How to Avoid the Top IRS Audit Triggers

April 6, 2011

A reader asks whether there are any new "red flags" this year that will likely trigger an audit. Here's a list of the most common reasons individual tax returns attract the unwanted scrutiny from the IRS.

Q: What are the most common tax return “red flags” that will trigger an audit, and are there any new ones to worry about this year?

A: This year the Internal Revenue Service has its eye on the wealthiest taxpayers, increasing the number of audits for taxpayers with adjusted gross income above $500,000. The audit rate for Americans earning $500,000 to $1 million rose to 3.4% from 2.8% for the fiscal year ended Sept. 30, according to the IRS. Nearly 20% of those earning $10 million or more came under scrutiny last year, up from 11% in 2009.

But even if you’re not among the wealthiest taxpayers, you could find yourself being audited if your returns include certain items -- or patterns of behavior -- that raise concerns. Here are some of the most common audit triggers, and what you can do to protect yourself.

• Under-Reporting Income. Failing to include all sources of income on taxpayer returns will nearly always result in an audit, and most of the audits relate to self-employed or small-business owners. Individual income taxpayers fail to report about 54% of income from sources for which there is no information reporting, such as sole proprietorships, according to the Tax Policy Center.

• Several Years of Small-Business Losses. Report business losses for two years or more in a row on your Schedule C and you’ll raise suspicion from the IRS that your “business” is actually a hobby. And while business losses are deductible against other income, hobby losses are not. Reporting even a tiny profit would lower the red flag.

• Schedule C Deduction Overload. While we’re at it, overloading your Schedule C with deductions that are not typical for the type of business you run -- for example, taking a large deduction for mileage and wear and tear on your car when you’re working from home full-time -- will attract IRS attention. If you do have special circumstances that warrant unusual deductions for your field, make sure you keep good records.

• Home-Office Gets a Break. If you, or your spouse, do work from home full-time or part-time, you no doubt fear the dreaded home-office red flag. The good news is the IRS isn’t targeting this tax break with the same gusto it had in years past. Still, you want to be sure you’re claiming only the breaks you’re entitled to take -- if you’re uncertain, check out IRS Publication 587.

• Home-Buyer Tax Credit. Due to reports of rampant fraud associated with this federal stimulus program -- a report by the Treasury’s inspector general found that thousands of individuals, including nearly 1,300 prison inmates, defrauded the government by claiming the tax break -- you will likely be asked for backup documentation to prove you’re eligible if you claim this credit.

• Large Mortgage Interest Write-Off. If you have pay unusually high mortgage interest of $50,000 or more, you may draw IRS scrutiny. You’re allowed to write-off interest on up to $1 million in mortgage loans, and interest on up to $100,000 of home-equity loans or lines of credit.

• Large Charitable Deductions. Overinflating charitable deductions is a perennial audit trigger, particularly if the donations are made in cash. If you have an unusually large deduction (for example, if you donate a used car or real estate), be sure to have documentation to back it up.

• Round Numbers. Most taxpayers round off cents to the dollar when they prepare their returns, but if too many of your deductions are suspiciously round ($100, $250, $1,000, $3,750, etc.) year after year, you may be communicating to the IRS that you’re playing fast and loose with the numbers. As always, keep good records to back up your reporting.

Bottom Line: You should never avoid claiming a legitimate tax break simply because it’s on IRS auditors’ radar, just make sure you have the documentation to back it up.

ASK THE EXPERT: Do you have a personal-finance or financial-planning question? Send your questions to tcullen@hcplive.com.