A few years ago, my wife Selenid and I received a letter that nobody particularly wants to receive. The New York State Department of Taxation and Finance was auditing our 2021 state tax return. Yup…a tax audit…

More specifically, they were questioning whether Selenid legitimately qualified for Real Estate Professional Status, or REPS, for that year. At the time, she was still working outside of real estate while also spending a significant amount of time managing our growing real estate portfolio.

I wrote about that entire experience here. It took nearly a year, multiple rounds of documentation, and plenty of frustration. But ultimately, we were able to demonstrate that Selenid met the requirements, New York State agreed, and the audit was closed with no additional taxes owed.

So, naturally, we figured we had proven our point.

Apparently New York State wasn't done with us yet. Eventually, another letter showed up. Our 2022 taxes were being audited.

Again.

Here we go again…

I will admit that this second tax audit surprised me more than the first one.

By this point, we had already gone through the process once. We knew exactly what New York State had questioned. We had provided extensive documentation. And most importantly, nothing about our tax strategy had changed in some questionable or aggressive way.

If anything, our situation in 2022 was even clearer.

Selenid only worked as a professor for about half of that year before leaving her academic position and focusing full time on our real estate business. She also logged more than 750 hours working in real estate during the year.

For context, the IRS generally considers someone a real estate professional for tax purposes when more than half of the personal services they perform in trades or businesses during the year are in qualifying real property trades or businesses in which they materially participate and they perform more than 750 hours of services in those real property businesses. Rental activities in which a qualifying real estate professional materially participates can then be treated as nonpassive rather than passive.

That distinction matters enormously

Normally, real estate losses are passive and therefore generally cannot simply be used to offset a physician's W-2 income. But qualifying as a real estate professional and materially participating in the rental activities can change that equation. This is one reason why the tax advantages of direct real estate investing have been so significant for us.

Importantly, however, the tax benefits are not why we bought our properties in the first place. We bought them because we believed they were good investments that would produce cash flow and build wealth. The tax benefits came on top of that.

And when you claim those benefits, you need to follow the rules.

We believed that we had.

At least the second tax audit wasn't our first rodeo

There was one major difference this time around: We knew what to do.

As soon as we received the audit notice, we contacted our tax advisor. Based on our experience from the previous audit, the recommendation was pretty straightforward. We needed to provide documentation of Selenid's academic work requirements along with a detailed log demonstrating the work she performed in our real estate business.

Thankfully, we had that documentation.

Selenid and I have always been meticulous about tracking her real estate hours. The somewhat ironic part is that our preferred tracking system is decidedly low-tech.

We use a written journal.

It is simply what works best for us. At the end of each day, Selenid will write down what she did related to real estate, or I will ask her and document it. We record the activity and the time spent performing it.

There is nothing fancy about it.

But there is a lesson here that carried over directly from our first tax audit: the best documentation system is the one you will actually use consistently.

The problem was that New York State did not particularly appreciate our handwritten system the first time around. They had previously deemed portions of it illegible.

So we knew what came next.

We sat down together and painstakingly went through the journal day by day. We transferred everything into an Excel spreadsheet, including the date, activity, property involved, and amount of time spent.

It was tedious. But we had the information. And that is a very important distinction.

Then came the waiting

We submitted everything. And waited. And waited some more. This was probably the most frustrating part of the entire experience.

About 6 months later, we received another notice. New York State was still saying that we owed approximately $20,000 in additional taxes, with interest continuing to accrue.

That gets your attention.

Even though we knew that we had followed the rules and had the documentation to support our position, seeing a bill for roughly $20,000 with the meter supposedly running is unsettling.

So we tried to figure out what was going on.

That was easier said than done.

Getting someone on the phone was incredibly difficult. Emails went unanswered. The online portal was not exactly a model of efficiency. And perhaps most frustratingly, whenever we submitted documentation, there was little meaningful confirmation that someone had received it, reviewed it, or was even actively working on our case.

You basically send your information into the void and wait.

Eventually, we learned that New York State wanted additional documentation regarding Selenid's other employment during 2022.

Again, this went back to one of the central requirements for REPS. It isn't enough to simply exceed 750 hours in real estate. More than half of the personal services performed in trades or businesses during the year also need to be in qualifying real estate activities.

So we went back to work.

We gathered Selenid's pay stubs from her academic position. We obtained a signed letter from her department chair documenting her work requirements and hours. Those records supported what we had maintained all along: she spent substantially more time working in our real estate business than she did in her academic position during that year.

We submitted everything again.

And then we waited again.

