Seven Ways to Trigger an IRS Audit

SMITH BRAIN TRUST – Could the tax deduction you take on mortgage interest actually result in a tax audit from the IRS? How about the early withdrawal you made from your retirement account last year, or the charitable donation you made? Smith School lecturer Samuel Handwerger warns that the deductions you plan to take this year could put your income-tax return squarely in the crosshairs of an IRS auditor. Handwerger says there are at least seven audit priorities for the Internal Revenue Service this tax year. They are:

Foreign Bank Account and Investment Income 

The IRS has been clamping down in recent years on taxpayers who fail to report income from overseas. At least two forms of information returns are required when taxpayers declare their overseas investments. Failure to file these can lead to big penalties. In addition, under the Foreign Account Tax Compliance Act (FATCA), the IRS is getting information from foreign countries and foreign bank accounts about the U.S. citizen taxpayers who have accounts there. IRS efforts in this area have returned billions of dollars in additional tax revenue in recent years. You can expect it to continue.

Real Estate Rental Losses

Real estate rental losses continue to dominate the IRS audit agenda. Even though the tax code allows for unlimited use of lost deductions for rental properties owned by real estate professionals, the IRS has been successfully winning cases where the real estate professional has not kept adequate records to prove special status.

Mortgage Interest Deduction

The mortgage interest deduction is limited to the mortgage interest on $1 million of acquisition debt and $100,000 of homeowner equity. A new form 1098 was devised by the IRS recently to give the tax agency more information on who might be exceeding their allowable mortgage interest deduction. That's why we can expect more scrutiny in that area.

Cost Basis on Assets

Cost basis on assets is hot on the IRS list. Often, taxpayers overstate their cost basis, thereby reducing their reported gain. Congress recently gave teeth to the IRS in enforcing this area by extending the statute of limitations for audit challenges. For overstating cost basis by 25 percent or more, the IRS now has 6 years to audit that tax return. This surpasses the general three-year statute for IRS audits. 

Early Retirement-Account Withdrawals

The IRS believes that almost 40 percent of taxpayers taking early withdrawals from their retirement accounts are failing to pay the 10 percent penalty. We certainly expect the IRS to step up enforcement efforts in this area.

Self-Employment (and Hobby-Law Rules)

Self-employed individuals cough up substantial dollars in taxes owed when the IRS audits these enterprises. And cash-basis reporting enterprises get particularly hard hit. Enterprises like these, including hair salons, restaurants and car washes, often underreport their income. And many of them overreport the deductions they can prove for vehicles, meals and entertainment and home-office expenses. When such businesses report losses in three out of five years, they’re subject to the hobby laws rules. Under the rules, the losing business is presumed to be a hobby and is precluded from deducting losses against other income. However, it is a rebuttable presumption that the taxpayer can overcome with proper documentation. Small business owners who find documentation to be an issue often cannot overcome these rules.

Charitable Donations

Charitable donations remain high on the IRS target list. Taxpayers often overstate the fair value on gifts of property they make to charities. Further, when the value of property given away exceeds $5,000, qualified appraisals are required and many taxpayers fail to attach that to their tax return. Even when they do, the IRS often challenges the value on the appraisal. The IRS keeps pretty good records to gauge normal donations per levels of income. That allows the agency to spot excess charity deductions easily through its computer-matching programs. Finally, most donations require the taxpayer to have and keep receipts from the charity - contemporaneous with the filing of their tax return. The IRS has been increasing their scrutiny of this requirement. Donations are now being denied when the taxpayer did not have the receipts at the time of filing their return.