8 tax audit red flags

Your home, your tax shelter
Your home, your tax shelter

Budget cuts at the IRS may mean fewer audits this year. But that doesn't mean everyone will get away scot-free.

While chances are low that your return will be targeted by the IRS, why put yourself at risk at all?

Here are 8 relatively easy ways to steer clear of an audit:

1. Report all of your income. Wages from most jobs are reported on W-2 forms, while any interest, dividends and capital gains you made are reported on 1099s, as is income earned by independent contractors or freelancers.

Those forms are sent to both you and the IRS. So be sure to include all information from them on your federal tax return.

Here's why: The agency uses an automated form-matching program to flag discrepancies between what you report and what the IRS has on file, according to the National Association of Enrolled Agents, who are tax preparers authorized to represent clients in an audit.

Any discrepancies will trigger a correspondence audit. Basically, the IRS will send you a letter telling you how much more you owe based on the income you failed to report.

It's up to you whether to just pay the bill or challenge it if you think the IRS didn't calculate it correctly.

2. Run a small business? Prove it. Very few people make a profit when they first start their own business. The IRS understands this... up to a point.

Report losses for three or more years and the agency will start to suspect your business is more of a hobby than a venture aimed at turning a profit, said former IRS tax attorney Garrett Gregory of Addison, Texas.

Such "hobby loss" cases may trigger a field audit, which is in-person and more onerous than a correspondence audit.

Related: Filing a false tax return comes with big penalties

To prove you have a real business, be sure to keep records of your business expenses and document how much time you spend on the business and what you do with it.

You want to prove that you "breathed it, ate it, slept it, drank it," Gregory said.

3. If anything seems weird, explain it. The IRS has its tentacles up for unreported income, so explaining anything that looks questionable may dissuade the agency from pursuing an audit.

For example, if your net income is too low to live on given such factors as where you live and your family size, include a disclosure statement detailing how you supported yourself, including any savings, loans or credit cards that you used to pay the bills, the NAEA recommends.

4. Watch the home office deductions. Typically your office is in one place -- either in a rental space or in your home. So don't report a deduction for both. (If you legitimately have offices in both places, explain why in a disclosure statement.)

If your rental expense is for a business storage unit or equipment, the NAEA recommends labeling that cost as a "storage rental" or "equipment rental."

5. Report the sale of mutual funds: If you sold a mutual fund that you bought before 2011 outside of a tax-advantaged retirement account and you reinvested the money in another mutual fund, you must report it on your federal return, said enrolled agent Stephen DeFilippis of Wheaton, Ill.

If you don't, the IRS will assume the total proceeds from the sale are all taxable gains. And it will send you a letter that recomputes your tax bill accordingly.

In that case, you'd need to go back and prove to the IRS that only a portion of the proceeds represent your capital gains and the rest was your cost basis (i.e.; the amount you originally invested in the fund). Or, if you sold the fund at a loss, that you don't owe any tax on the sale.

6. Come clean about any money overseas: U.S. taxpayers who have bank or investment accounts abroad must report any income they earned on those accounts to the IRS.

While that's always been the case, under the relatively new Foreign Account Tax Compliance Act (FATCA) your foreign financial institution may soon start to report that information to the IRS like any other bank or brokerage would in the United States.

If you've had the account for years, never reported it, and the IRS finds out about it from your foreign bank or investment firm, you could owe some serious penalties in addition to back taxes if the account has generated taxable income, Gregory noted.

Related: IRS will do fewer tax audits this year

To pre-empt such expensive surprises, the IRS has sponsored an offshore voluntary disclosure program that lets people come clean on their own volition and by doing so, reduce any penalties they may owe.

7. Report the sale of your home: When you sell your home, the title company will send you and the IRS a 1099-S form, recording the proceeds from the sale.

Even if all your capital gains on the sale are tax-exempt (because they didn't exceed $250,000 if you're single or $500,000 if you're married), DeFilippis recommends you report information from that 1099-S on your return anyway.

His reason: the 1099-S is part of the IRS form-matching program. Not reporting it may generate a correspondence audit.

8. Be smart about mortgage interest: When you own a home with your spouse, your lender will send you and the IRS a Form 1098, which records how much mortgage interest you paid during the year.

But sometimes the form only includes the name and Social Security number of one spouse, DeFilipis said. Should that person die, and the surviving partner tries to claim the mortgage interest deduction, that may trigger a correspondence audit.

So have the lender change the name and Social Security number on the 1098 before filing. Or, if there's not time for that before April 15, file for an extension and submit your return when you have an amended 1098 in hand.

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