5 tax moves that may trigger an audit
But my mother's advice only goes so far. You see, when it comes to taxes, being normal is a good thing. You want to blend in -- you don't want to be the kind of taxpayer who attracts attention. Here is a list of five red flags that might call attention to your return (and that's rarely a good thing):
Home office deductions. If you use part of your home for business, you're entitled to deduct the related costs as a home office deduction. However, taxpayers occasionally claim non-deductible personal expenses as deductible business expenses. That, of course, has made the IRS suspicious of home office deductions.
To qualify for the home office deduction, the IRS says you must use the part of your home attributable to business "exclusively and regularly for your trade or business." That means your home office must be your actual office, not just a spot in your home where you sometimes do work. And it must be exclusively workspace and not used for other purposes.
To figure out your home office deduction you must pro-rate the use between business and personal. Calculate the amount of space attributable to your business compared with your home's total square footage. For example, if your home office space is 150 square feet and your home is 1,500 square feet, you could claim 10% of your home-related expenses -- including insurance, taxes and mortgage interest -- as a home office deduction. Report the home office deduction on federal form 8829, Expenses for Business Use of Your Home on your personal 1040.
For more information about home office deductions, check out our prior post on the subject.
Disproportionately high charitable deductions. Charitable deductions are one of the most common deductions claimed on a personal income tax return. In fact, more than 90% of taxpayers who opt to itemize claim charitable deductions.
But just because everyone takes the deduction doesn't mean the IRS won't take a second look. The IRS will review returns that include charitable donations that appear disproportionately high as a percentage of income.
What qualifies as high? Taxpayers who claim the charitable deduction donate, on average, about 3% of their income. Anything above that may start raising some eyebrows.
So if you start climbing too far above that number, you might turn some heads. Does that mean taxpayers who donate more are automatically in trouble? Of course not. Many taxpayers routinely donate higher percentages due to religious or other charitable reasons. Just be sure and document your donations properly -- and make sure the values of non-cash donations make sense.
Schedule C. Unlike some tax transactions where the amount in question can spark interest by the IRS, the mere presence of a Schedule C may be enough to call attention to your return. In fact, statistically, taxpayers who file Schedule C are more likely to face an audit. But that's no cause for panic -- the rate of audit for small businesses is still less than 2% of taxpayers.
If you run your own business, and you are not incorporated, a Schedule C is absolutely the proper form to file with your form 1040. Keep in mind, however, that the assumption is you're in business to make money. Filing a loss year after year might make the IRS question whether you're serious about your business -- and how you're getting by.
A double whammy? Filing a Schedule C when you're also an employee. It's not impossible that you're working as an employee and are also self-employed. But remember the profit motive -- losing money when you're also working for someone else may make your business look like a hobby.
If you're a business owner and are worried about your audit exposure, you do have an option: incorporate. Many tax professionals recommend that taxpayers who are collecting substantial income from a small business consider incorporating in order to avoid filing a Schedule C that attracts attention.
Rental Real Estate Losses. A few years ago, rental real estate was the hot ticket to financial success -- or so it seemed. Television show after television show boasted how to buy and renovate real estate. Real estate was a guaranteed money maker.
Cut to today. Losses on real estate -- either at sale or as a rental -- are not that uncommon. In a tough market, landlords are taking cuts in rent in order to get leases signed and occasionally find themselves out of pocket money when tenants leave early or get evicted. The result may be a net loss, however, so be careful when claiming the loss. The rules that govern rental real estate are complicated and can be confusing if you're not familiar with them.
As a rule, the IRS considers all rental real estate activities that aren't performed by real estate professionals to be passive activities. For tax purposes, that means expenses associated with rental real estate activities will be deductible only to the extent of rental income. In some circumstances, there is maximum special allowance of $25,000 in losses for single taxpayers and married individuals filing a joint return. Those losses are subject to phase outs beginning at modified AGI of $100,000 and are completely eliminated at modified AGI of $150,000.
There is a huge exception to these limitations: the material participation rule. If you're considered to be in the business of renting real property because of your active involvement, you may be entitled to deduct rental real estate losses in full. It's unusual -- but not impossible -- that a taxpayer will devote himself or herself to the nearly full-time job of running a rental real estate company. But if you do, don't be afraid to claim losses.
If you're out there cleaning the property, collecting and depositing rent checks and otherwise acting like a real estate manager, you are running a business. In a good market, you're entitled to the profits from your venture; on the flip side, in a bad market, you're also entitled to the losses.
For more information about rental real estate, see IRS Publication 527.
Unlikely business-related deductions. To be considered a bona fide business expense, an expense must be both "ordinary and necessary ... in carrying on any trade or business." 26 USC Sec 162(a) An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business.
A good rule of thumb when determining whether to claim a business-related deduction is that there should be a clear connection between your expenses and your business in order to take the deduction. Don't try to make something fit that clearly doesn't qualify.
If you have a lot of deductions that seem a bit out of the ordinary for your trade or business, you may call attention to your return. But that doesn't mean it's not a legitimate deduction. The IRS may question why you claim the purchase of 500 yards of paisley fabric in your dog grooming business, but it's okay if it's your signature kerchief after each wash. Similarly, deducting the purchase of lemons and vinegar for your house cleaning business might raise an eyebrow -- unless those are alternatives to chemical products. To reduce the likelihood of confusion, annotating or explaining unlikely or unusual deductions on your return isn't a bad thing and may satisfy the IRS at a first or second glance (instead of at audit).
Now here's the important part: An audit flag doesn't necessarily mean you'll end up with an audit. It simply means your return is more likely to get a second look.
Don't be intimidated. If you're entitled to a proper deduction for a home office, claim it. If you have a legitimate business, file a Schedule C. If you lost money in a down market on rental real estate, take the loss. There's nothing in the Tax Code that says you have to pay more taxes than you have to. The key to is be honest and, of course, keep good records.