Behind on Rental Property Books: How to Catch Up and File

Where do I start when my rental books are years behind?

Start with the oldest missing year and work forward, one property at a time. Two problems are mixed together: paperwork (books and records that are missing or wrong) and filing (returns never filed). The IRS says to file every past due return, even if you cannot pay in full. How many missing years the IRS expects is covered in catching up on unfiled returns.

Order matters because each year starts from the one before it: basis (what you paid for the property, adjusted each year), depreciation taken and any suspended passive loss (a rental loss the rules do not let you use yet, carried to a later year) all roll forward. The steps:

1. List every property, who holds title (you, an LLC, a trust, co-owners) and the dates it was rented.
2. Find out which returns the IRS has, using transcripts.
3. Gather the documents for the oldest missing year.
4. Rebuild that year property by property, file it, then carry its ending balances into the next year.

Gather for each property: bank and card statements, the closing statement, Form 1098 or lender statements, tax bills, leases and rent records, property manager statements, and your last filed return and IRS transcripts. Ask each bank, card issuer and lender for statements you no longer have; how far back they can supply them varies. The size of the job is properties times entities times accounts times months, so each added year, entity or unreconciled account adds work.

The case is not simple when two or more years are missing, there is more than one property, an LLC or trust holds title, a former bookkeeper left books you cannot trust, an IRS letter has arrived, or a lender, court or new preparer is waiting on a date. See "Different for you?" at the end.

Which returns are missing: my Form 1040s, an LLC's Form 1065, or both?

The return generally depends on who holds title to the property, not on who collected the rent.

A domestic partnership must file Form 1065 unless it neither received income nor had deductions, and an LLC with at least two members and no election is classified as a partnership (Form 1065 instructions). An LLC that elected corporate treatment files a corporate return, which this page does not cover. An LLC owned only by a married couple as community property may be treated either as a disregarded entity or as a partnership, and the IRS accepts the couple's treatment (Revenue Procedure 2002-69); changing that treatment counts as a conversion of the entity. An LLC's classification also follows its members: a one-member LLC that adds a second owner becomes a partnership from that date, and a partnership ends when one person buys all the other interests, so one LLC can have Schedule E years and Form 1065 years (Revenue Rulings 99-5 and 99-6). List the date each owner joined or left.

File the partnership's returns first, oldest year first: each partner's personal return needs the K-1. For an LLC that never filed, see unfiled business returns. For co-owners who hold title directly, see Schedule E or partnership return. For the partners' capital accounts and K-1s, see rebuilding partnership capital accounts. Money moving between an LLC, a trust and you personally is usually a loan, a contribution or a distribution, not rental income or expense: see books for an LLC per rental and mixed funds.

How do I get my old returns and the income forms the IRS already has?

Order transcripts for every missing year and for the last year you filed. They show what the IRS holds, the first check on your rebuild (IRS transcript types).

The wage and income transcript shows only forms filed with the IRS, which may not be every form issued to you. Online it is limited to about 85 documents; past that, the IRS directs you to Form 4506-T. A non-filing letter does not say whether you were required to file. A property manager reports rent paid over to an owner on Form 1099-MISC when it meets the form's reporting threshold (instructions); match any such form to the manager's statements and your deposits.

Your last filed return holds the numbers the rebuild starts from: depreciation to date, any suspended passive loss and each property's basis. If an old preparer or software holds them, ask now; see rebuilding a missing depreciation schedule.

What can I rebuild from bank statements, and what must I get from others?

Bank and card statements rebuild what moved and when. They do not show what a payment was for or what a property cost. A statement can prove payment if it shows the payee, amount and date (and the check number for a check), but proof of payment alone does not establish a deduction; keep the invoice or receipt (Publication 583).

The title or escrow company, the lender and the county assessor can supply copies; the IRS names them in its guidance on reconstructing records after a disaster, which is written for casualty losses but points to the same offices (IRS). For the closing statement, see entering it in the books. To work from bank statements alone, see rebuilding books from bank statements.

What if the books exist but a former bookkeeper left them wrong?

Do not start from the old totals. Reconcile every bank, card and loan account to its statements, month by month, then check how the old books handled:

• uncategorized or suspense balances;
• deposits booked as rent that were security deposits, loan proceeds or transfers between your own accounts;
• mortgage principal booked as an expense;
• improvements booked as repairs;
• personal spending mixed in;
• depreciation never booked.

