Many people panic and break out in a sweat when they receive an IRS audit letter. But the truth is that an IRS audit doesn’t have to be so scary.
Sloppy recordkeeping is a common audit trigger. If you claim a home office deduction, be sure to keep detailed mileage logs and accurate records of square footage usage.
Home Office Deduction
The home office deduction is a common audit trigger because it allows the IRS to compare your return with that of other taxpayers. You can qualify for this write-off if you use a portion of your house or apartment exclusively for business and meet other requirements, such as meeting clients in your home or keeping records at work. It’s also important to keep good records of any expenses you claim for your home office, such as photos and receipts, so you can prove them if you’re audited.
For effortless IRS-compliant mileage reporting using real drive data, MileageWise allows users to create accurate free mileage logs with Google Timeline integration at https://www.mileagewise.com/free-mileage-logs-with-google-timeline/, automatically populating trips logged in Google Maps.
Another common audit trigger is claiming large charitable donations. If you itemize your deductions, keeping track of all your cash and noncash donations, including their value is a good idea. It’s especially important to have documentation for high-value items, like artwork or vehicles, which may require a professional appraisal to get the most accurate valuation and deduction amount.
While COVID-19 has allowed more people to start working from home, this doesn’t necessarily make them eligible for a home office deduction. You’re only eligible for this tax break if you run a bona fide business as an independent contractor or entrepreneur, and it must be your principal place of business. The space doesn’t need to be huge, but it must be a room or part of a room that is used exclusively for your business.
Some financial service providers say that you can satisfy the exclusive-use test by limiting your home office to one area of the home, such as a spare bedroom or an alcove in a living room. It’s also important to have a separate phone line, internet service, and utilities for the space and to limit personal activities such as watching TV or playing video games.
You’re more likely to be audited if you earn a higher income, but the rates for wealthy individuals have fallen in recent years. Nevertheless, those who receive a large sum of money from an inheritance or investments are still at higher risk of being audited than lower-income people. If you’re among the wealthy, reviewing your returns with an experienced tax professional before filing is a good idea.
Car Expenses
You can deduct mileage and related car expenses for business trips, even if you don’t use a separate vehicle solely for business. But you must be able to back up the expense with meticulous car-related logs and other records. Sloppy recordkeeping is a big audit red flag.
The IRS established a standard mileage rate to make it easier for independent contractors to claim their write-offs, but you can also choose to use actual expenses instead. Using the actual expense method allows you to deduct your gas, oil, repair costs, insurance, taxes, and loan interest. You can also write off the depreciation on your old car if you bought it new or used it for more than five years.
Using your home for both personal and business use is another common audit flag. If you have a dedicated work area in your home, measure the square footage and carefully document how much time you spend each year working in that space to calculate your percentage of work-related home office use.
Traveling for business is a legitimate and deductible expense, but the IRS is very strict about keeping detailed and accurate records. Be sure to keep a log book in your vehicle for recording miles and other related expenses, including parking fees, tolls, gas, oil, car washes, and repairs. A simple app like Stride can help you easily track your vehicle-related expenses and provide a detailed log that the IRS will accept as proof of your deductions.
A tax professional can help you understand your audit risk and determine whether you are highly likely to be selected for an IRS examination. The good news is that audits are less common than many people think. According to Syracuse University, Americans filed over 157 million individual tax returns in fiscal 2020, and only 626,204 were audited by the IRS.
However, the number of audits is increasing, especially for individuals with higher incomes. This is because the IRS needs more staff to review higher-income returns. It’s also because the IRS has a larger and more comprehensive database of income information to analyze for discrepancies.
Large Charitable Donations
Whether it’s cleaning out your basement and donating used clothes or getting rid of old furniture at a thrift store, charitable donations can be a great way to save on taxes while helping others. However, it’s important to be careful when planning large donations. Specifically, you’ll want to make sure that you don’t time your donation to land in a different tax bracket. You’ll also want to be cautious about claiming too many home office expenses or making excessive deductions from noncash gifts.
According to the Boston Consulting Group, one of the biggest triggers for an IRS audit is large charitable donations. The reason: the very wealthy give away a much higher percentage of their income than people in other groups do. In fact, the average American household gives away between 4 and 6 percent of its discretionary income to charity — well above the global average of 2 percent. And that’s especially true of people in major cities.
In the case of San Antonio, for example, the city’s wealthiest residents donate a robust 7 percent of their income to charity. By contrast, denizens of other major cities like Boston and Providence give away only 2 percent of their income to charity. Even Silicon Valley lags behind, with San Jose and San Francisco residents giving away just 2.2 percent of their income.
When maximizing your charitable donations, it’s important to keep good records and get receipts for noncash gifts valued at more than $500. You should also have any donation appraised and file Form 8283 for any property worth more than $5,000. And if you claim any of your donations as a deduction, it’s essential that you itemize on Schedule A of your return.
It’s also smart to consider specialized charitable vehicles, such as private foundations or donor-advised funds, which can help you manage your donations and minimize taxes at the same time. For instance, a donor-advised fund allows you to take a current-year tax deduction for appreciated assets invested long-term while allowing you to continue managing those investments over time.
High-Income Individuals
While the overall audit rate has declined in recent years, it’s important to understand what makes you more prone to drawing the IRS’ attention. The good news is that mitigating these 9 audit triggers can help you avoid being selected for a full-blown IRS examination and help you prepare in case the federal agency audits you.
Math errors: Small math and clerical mistakes like transposing digits or forgetting to include a zero can attract the attention of an IRS examiner, but they typically don’t lead to a full-blown audit. Instead, the IRS might send you a CP2000 notice, which states that their computer system has found an inconsistency between your return and official income tax documents they receive, like W-2s or 1099s. The CP2000 notice usually asks you to explain the discrepancy and provides proposed changes that they may make to your return.
Large charitable donations: If you itemize deductions on Schedule A of your tax return and donate items that are valued at more than $250, the IRS may audit you to ensure you’re getting a fair amount of the deduction. If you’re donating valuables, the best practice is to get a written appraisal from the charity and keep it in your records.
Hobby losses: The IRS is on the lookout for taxpayers who report substantial losses year after year from “hobby-sounding” activities to offset other, higher-grossing income sources such as wages or business or investment income. The IRS has lost many of these cases in court, but they’re still worth avoiding if you can.
Non-filers: While the IRS hasn’t always been diligent in pursuing individuals who don’t file required returns, the government agency does now put this issue near the top of its enforcement priorities. Individuals who don’t file risk fines and even criminal prosecution.
If you’re selected for an IRS audit representation, the agency will send you a letter that provides details about when and where the exam will occur. The review could take place at an IRS office, your home, or your tax preparer’s office. The IRS can choose to audit returns from the past three years for personal matters and up to six years for business matters.