even more concern that pass-through entities would become a major target. The IRS also attempted to build more specialized resources around pass-through audits. But despite those developments, partnership audits still have not become nearly as common as many expected.

Why Audit Risk Still Matters

Even though the odds of a partnership audit may still be low, Nathan emphasizes that investors and sponsors should never rely on low audit probability as part of their tax strategy. His view is that every tax return should be prepared as if it could be selected for audit.

That matters because once an issue is challenged, the process can quickly become expensive and time-consuming. An agent may initially raise a question, then elevate it to a manager, and eventually pull in technical experts if the issue becomes more complex. At that point, the cost of defending the position can grow significantly, even before tax, interest, and penalties are considered.

Aggressive Tax Positions: Understanding the Tradeoff

Matt makes the important distinction that not all aggressive tax positions are improper. In real estate, there are many issues that fall into gray areas, and some positions may be defensible based on facts, Treasury guidance, or case law. The key is understanding the level of risk involved and having a clear conversation with your CPA about your tolerance for that risk.

Some taxpayers are willing to take more aggressive positions if they believe the law supports them. Others are not interested in becoming the test case for a disputed strategy. Both approaches are valid, but the decision should be intentional. The hosts stress that the wrong move is blindly taking aggressive positions just because audit odds seem low.

Why “Audit Roulette” Is a Dangerous Mindset

Nathan describes what he calls the “audit roulette” mindset: the idea that because audit odds are low, taxpayers can take questionable positions and hope they are never challenged. He warns that while the probability of audit may be small, the cost of being wrong can be extremely high. That includes not only tax due, but also penalties, interest, professional fees, and the sheer time and stress involved in the process.

In other words, low audit rates do not make a weak tax position a good one.

A Real Example of Why the Details Matter

Matt shares an example involving a client who invested in a land conservation easement transaction through an LLC. The client received a large charitable contribution on the K-1, but had not even fully used the tax benefit before the entity itself was audited and settled at the partnership level. The result was that the investor ended up on the hook for additional capital to help cover taxes and penalties tied to a benefit they had not yet even realized.

The lesson is that investors need to understand not just the advertised tax benefit, but also the structure, timing, and downside if the arrangement is challenged.

Final Thoughts

The biggest message from the episode is that audit risk should be managed, not ignored. Most notices are routine, and full partnership audits are still uncommon. But that does not mean sponsors and investors can afford to be careless. The right approach is to take defensible positions, understand the gray areas, and make tax decisions based on sound planning rather than the hope that no one looks too closely.

For real estate investors, that means working with advisors who understand both the technical rules and the practical realities of how these issues play out when the IRS actually shows up.

Interested in working with tax experts? Schedule a discovery call with our firm.

Disclaimer: This podcast summary was generated from the transcript and may contain some errors or miss key points from the audio recording. Any mention of third-party vendors, products, or services does not constitute an endorsement or recommendation. You should conduct your own due diligence before engaging with any vendor.