Compare each year's rent total with the wage and income transcript, the filed return and the leases. A figure that no statement or document supports is one to question, not to carry forward. If a filed return used wrong figures, see amending for income left off past returns.

How do I sort each deposit and payment into rent, deposits, loan principal, interest, repairs, improvements and personal?

Sort every line before totaling anything. A deposit, a loan payment or a personal payment in the wrong place changes the year's income (Publication 527).

A mortgage payment that includes escrow is interest, principal and a deposit. The deposit is not an expense: use the escrow statement to record property tax and insurance when the lender pays them; for taxes, only what the lender actually paid is deductible (Publication 530). For each bucket, see security deposits, repair or improvement, property manager statements and, if rental and personal money share an account, mixed funds.

What do I do about repairs paid in cash or with no receipt?

Assemble every other record that shows who was paid, how much, when and for what, and write dated notes now. The IRS says that when a cash payment has no receipt, you should make an adequate explanation in your records at the time of payment (Publication 583). For past years that moment has passed, so date anything you write as written today and never make a document look older than it is.

Whether a cost with no record at all can be estimated depends on the facts, and an unsupported cost may be disallowed on examination. What counts as support is covered in rental property records and receipts.

How do I rebuild each property's basis, land share and depreciation?

For each property bought for rental, start from cost, take out land, start depreciation on the date the property was ready for rent, and reduce basis by the depreciation allowed or allowable. A residential rental building is generally depreciated straight-line over 27.5 years under the general depreciation system, with a mid-month convention, and the first year counts only the months in service (Publication 527).

If earlier years skipped depreciation, see missed depreciation on a rental.

How do passive losses and depreciation carry from one year to the next, and why does one wrong year change the rest?

Each year's ending balances are the next year's opening balances, so a figure wrong in one year is wrong in every year after it.

Rental losses are generally passive, except for certain real estate professionals. A landlord who actively participated, which means owning at least 10% and making management decisions such as approving tenants and repairs, may deduct up to $25,000 of rental loss against other income. The allowance phases out between $100,000 and $150,000 of modified adjusted gross income for a single or joint filer, so a higher-income landlord's loss is suspended instead (Publication 527). A married person filing separately has no allowance if they lived with their spouse at any time during the year, and has $12,500 (phasing out between $50,000 and $75,000) if they lived apart all year (Publication 501, Publication 527). A partnership keeps no record of a partner's suspended losses; the partner tracks them (Form 8582 instructions).

A missed depreciation year, a wrong land share or a repair booked as an improvement does not stay in its own year. For years never filed, file them with the right balances. For a year already filed, an amended return may correct a wrong depreciation amount, but the same wrong treatment, even none, on two or more consecutively filed returns becomes your method, and changing a method generally takes Form 3115 (Publication 527, Publication 946); see missed depreciation on a rental. That is why the rebuild runs oldest year first.

What will filing late cost, and what if I am owed a refund?

Late filing and late payment each add a percentage of the unpaid tax for each month or part of a month, up to 25% and 25% (filing, payment), and interest runs on unpaid tax and on penalties. Personal-return detail is in catching up on unfiled returns. Because the penalties are percentages of unpaid tax, a year in which withholding and payments covered the tax may have no percentage penalty.

A late Form 1065 is different: a set amount per partner for each month or part of a month, up to 12 months, whether or not tax is owed. The amount is indexed each year; the base rate for each return due date is in the table on the failure to file penalty page. For relief, see the late partnership return penalty and small-partnership relief guides.

For a year never filed, the IRS can assess tax at any time; filing your own return starts the usual three-year assessment limit, which is six years if the return leaves out more than 25% of the gross income it shows (IRS, 26 U.S.C. 6501). If withholding or estimated payments exceeded a year's tax, the refund generally must be claimed by filing within three years of that return's due date, plus the length of any filing extension you had; a Presidentially declared disaster can add time (IRS). The IRS holds a current refund while an earlier return is past due (IRS).

What if an IRS letter, a lender, a divorce or a new preparer is waiting on a date?

