About a year ago, Selenid and I received an unexpected letter from the New York State Department of Taxation. Basically, they were informing us that they performed an audit of our 2021 state tax return and disputed our claim that Selenid met the criteria for Real Estate Professional tax status or REPS. Well, fast forward one year later and the issue is finally resolved. It was obviously an interesting experience and probably qualifies as every tax payers worst fear. So, I’d like to share the experience as well as a few helpful lessons that we learned from this tax audit.

Our tax audit experience

Like I mentioned, the issue at hand in this New York State audit was Selenid claiming Real Estate Professional Tax Status.

Briefly, REPS is simply a definition created by the IRS. When you meet the criteria to achieve REPS, that means that you are someone whose main job is real estate. And those people are entitled even more massive tax benefits of real estate as they can use the usually passive real estate losses to offset active taxable income.

Based on the IRS definition, to qualify as a real estate professional you must meet three conditions:

• You worked more than the minimum threshold of 750 hours during the tax year in real property trades or businesses
• Over half of the personal services you perform during the tax year were in your real estate business
• Material participation in these real estate activities

There are actually some other criteria that you can meet in order to qualify for REPS, but these 3 here are the most straightforward and feasible.

(You can find a comprehensive post going over REPS here!)

And, in this case, New York State was first disputing that Selenid has spent more hours working in real estate than in her, at that time, work as a fellow at Buffalo State University. They claimed that they did not feel she met these criteria and thus we owed New York State $15,000+ in taxes.

This is an aside, but if you are wondering why we invest in real estate or how doctors can successfully invest in real estate like us, this post is a great start!

Our initial response

First, we reached out and contacted our tax advisor, Alexis Gallati at Cerebral Tax Advisors. Alexis and her team guided us the whole way through this process and I can’t say enough how helpful and reassuring it is to work with a tax advisor like her during a process like this.

Second, we sent back documentation showing that Selenid had worked over 900 hours materially participating in our real estate business. We also sent back documentation of her hours worked as a fellow in the forms of her contract and pay stubs.

This was all pretty easy to dispute. So we mailed it off and waited.

The next part of the saga

About 6 months later, NYS finally got back to us. They agreed that Selenid worked more hours on real estate than any other gainful employment.

But now they were disputing something else. They argued that the work performed did not meet the criteria for material participation.

Again, we knew that this was just not the case. We again consulted with Alexi and her team at Cerebral Tax Advisors. They designed for us a spreadsheet where we could re-document every hour that Selenid spend on the real estate business with additional evidence.

We completed this and sent it back.

And finally, after almost a year of dealing with this, we received the last letter from the New York State Department of Taxation, stating that no back taxes were owed on our part and the matter was closed.

Some quick commentary on the whole process

Going through an audit like this is stressful. And we were stressed. There is no denying it.

However, when you know that you played by the rules, it makes things a lot easier. And we knew that we did things the right way.

Then, the stressful part becomes not trying to skirt anything but instead just making sure you can prove beyond a shadow of a doubt exactly how you played by the rules.

3 lessons learned from our tax audit

With this tax audit experience in mind, here are the 3 biggest lessons that Selenid and I learned and want to share for anyone worried about going through something similar…

1. Document, document, document

When it comes to the IRS or state tax entity or whatever it is, the onus is on you to prove that you followed the rules. It’s not enough just to say so.

Therefore you need to make sure that you have documented every little thing and save receipts…the literal and figurative kind.

In this specific example, we chose to document Selenid’s hours in a written calendar every day. In fact, we still use this method currently. It just works better for us than doing it electronically. We have a calendar that sits on our desk and every evening either she fills it out or I ask her what she did and fill it out myself.

Ultimately this is what saved us during this audit. It was simple for us to look back and just relay this information. We also had proof of activities in the form of text messages, e-mails, spreadsheets, physical and electronic receipts and other odds and ends. We even had photos of us doing the work.

So, whatever tax strategy you are implementing, make sure you understand the rules and that you document every little thing along the way. In fact, it’s best to imagine that you will be going through an audit and prepare that way.

2. Have a team

The one I cannot emphasize enough. Of all the lessons we learned from the tax audit, this one is probably the most important. Like I said before, going through an audit of any kind is stressful. Even when you know you followed the rules and did nothing wrong, you can start to doubt yourself or worry about your ability to prove so.

Having an experience team makes all the difference for two main reasons:

1. They know the tax rules in and out. So before you even implement a strategy, they can let you know of everything you need to be aware of and need to do to be successful. And they can tell you what you need to be documenting along the way, and
2. They have been through audits before. So they understand how they work and can guide you through the process to make sure you come out on the other side fairly.

In our case, our tax advisor is Alexis Gallati and her team at Cerebral Tax Advisors. First, they meet with us throughout the year to go over tax strategy as we prepare. This allows us to be proactive in our planning and in implementing strategies. Second, during tax filing, they make sure we have crossed and t’s and dotted all i’s. And third, when an audit did come through, they had all the experience to reassure us, tell us exactly what we needed to do, help us prepare documents, and submit on our behalf.

Good tax advisors are expensive. But I can tell you that having one was well worth it and even more so throughout this process.

3. Build a cash buffer

When going through an audit, you can feel like you are under some criminal investigation. But you aren’t. The tax entity is simply just making sure that you paid your fair share of taxes. The worst thing that can happen is that you owe them money. And this is only in the case where you actually did not follow the tax rules appropriately.

In our case, New York State was disputing about $15,000 in taxes. Again, we knew we did everything right and should not owe this money. But, we also knew that, even in the worst case scenario where we did have to pay that money, we would be just fine.

And this is because we have an emergency fund with more than enough cash buffer to cover this amount if we absolutely needed to pay it.

But you can take it even a step further. Let’s say you are implementing a tax strategy and, even though you know it is legal and are following the rules, you worry about it. Well, you can also just save a cash buffer in the amount of taxes you would otherwise owe without using the tax strategy in case.

Now, this is a pretty conservative approach. I think that having an adequate emergency fund is enough. Because if you are that concerned about a tax strategy backfiring, it’s probably not one you want to utilize. But, if you are just more nervous about this stuff in general, it’s an approach that can help you be more aggressive in your tax planning.

The moral of the story

Here are the main lessons from this whole tax audit experience.

• My outlook on taxes has not changed. We all have to pay our fair share in taxes. But we don’t have to leave a tip. The tax code is written to provide incentives for certain activities. It is okay to take advantage of those incentives.
• When you use the tax code to your advantage, you have to do so according to the rules. Make sure you document how you are doing so along the way.
• An audit can feel scary, but as long as you follow the rules, you don’t have anything to be scared of.
• It’s well worth it to have a tax advisory team that you pay well (and fairly) on your side.
• Don’t let the risk of an audit deter you from being aggressive in your tax strategy.

For more tax related resources and help curated to physicians, you can check out these posts:

• Tax Planning for Doctors: What to Expect in 2025 and Beyond
• An Inside Look at My Personal Tax Plan
• An Introduction to Tax-Loss Harvesting for Doctors
• 3 Important Things to Know About Our Progressive Tax System
• Should Doctors Invest in Real Estate Just for the Taxes?

What do you think? Have you ever had a tax audit? What lessons did you learn from the tax audit experience? What is your tax plan moving forward? Let me know in the comments below!