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Sunday, February 12, 2023

Avoid an IRS Tax Audit With 10 Tips

Tax season is here, and we’ve got a few pointers for keeping Uncle Sam from giving your return a closer look.

Bleah, taxes! You’ve been prepping for your CPA or getting ready to fill out tax forms yourself and feel done, done, done with the whole subject. We don’t blame you. But making sure that you don’t have to endure the extra hassle and headache of an audit down the road is worth educating yourself about what might trigger one, and how you can avoid it.

The good news is that your chances of getting audited are small. Far fewer than 1% of Americans have undergone an audit in recent years, and most of these were by mail rather than in person. However, in 2020 the IRS announced it would be hiring additional auditors. 

Some audits are random, but most begin with an anomaly in the tax return itself that causes an eyebrow to raise somewhere in the vast offices of the IRS. Let’s try and avoid that happening to your return by sidestepping the following audit triggers and making sure you conform to the rules.

  1. Making Big Bucks. Everybody likes to have a healthy income, but if yours is significantly higher than most, or if you got a big payout this year, your chances of an audit go up. That just means that you want to listen to your CPA and have all your ducks in a row.
  2. Deducting Outsized Losses. If you’re taking deductions for bad debt or securities that have declined, in particular if you report them as ordinary loss, you may be in for increased scrutiny. Losses from the sale of rental property can also catch the attention of the IRS, particularly if that loss offsets W-2 income, pensions, or income from other sources.
  3. Failure to Take Required Minimum Distributions. Owners of IRAs face a hefty 50% penalty for not taking RMDs at age 72 and older. There is an exception allowing those turning 72 to delay the first payout until April 1 of the following year. Also, if you are still working you can mostly avoid taking money out of your current employer’s 401(k) until after you retire.
  4. Writing Off a Hobby Loss. Did you fudge a little and try to write off your hobby as a business on Schedule C? Careful there! The IRS doesn’t like it when your stamp collection, jewelry making, or dog breeding “business” loses money year after year and offsets income from other sources. Your business needs to make money three out of five years (two out of seven for horses) and have a reasonable expectation of profitability.
  5. Hiding Gambling Wins or Claiming Outsize Losses. Whether you got lucky on the slots in Las Vegas or made the right wager at Pimlico, Uncle Sam has a hand out for his cut and he will know if it’s missing, because the casino or racetrack will report it on Form W-2G. Recreational gamblers should report winnings as “other income” on their 1040; professionals report it on Schedule C. 
  6. Improperly Claiming Day-Trading Losses. Day traders have some enviable tax advantages. Their expenses are fully deductible and free from self-employment tax. But the IRS is looking for folks who try to trade frequently for a month or two to qualify, but don’t. Valid trading must be continuous over the full year and show an attempt to profit via short-term price changes. 
  7. Not Reporting Virtual Currency Transactions. The IRS has taken a very deep interest in taxpayers who sell, receive, trade, or in any way deal with bitcoin or other virtual currencies, including assembling teams of agents to work exclusively on crypto audits. Virtual currencies are treated as property. See these frequently asked questions for details.
  8. Forgetting to Report a Foreign Bank Account. If you’ve had reason to put money in a bank abroad, maybe for travel or to buy property, you must report it if the balance totaled $10,000 or more at any time in the tax year. Foreign banks will nearly always disclose information to the IRS, so come clean about accounts outside the US.
  9. Claiming Rental Losses. The IRS takes a second look at returns claiming large rental losses. That’s because passive loss rules prevent the deduction unless you actively participate in the renting of your property or if you are a real estate professional spending more than half your working hours and more than 750 hours per year materially participating in real estate. If you qualify, make sure you can prove it.
  10. Running a Business. There are plenty of legitimate businesses claiming deductions on Schedule C, and you’ve earned them. But it’s unwise to try and claim excessive deductions or only a portion of your income because the IRS is looking out for these tricks. The agency pays particular attention to sole proprietorships with more than $100,000 of gross receipts, cash-heavy businesses like hair salons, restaurants and bars, and business owners who report large losses but also have significant wages or other income. 

The bottom line is that if you’re filing more than a simple tax form, it’s a good idea to find a CPA or other tax professional to assist you in filing. They see hundreds of returns every year, and they will likely know if yours could trigger further scrutiny from the IRS. They can tell you what information you need to have in case the IRS comes knocking, and often serve as an intermediary if needed. Consider the cost of your tax professional as insurance against an audit. The peace of mind is worth every penny.