One very anticlimactic letter

Another 6 months or so passed. Then we received a very simple letter from New York State. The audit was closed. No additional tax was due. That was it.

After roughly a year of documentation, spreadsheets, letters, unanswered communications, a potential $20,000 tax bill, and plenty of uncertainty, the whole thing ended with an incredibly mundane piece of mail.

And I was very happy to receive it.

Knowing you are right doesn't eliminate the stress

One thing I learned during our first tax audit, and relearned during this one, is that knowing you followed the rules does not make an audit completely stress-free.

It certainly helps.

At no point did Selenid or I think, “Uh oh, they caught us.” There was nothing to catch. We knew how many hours she worked. We knew what she did during those hours. Plus we had documented those activities contemporaneously. We had worked with a professional tax advisor to make sure we were interpreting and applying the rules appropriately.

But there is still uncertainty.

What if the state disagrees? Or what if they interpret something differently? What if this ends up going to tax court? How much time and money are we going to have to spend proving something that we already know to be true?

Those thoughts inevitably creep into your mind. Ultimately, though, we kept coming back to the same thing: we followed the rules.

The tax code provides incentives for certain behaviors. Real estate happens to receive a number of significant tax advantages, including depreciation, which allows investors to deduct the theoretical decline in value of a building even when the property's actual market value may be increasing.

There is nothing wrong with taking advantage of incentives that are intentionally written into the tax code. But there is a huge difference between tax optimization and making things up.

Our job is to understand the rules, follow them, and document that we followed them.

Is real estate still worth all of this?

Whenever I share these stories, I inevitably hear some version of this question: “If you have to deal with audits and keep all these records, is real estate really worth it?”

For us, absolutely.

Would I prefer not to spend hours transferring handwritten real estate logs into Excel spreadsheets for the New York State Department of Taxation and Finance?

Of course.

Would I prefer not to wait months wondering whether a $20,000 disputed tax bill is going to disappear?

Definitely.

But these annoyances don't fundamentally change the investment.

Real estate has been an important part of our wealth-building strategy because of cash flow, leverage, appreciation, loan paydown, and tax advantages. The taxes are just one piece of the equation, which is exactly why I don't think doctors should invest in real estate solely for the tax benefits.

There are hoops to jump through. Absolutely there are toilets that leak. There are tenants to manage. There is bookkeeping. And yes, sometimes there are audits.

That is part of running a real estate business.

For us, the benefits have been well worth the additional work.

The biggest lesson from our second tax audit

If there is one lesson that has become even clearer after going through this twice, it is this: Operate as if you are going to be audited.

That doesn't mean being afraid of an audit. It means creating your documentation at the time you perform the activity rather than trying to reconstruct everything years later.

Keep logs. Save receipts. Keep emails. Save contracts and pay stubs when they may be relevant. Document the properties involved and the work performed. And if you are using a tax strategy that depends on meeting a specific threshold, make sure you can actually demonstrate that you met it.

I would also strongly recommend working with a tax professional who understands the strategies you are implementing.

Our tax advisor has now helped us navigate two audits. Beyond helping us implement our tax strategy correctly in the first place, they helped us understand exactly what information the auditors were requesting, reviewed our responses, and helped communicate throughout the process.

That expertise matters.

There is also a psychological benefit. When you receive a letter saying you potentially owe tens of thousands of dollars, it is nice to have someone who deals with this professionally tell you what it actually means and what needs to happen next.

So…see you next year, New York?

Our 2021 New York State return was audited.

Our 2022 New York State return was audited.

So I suppose the question now is whether 2023 will be next.

Interestingly, through all of this, we have never been contacted by the IRS regarding these returns. Both audits have come from New York State.

Maybe that is just coincidence. But it is also another reminder that where you live matters when it comes to taxes. State tax rates, deductions, enforcement, and overall tax environments can differ significantly. New York is certainly not known as a low-tax state. But our experience also demonstrates something important: living in a high-tax state does not mean you cannot invest in real estate or legally optimize your taxes.

You just might have to work a little harder to prove it.

If another audit letter arrives, I certainly won't be excited. But at this point, we know the drill. We'll call our tax advisor. We'll pull out the documentation. And we'll probably spend way too much time putting everything into whatever format New York State wants.

And then we'll trust the process.

Because after two audits, my perspective on taxes remains pretty much the same as it was before.

Pay every dollar you owe. But you don't need to leave a tip.

What do you think? Have you ever gone through a tax audit? What was your experience like? How stressed were you? How did you handle it? Did it impact your tax strategy moving forward? Let me know in the comments below!