Read the date on the letter or the lender's request first. The work order stays the same, oldest year first, and only the pace changes; a legal deadline, such as a Tax Court petition date, is met on its own date.

When the stakes are a refinance, a court date or an IRS deadline, the order of years and entities and what is realistic by the date are judgment calls. See "Different for you?" below.

Do I need software to catch up, or is a spreadsheet enough?

In most cases the law does not require any specific kind of records; any system that clearly shows your income and expenses will do (Publication 583). A catch-up needs one ledger per property that ties to the Schedule E lines, keeps repairs and improvements apart, and carries basis and depreciation forward. For the trade-offs, see spreadsheet or software for rentals.

How do I keep the books current once they are caught up?

Close each month, and keep what proves each entry:

1. Record every deposit and payment monthly, by property, using the buckets above.
2. Reconcile each account to its statement so a missing or duplicate entry shows up while it is small (Publication 583).
3. Book a repair or improvement correctly when it is paid and keep the invoice; you need the cost of improvements to depreciate and to sell (Publication 527).
4. Keep rental money in accounts used for the rental: a separate bank account for each rental.
5. Keep property records until the limits run for the year you dispose of the property, and indefinitely for any year never filed (IRS).

Example

These examples are illustrative; amounts are in US dollars.

Two condos, three years unfiled

A landlord owns two condos in their own name and has not filed for three years, called Year 1 to Year 3. Rent is about $36,000 a year in total, cash expenses (interest, property tax, insurance, repairs) about $28,000, and depreciation about $10,000, worked out from each closing statement and land share. Assume both condos were rented all year in all three years, the landlord has no income from other passive activities, no suspended loss from an earlier year and no at-risk limit, and nothing is sold. Modified adjusted gross income is at least $150,000, so the rental loss allowance is zero (see the carry-forward section) and each year's loss is suspended: held and carried to a later year instead of deducted.

The landlord rebuilds Year 1 first, files a Schedule E with a column for each condo, then starts Year 2 from Year 1's ending basis and suspended loss. Had Year 1 left out depreciation, it would show $8,000 of income instead of a $2,000 loss, and Years 2 and 3 would start from the wrong basis and the wrong carryover.

A refinance waits on two years of returns

A landlord plans to refinance a $400,000 loan on a rental. The lender wants the last two years of returns. Both are unfiled; the year before them was filed. The lender's date sets the schedule, not the order: the older of the two years is rebuilt first, from the last filed return's basis and carryovers, then filed, then the newer year. The IRS says processing takes approximately 6 weeks, so the schedule counts back from the lender's date by that time plus the time to rebuild each year. If the date is closer than that, the lender needs to be asked what it will accept.

Two partners and a rental LLC

Two people own a rental LLC 50-50, with no entity election. No Form 1065 or K-1s were filed for two years. The LLC files a Form 1065 for each year, oldest first, and each partner's own return takes its rental figures from the K-1. The late-filing penalty runs per partner per month: 2 partners times up to 12 months is up to 24 partner-months for each year, at that year's amount, unless relief applies. The partners' personal returns for those years wait on the K-1s.

Different for you?

• Two or more years are missing, or more than one property, LLC or trust is involved: which years and entities file first, and what the books must rebuild, are judgment calls. Get bookkeeping help, and see catching up on unfiled returns for the personal-return side.
• An LLC or partnership never filed Form 1065: follow unfiled business returns and bring the books to bookkeeping help.
• An IRS letter has arrived: a notice sets its own deadline. See catching up on unfiled returns for substitute returns and responding to an underreporter notice for a mismatch letter, then get bookkeeping help with the records it asks for.
• A lender, court or new preparer is waiting on a date: what is realistic by that date depends on the years, entities and records involved. Get bookkeeping help; for a lender's statement, see a rental profit and loss for a lender.
• Depreciation was never taken, or the old schedule is gone: see missed depreciation on a rental.
• A former bookkeeper or preparer left books you cannot trust, or filed returns left out rent: which entries to keep, which years to redo and whether filed returns need amending are judgment calls. Get bookkeeping help; for income left off filed returns, see amending for income left off past returns.
• You are selling or sold the rental: see depreciation recapture when selling a rental.
• You live outside the US: see nonresident landlords.
• The books are behind but it is not a rental: see catching up on overdue books.