If you read last month’s newsletter you learned that the chances of getting audited by the IRS are relatively low for those earning less than $200,000. However, there are certain red flags which will trigger an audit regardless of income. Avoiding these red flags may further reduce your chances of an audit.
Failure to Report all Taxable Income
The IRS receives copies of all 1099s and W-2s issued to you. The IRS computers match the income reported on your tax return with the information they have received regarding your income. If the information does not match, you will receive a letter from the IRS alerting you of the unreported income, adjusting your tax liability and asking that you either pay the amount or dispute the adjustment.
Taking Higher-Than-Average Deductions
If the deductions on your return are disproportionately large when compared with your reported income, your return may be selected for audit. If you are entitled to the deduction, by all means claim it. The key is to make sure you have all the necessary paperwork to substantiate the deduction in the event you are audited.
The IRS has information regarding the average charitable donation for taxpayers of
your income level. If the charitable deduction on your tax return is not in line with the
average charitable deduction for your income level, as determined by the IRS, there is a higher chance that your return will be pulled for audit.
In addition, if your charitable donation is of a type that requires an appraisal or that
you file a Form 8283 and you fail to do so, the likelihood of an audit becomes much
greater. Certain types of donations, such as easements, almost guarantee an audit.
When making charitable donations make sure to obtain and retain the documentation
required by law. Doing so will make any audit much more likely to result in a favorable
outcome for you.
Failure to Take Required Minimum Distributions
If you are the owner of an IRA, or a participant in a 401(k) plan or another retirement plan to which the required minimum distribution rules apply, you must take the yearly distribution and properly report it on your tax return. While there are some exceptions, the general rule is that required distributions must begin when you reach the age of 70½ and must be taken by the end of the year. Failure to do so will result not only in an adjustment to your income tax, but may also result in a penalty for failure to take the required minimum distribution.
Claiming Real Estate Rental Losses
One of the draws of having rental real estate is the large deductions generated. These deductions generally result in a rental real estate loss which can then be used to offset other income. The passive activity loss rules were instituted largely to prevent this. There are two major exceptions to the passive activity loss rules. The first is if you actively participate in the renting of the property and the second is if you are a real estate professional.
The IRS heavily scrutinizes real estate rental losses. If your return claims large rental real estate losses you can expect to hear from the IRS. Proving up active participation or real estate professional status are not easy tasks. If you qualify for either of these designations it is important that you keep contemporaneous records of the required activity. There are numerous court cases holding that preparing the records in anticipation of an audit or during an audit are not acceptable.
Gambling Winnings or Losses
Gambling winnings are reported by the casino to the IRS. Failure to report these winnings will draw scrutiny from the IRS. Keep in mind that gambling losses can only be deducted to the extent you report gambling winnings. Different rules apply to professional gamblers. The odds that someone who reports large gambling losses by claiming to be a professional gambler will have their return reviewed by the IRS are high.
Writing Off Hobby Losses
It is possible that your business may be operating at a loss entitling you to claim and deduct the loss. However, the activity must be carried on in a business-like manner and there must be a reasonable expectation that the activity will generate a profit. If not, the activity is a hobby.
While you can deduct expenses generated to the extent of income earned from the hobby, losses generated by the activity are not deductible. If the gross income of the activity exceeds the deductions in at least three out of five consecutive years, the law presumes that the activity is not a hobby, unless the IRS establishes otherwise. There are different rules for horse breeding, racing, training and showing.
It is important that you maintain records which prove that the activity is a legitimate business and not a hobby.
Failure to Report a Foreign Bank Account
There are rules regarding bank accounts held in foreign countries. These accounts may have to be disclosed to the IRS. Some holdings may require the filing of financial forms. The IRS has had success in getting foreign banks to disclose information about accounts held by US taxpayers. The penalties for failure to disclose foreign accounts are steep and involve not only civil penalties, but may also involve criminal penalties. Hence, it is very important that you properly report any such accounts you may have.
If you should win the IRS audit lottery, recall that I am available to help you through it.