IRS audit! The mere thought of those two words sends shivers up the spines of many American taxpayers. The good news, though, is only around one out of every 116 individual tax returns from 2014 was audited by the IRS, according to Kiplinger. Those aren't terrible odds.
But here's the bad news. Certain tax deductions increase the likelihood that your tax return could be flagged for auditing. Here are five deductions that the IRS watches closely.
1. Business travel and entertainment
You definitely will want to deduct any legitimate business-related travel and entertainment expenses. However, the amount of those expenses you report could put you at higher risk of an audit.
The IRS compares business travel and entertainment deductions against other tax returns for people in the same occupation. Amounts that are significantly higher than the average make it more likely you'll be flagged for an audit.
For example, suppose you own a small coffee shop. If you reported $12,000 in business travel and entertainment deductions, you'd probably be much more likely to be audited than your next-door neighbor who ran a consulting business and submitted the same amount on her tax return. Consultants tend to travel a lot more than small business owners -- and the IRS knows it.
2. Rental property losses
Many expenses related to renting property can be written off as tax deductions, including maintenance, insurance, taxes, and interest. However, the IRS wants to make sure that taxpayers have a motive of making profits when rental property deductions are taken.
Let's say you have a beach house that you only rent out occasionally. Maybe you vacation there frequently or let your out-of-work nephew live there for free. Both are great things to do -- but they could disqualify your rental property deductions.
One way to minimize your chances of an audit related to rental property losses is to be able to show a profit. That means you have to rent out the property often enough during the year to make at least a little money off of it, thus showing the IRS you have that critical profit motive.
3. Alimony payments
If you receive alimony payments, you need to report them as income. But if you pay alimony to a former spouse, you could deduct the amount. Be aware, though, that these alimony deductions are likely to increase the odds that your tax return is audited.
The IRS has some strict requirements on alimony deductions. If you pay child support, for example, you can't deduct it like you can alimony. Also, suppose you agree to give your former spouse more money than the divorce or separation decree specified. Only alimony specifically included in the decree can be deducted.
It's also very important that you include your former spouse's Social Security number or individual taxpayer identification number on your tax return. If you don't, your deduction could be disallowed. And if you do supply your ex-spouses number, and they declare a different amount for alimony income than you attempt to take in alimony deductions, your chances of an audit will be much greater.
4. Hobby losses
If you earn money from a hobby, you have to report it as income on your tax return. On a positive note, though, you can also deduct expenses related to that hobby. The risk comes if you report more expenses than you have in earnings from it. Those hobby-related losses could interest the IRS.
The IRS only allows losses for hobbies if you treat them like a business. There are several questions that can help you determine if your hobby qualifies a business operation, including the following:
- Does the time and effort you put into the hobby indicate an intention to make a profit?
- Have you made a profit from the hobby -- or, if not, do you expect to do so in the future?
- Do you depend on your income from the hobby?
One slam-dunk way to prove that your hobby is a business is to show a profit from it in at least three of the past five years. If your hobby is breeding, showing, training or racing horses, the criteria for qualifying as a business is achieving a profit in at least two of the past seven years.
5. Any really large deduction
As a general rule, any deduction that comprises a high percentage of your income could flag your tax return for an audit by the IRS. The deduction could be for charitable giving, small business expenses, or gambling losses. If it seems to be large, the IRS just might be curious.
The main thing the IRS is focused on here is the proportionality of the deduction to your income. A charitable deduction of $10,000 isn't nearly as likely to attract attention if you make $100,000 per year as it would be if you make $30,000 per year.
Don't be afraid to report any and all legitimate expenses when you file your tax return. But if your deductions fit into any of the categories mentioned above, it's smart to follow the Boy Scout motto: Be prepared.
If you are audited, there's a good chance that the audit will be conducted entirely through mail correspondence. Some audits, though, are done in person. The most important thing for you to do is have all the documentation related to your tax return available.
Finally, there's always the possibility that an IRS audit might actually work in your favor. Out of the 1.2 million audits conducted by the IRS in 2014, taxpayers received additional refunds more than 38,000 times. Sure, that's a small percentage, but you could be one of the lucky few.