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5 audit red flags
Do you really think you can outfox the IRS? It's best not to try.
November 3, 2005: 3:26 PM EST
This is not the place to be creative as the IRS is watching.
This is not the place to be creative as the IRS is watching.

NEW YORK (CNN/Money) - The overall number of individual audits is still relatively small, but membership in this club is open to all.

Unfortunately, you can never be sure what will trigger an audit.

"That's a very closely guarded secret that not many people in the IRS know," said Bernard S. Kent, a partner with the human resource services group at PriceWaterhouseCoopers and co-author of "PriceWaterhouseCoopers Guide to the 2005 Tax Rules."

"There are only a few items the IRS has specifically said increase the chance for an audit."

You may not be an outright tax cheat, but your return may contain a couple of those red flags. Here are five to watch out for.

Itemized deductions

The IRS is more likely to scrutinize returns with itemized deductions than those that take only the standard deduction.

The agency keeps a range of "normal" deductions for each tax bracket based on the average claim taken. So if you are earning $45,000 a year and deduct half of that for mortgage interest -- but the average for your tax bracket is around $5,000 -- the taxman may come calling. $7,000 on business meals? If the average for your tax bracket is only $1,500, watch out.

Eric Tyson, co-author of "Taxes 2005 for Dummies," says that if you can legitimately claim those deductions, by all means take them. But hold on to your receipts.

Hobby losses

If you are holding down a full-time job but are running a side business, you may be targeted for an audit if your pet project posts a loss year after year. Schedule C is used to report income or loss from sole proprietorships, but some businesses are little more than a cover-up for a loss-producing hobby.

"The code does not permit you to deduct hobby losses," Kent said.

The gentleman farmer that doesn't intend to turn a profit, Kent says, is an example of a hobbyist. And the IRS agrees.

Even if that hobby generates a few bucks, it may be in your best interest to stay far, far away from Schedule C because the IRS may not be satisfied with a modest profit.

Schedule C filers are among the highest audit risk group so be prepared to justify your claims. Kent advises his clients to draft a business plan and to enlist expert help, if needed. Also, carefully record your business expenses and keep them separate from your personal expenditures. The goal is to present yourself as a professional, not an amateur.

Home office deductions

If your place of business is also your residence, be careful with that home office deduction.

"The room has to be used exclusively for business purposes," Kent stated. "You cannot just have a desk in your living room where you have a television set."

Have a tape measure handy because the IRS limits that deduction to the actual space your office occupies. So if your office takes up 200 square feet in a 1,000 square foot apartment, then only 20 percent (200 divided by 1,000) of your total housing expenses are eligible for that deduction. Your total housing expenses includes any rent or mortgage, insurance, utilities, and maintenance associated with the residence.

Tyson notes in his book that a home office deduction cannot result in a loss. The example he uses is that if your business income totals $6,000, but you have $5,000 in business expenses and $1,500 in home office costs, that last $500 cannot be deducted from your taxes.

You can, however, carry that deduction over to the next year provided you have sufficient income.

Casualty losses

The rules regarding casualty losses are very specific. As Kent explains such losses must exceed any insurance reimbursement by $100. Even then, that first $100 is not deductible.

Next, your loss must be attributed to a sudden event such as theft, fire, or hurricane damage. Losses that result from a gradual wearing down of conditions -- erosion for example -- do not qualify.

And finally, the total loss must exceed 10 percent of an individual taxpayer's adjusted gross income (AGI) after any insurance payments have been received. That percent isn't deductible either and you cannot claim the loss until you've been reimbursed by your insurer.

An example Kent uses in his book is if your home was damaged by lightning and your loss, after any insurance payments have been received, totaled $20,000 the first $100 is not deductible. Now if your AGI is $70,000 then the first 10 percent, or $7,000, of the remaining $19,900 isn't deductible either. That leaves you with only a $12,900 casualty loss deduction.

Also note that your deduction is limited to the actual cost of the item, not its value.

High income

Not only are your taxes higher, you are chances of being audited are 1 in 20 if you earn $100,000 or more.

"Higher income earners are more likely to be audited because there is more tax money at stake," Tyson said. "The IRS is a business, they have employees and they do not have time to let them audit people if they are only going to earn $2 worth of tax."

Earning less money really isn't an option, but high earners should be aware that the government is eyeing their returns very carefully. So any temptation to tack on another $1,000 to a charitable deduction shouldn't be indulged.

Luckily, none of that applies to me...

You may not fall into any of those categories, but a few careless errors may cause the IRS to take a second look at your returns.

Using tax preparation software could alleviate some of the drudgery and cut down on simple mathematical errors. If your math is off, the IRS will likely re-compute your taxes.

"If it is a relatively small thing, like you transpose two numbers, that is less likely to trigger an audit than if you omit a large portion of your income," Tyson said.

Also, be sure to sign and date your return once it is completed. This isn't an audit red flag either, but you don't want to lure the IRS into looking over your return for more than is necessary.  Top of page

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