7 Red Flags for IRS Audits
7 Red Flags for IRS Audits - What You Need To Know
IRS audits of individuals are down. According to statistics for 2019, the overall audit rate fell to the historically low rate of .4%. Even rates for high-income earners — traditionally favorite targets of the IRS — were relatively low. For nonbusiness taxpayers with income between $200,000 and $1 million, the rate was a similar .4%; it was 2.4% for those above $1 million. And rates are expected to drop even further for 2020 due to the pandemic.
Does that mean you can relax completely? Not on your life. In fact, it’s as important as ever to toe the line so you don’t wind up as one of the “chosen few.”
Reduce your exposure
How can you reduce your audit chances? Be aware of possible warning signs that may trigger scrutiny from the IRS. While there’s no question that you can claim legitimate tax breaks, you must strictly adhere to the rules. Watch for these seven red flags:
- Large charitable donations. The IRS can reference data providing average charitable deductions based on various income levels. If you’re “above average” for your category, you might call attention to yourself. This is especially true if you’ve deducted charitable gifts of appreciated property. Make sure donations are supported by independent appraisals, if required.
- Gambling losses. Generally, you can deduct losses up to the amount of your winnings on your personal return, but you must have proof to back up your claims. If your gambling activities rise to the level of professional gambler, you might be able to deduct a loss, but the IRS often contests this tax treatment. Recognize the risks.
- Unreported income. It’s easy to miss income that might fall through the cracks, such as interest and dividends as well as nonemployee compensation from Form 1099-NEC. If you fail to report the income, the IRS may uncover a discrepancy with the forms it receives. Be sure to provide your tax return preparer with all forms you receive.
- Rental income and deductions. You don’t want the IRS to find that you played fast and loose with the rules for rental properties. Showing a loss for the year despite a high rental rate could trigger an inquiry. Generally, you may use up to $25,000 of loss to offset income from non-passive activities, but you must meet specific participation requirements. Check with your tax advisor to see if you’re on firm ground.
- Home office deductions. If you use a portion of your home regularly and exclusively for your business, you may be able to deduct the expenses and depreciation associated with the space. Usually, the greater the business percentage claimed for use of the home, the greater the audit risk. Employees who work from home (as opposed to self-employed people) currently can’t claim deductions. The IRS may ferret out taxpayers trying to bend the rules during the pandemic.
- Casualty losses. Despite recent legislative changes restricting casualty loss deductions, you can still write off losses to personal property sustained in a federally-designated disaster area. What’s more, you may even elect to deduct the loss on the return for the year preceding the year of the casualty event. But be aware that the IRS may scrutinize appraisals to determine if you’re inflating a disaster-area loss.
- Business vehicle expenses. The IRS often flags returns with large deductions for business vehicles, especially if they reflect double-digit depreciation allowances. Briefly stated, you’re required to keep a contemporaneous log of your driving activities, along with proper substantiation. Collect all the proof needed to withstand an IRS challenge.
Don’t panic
Of course, this isn’t the end of the list — not by a long shot. There are many other potential problem areas, depending on your particular situation. Contact your tax advisor about how to proceed. With proper documentation and professional help, you can avoid triggering an audit — or withstand one with flying colors if it does occur.
Sidebar: Other potential IRS triggers
Here are some other potential IRS triggers to be aware of:
- Cryptocurrency transactions. This is a relatively new potential audit target. Generally, transactions involving cryptocurrency like Bitcoin are traded like other property transactions for tax purposes. The IRS now specifically asks on your return if you’ve bought or sold cryptocurrency. If you’ve answered yes, be prepared to verify your information.
- Day trading activities. Most taxpayers offset capital gains and losses from securities sales on Schedule D of their personal tax returns. But claiming to be a “day trader” may help you benefit from favorable tax provisions, including deductions for specific expenses. If you do this, consult with your tax advisor to ensure you’re ready to respond to any IRS inquiries.
- Foreign bank accounts. Checking the box on Schedule B that indicates you have a foreign bank account could increase your chances of an audit. But failing to do so, when you should, could trigger one, too. The IRS matches up information it receives on foreign bank accounts. Generally, a taxpayer must file a Report of Foreign Bank and Financial Accounts (FBAR) if the aggregate value of assets in foreign bank accounts exceeded $10,000 during the prior year.
Consult your tax advisor if any of these are potential trouble areas for you.
This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.
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