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Some deductions get more scrutiny than others

The odds of being singled out by the Internal Revenue Service are very low, but certain types of deductions, even very common ones, can raise red flags with tax collectors and possibly trigger an audit.

To minimize the chance of getting an audit request from the IRS, tax experts say take care with certain deductions and keep good paperwork to back up claims.

Joy Taylor, assistant editor for The Kiplinger Tax Letter, said 0.96 percent of individual tax returns last year were audited, the first time in seven years that the overall individual audit rate slipped under 1 percent. The IRS has fewer resources, lower budgets and less personnel than before, she said, which is why there were fewer overall audits.

However, that doesn’t mean the IRS has gotten any less zealous about audits. Instead, Taylor said, “They’re more hyperfocused, doing what will get them the most bang for the buck.”

One of the biggest red flags the IRS looks for is outsize charitable donations relative to income. Taylor and Leif Novie, principal at Morrison Brown Argiz & Farra LLC, both said the IRS charts average deductions based on a person’s income, so if charitable donations appear excessive, it may raise eyebrows.

The IRS may ask for proof of such donations; Taylor and Novie said charities will give receipts for contributions. Noncash donations of more than $5,000 without an appraisal of the item’s value will invite closer examination.

Novie said one of the most common deductions for self-employed individuals that can trigger an audit is for a home office.

“Lots of individuals are under the misconception that they can deduct their home office even if they have another office to work in. The rule is you can only deduct a home office if you don’t have another office available to you,” he said.

It has to be an area that’s devoted exclusively and regularly to business, Taylor said. “If you have an office in the home, but it’s also used as a rec room, that won’t count.”

An offshoot of the home-based business deduction is one for a work vehicle, she said. Trying to claim that an auto’s use is all business is risky.

“Many people might own two vehicles and write one off 100 percent for business use. But you may be also dropping the kids off at school in the same car, taking them to practice, running personal errands in that car. There’s a lot of fudging (by people) with business vehicles,” she said.

Many business owners will deduct losses, but Novie and Brittney Saks, U.S. personal financial services leader at PwC, said showing losses year after year may pique the agency’s interest.

“If you have a business, you have more ability to offset your income with expenses, so there’s more subjectiveness in there,” Saks said. “In particular (the IRS wants) to make sure it’s a real business and not a hobby … It doesn’t mean it’s not a business. Over time, if you’re going to have losses over three to five years, the burden of showing it’s a business and not a hobby may shift to the taxpayer.”

Make certain that income and deductions match, Novie said. He gave the example of a client who wanted to deduct interest expenses from a Form 1099 that belonged to her husband, who filed a separate return.

“The fact that she wanted to declare an interest expense without a corresponding 1099 is going to raise a red flag. Just in that vein … people who get a 1099 on interest or dividends or capital gains, and they fail to match what’s on their tax return with that 1099, that’s the most obvious red flag there is,” he said.

Gene Sulzberger, senior vice president at EFG Capital Advisors, said that for affluent individuals, the IRS has turned a laserlike focus on foreign accounts. In the past, holders of overseas investment and bank accounts could just claim that not disclosing the accounts was an oversight, but that’s no longer the case.

“Before you could say, ‘Oops, I have not been reporting that foreign income; I better fix that now.’ No longer. It’s gotten to the point now where the IRS has been demanding this (information) for some time. If you haven’t been doing it, consult a tax attorney and your accountant right away. Some of the penalties include losing a good portion of that account, and it could be jail time depending on the level of culpability in not informing the U.S. government,” Sulzberger said.

Finally, Saks said, people worry simple mistakes like computational errors or transposing numbers will trigger an audit, but that’s unlikely. The IRS will notify the taxpayer, since the agency has data matched up on a computer, but she said those typos are easily fixed.

Another simple mistake that will lead to IRS questions, but not necessarily an audit, is failure to file all necessary documents, Saks said. Some investment firms that issue more complex tax forms may send them late, so taxpayers with complicated investments may need to wait before finishing their taxes. That could result in the need to file for an extension.

Saks said taxpayers who forget these extra forms will get a notice from the IRS to amend their taxes, and doing that might just take care of the problem.

But any time taxes need to be amended, she said, “The IRS is giving your return a second look. By doing that, it may spark some interest, or lead them to say, ‘Is there anything else we should look at in greater detail?’ It doesn’t necessarily mean you will owe any more money. It does take time, but it does emphasize the importance of having good records.”