The IRS’ audit rate on individual income tax returns was 0.59% in 2018, which represented the lowest rate in the prior 17 years. Households in all tax brackets saw a decline in audit rates, except the $50,000-$75,000 bracket, which experienced a 0.06% increase.
Overall, the low audit risk sounds like good news for taxpayers, but the numbers reflect averages across the entire population of taxpayers. There are several factors that will increase your risk of being audited. Being in a higher income bracket will always increase your audit risk, but thinking you earn less than the super-rich shouldn’t lead you into complacency.
While an IRS audit can be a stressful process, you have nothing to fear if you’re playing by the rules and claiming legitimate deductions. The audit is simply an experience of “show and tell”. You have filed your return, which is the “show” part. The IRS would like you to support what you have shown—the “tell” part.
Here are some of the biggest red flags to keep in mind:
1. Deductions that are exceptionally large in proportion to your income
If your deductions look unreasonable relative to your income, the IRS is likely to take a closer look. For example, say your income is $100,000 and you claim $40,000 in deductions, which leads you to itemize your deductions. Although you may have extenuating circumstances that led to legitimate write-offs, the IRS only sees the bottom-line numbers. Deductions representing 40% of your income are likely to catch their attention.
How to mitigate your audit risk: Make sure you keep detailed documentation of all your deductions. If you deducted expenses, such as mortgage interest or medical bills, keep copies of your statements, bills, and tax forms. Many people, when they receive an audit notice, scramble to come up with the documentation to show that they were in the right. By having all your paperwork at hand, you’ll be ahead of the game.
2. Significant charitable deductions
Like item #1, large charitable deductions are another audit red flag. While the IRS may look at the size of your charitable deduction in proportion to your income, it also knows that you can deduct non-cash gifts (e.g. furniture, vehicles, etc.), which are subject to a variety of regulations based on the type of item donated.
How to mitigate your audit risk: If you’re planning to donate a big-ticket item, be sure to research the rules for that specific item in order to ensure you’re taking a valid tax deduction. There are many nuances, and it may be worth consulting with a tax professional if the donation will represent a significant tax benefit to you. Also remember that you’ll need to have enough deductions to itemize in order to receive the benefit. Finally, it all comes down to documentation. Charitable organizations are required to provide you with a written acknowledgement of receipt of your donation, and you’ll need that document to defend your deduction in the event of an audit.
Timeshare tip: If you’re planning to donate a week at your timeshare or vacation home for a fundraising auction, be aware that you won’t be permitted to take a charitable write-off for that gift because you only gave a portion of your interest in the property. Further, if you rent out your property, the time used by the winning bidder counts toward your personal use for tax purposes.
3. Deducting alimony payments
A new policy relating to alimony payments went into effect for tax year 2019. If your divorce was finalized after December 31, 2018, the ex-spouse who pays alimony may no longer deduct that amount, and the recipient of the alimony won’t have to pay taxes on the alimony income. For divorces finalized in 2018 and earlier, the payer may be able to deduct alimony payments, but the conditions are complex. The IRS takes a close look at returns with alimony deductions to ensure that the taxpayer meets the requirements.
How to mitigate your audit risk: Carefully examine the alimony deduction requirements before you count on taking the deduction. If your situation is unclear, consult a tax professional. Also, remember that the IRS may audit your entire tax return—not just the item that raised the red flag. If you’re deducting alimony payments, take extra care to have all your tax-related documentation in order.
Alimony tip: While the new rules related to alimony payments only apply to divorces finalized from 2019 on, the IRS does allow former spouses with older divorces to take advantage of the new regulations by amending their legal divorce agreements. Note that both ex-spouses will need to agree to make the change.
Other common audit risks
There are several other well-known deductions, credits, and tax situations that will raise your audit risk. If you claim any of the following, be fastidious about your documentation and consult a tax professional with any questions.
- Foreign tax credits
- Claiming the earned income tax credit
- Claiming the health premium credit for health insurance policies purchased on a state or federal insurance exchange
- Investing or dealing in virtual currencies, such as bitcoin
- Failing to report a foreign bank account
- Working abroad and claiming the foreign earned income exclusion
Remember, when it comes to taxes, planning early is your best defense. We offer tax planning services and can answer your questions about unique and nuanced situations. Contact us to learn more.