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Q: My son has owned his home for 25 years. He rents out three of his rooms, charging $300 to $500 a month. He doesn’t take checks, only cash, which he does not report on his tax form. I told him that he’s wrong and could face a heavy fine. Isn’t that right?

A: We’ll assume you tried to teach your boy right from wrong, so that particular ship has sailed. What often motivates people with, shall we say, “challenged” ethical systems is fear of getting caught.

Your son is probably counting on the Internal Revenue Service’s low audit rate to prevent his little scheme from being uncovered. But all it takes is one disgruntled renter willing to call the feds, and his moneymaking scheme could be exposed. Then he would have to pay taxes and penalties on the undeclared income.

If he has underreported his income by 25% or more, he could be in twice as much trouble. Normally, the risk of an IRS audit essentially ends three years after a tax return is due. But if you’ve underreported your income by more than 25%, the IRS can reach back six years.

If the IRS is successful in arguing that your son intended to commit fraud by filing a false tax return, there is no statute of limitations at all, said tax analyst Mark Luscome of CCH Inc., a tax research firm. The IRS could audit and assess taxes for the entire 25-year period he’s been collecting rents under the table.

In any case, your son might discover that declaring the income is a better deal than he thought. Once the rent is on the books, he can start deducting plenty of expenses that otherwise wouldn’t be write-offs, such as a portion of the utilities, insurance and home-maintenance costs. Combine that with the depreciation he could take on the rented portion of a house, and he may find himself ahead financially.

He would have a tax issue when he sells the house, though. Typically, he would be able to exclude up to $250,000 of home sale profit from his income when he sells. But he would have to pay a 25% “recapture” tax on the depreciation he took after May 6, 1997. That’s still no reason not to declare the income, though, because the recapture tax is just a return of some of the deduction he took in earlier years.

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Categories : Q&A, Taxes