Eight Red Flags for IRS Audits

The number of people being audited by the IRS isn't that high. For many years, less than 1% of taxpayers undergo face-to-face audits (although wealthy taxpayers have a greater chance of being audited). However, the fact that audit rates are low isn't much consolation if you're chosen. And just because audit rates aren't high doesn't mean you can relax. In fact, it's important to toe the line so you don't wind up being selected.

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 eight red flags:

1. 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.
2. 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 a professional gambler, you might be able to deduct a loss, but the IRS often contests this tax treatment. Recognize the risks. 
3. Unreported income. It's easy to miss income that might fall through the cracks, such as interest, dividends, and independent contractions (nonemployee compensation) from Form 1099-NEC. If you fail to report the income, the IRS may uncover discrepancies with the forms it receives. Be sure to provide your tax return preparer with all forms you receive.
4. 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.
5. 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.
6. 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 casualty event. But be aware that the IRS may scrutinize appraisals to determine if you're inflating a disaster-area loss.
7. Business vehicle expenses. The IRS often flags returns with large deductions for business vehicles, especially if they reflect double-digit depreciation allowances. Briefly stated that 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.
8. Making large purchases in cash. If you've made large cash purchases or bank deposits, prepare for scrutiny. Financial institutions are required to report cash transactions of $10,000 or more, so the IRS won't have trouble following your paper trail.

More Potential IRS Triggers

Here are some other potential IRS triggers to be aware of:

Cryptocurrency transactions are 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 you if you've bought or sold cryptocurrency on your return. 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 could trigger one, too. The IRS matches up the 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 exceeds $10,000 during the prior year.

Consult your tax advisor if any of these are potential trouble areas for you.

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. 

Keep in mind that just because a return is selected for audit doesn't mean that an error has been made. Some tax returns are randomly selected or chosen based on a statistical formula. Returns can also be selected for audit when they involve issues or transactions with other taxpayers who were previously selected for audit. For example, this may happen with business partners.

In addition to face-to-face audits, correspondence audits can be conducted by mail. In the case of face-to-face audits, interviews may be at an IRS office or maybe a "field audit" at the taxpayer's home, place of business, or accountant's office. 

Important point:  Even if your return is audited, an IRS examination may be nothing to panic over. In many cases, the IRS asks for proof of certain items and "closes" the audit after the documentation is presented.

Still afraid of an IRS audit? You probably don't even have to attend. You can stay home and designate your tax advisor to act on your behalf. Consult with your tax advisor about how to proceed. With proper documentation and professional help, you can avoid triggering an audit — or withstand one if it does occur.

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