No one wants to see an Internal Revenue Service (I.R.S.) auditor show up at their door. But the good news for taxpayers is that odds of an audit continue to decline. In 2019, the IRS audited 0.45 percent of personal income tax returns. The I.R.S. budget was roughly $1 billion less than it was 8 years ago, down from $12.1 billion in 2010 to $11.2 billion.
The I.R.S. can’t audit every American’s federal tax return, so it relies on guidelines to select the ones most deserving of its attention. Here are six flags that could make your tax return ripe for an I.R.S. audit.
The chance of an audit rises with income. According to the I.R.S., less than 1% of all individual taxpayer returns are audited. However, the percent of audits rises to over 1.5% for those with incomes between $200,000 and $1 million who attach Schedule C and is over 4% for those making more than $1 million annually.2
If your 1040 deviates greatly from the returns of similar taxpayers, that could raise a red flag. The I.R.S. has a scoring system called the Discriminant Information Function (DIF) that is based on the deduction, credit, and exemption norms for taxpayers in each of the income brackets. The agency does not disclose its formula for identifying aberrations that trigger an audit, but it helps if your return data is within the range of other taxpayers with similar incomes.3
If your business passes for a hobby, you could be scrutinized. Taxpayers who repeatedly report yearly business losses on Schedule C increase their audit risk. In order for the I.R.S. not to consider your business as a hobby, the business typically needs to have earned a profit in three of the last five years.2
Not fully reporting your income boosts the chances of an audit. The I.R.S. receives copies of all of your 1099 and W-2 forms. Individuals who overlook reported income are easily identified and may provoke greater scrutiny.2
Alimony discrepancies between exes can raise eyebrows. When divorced spouses prepare individual tax returns, the I.R.S. compares the separate submissions to identify instances where alimony payments are reported on one return, but alimony income goes unreported on the other party’s return. Keep in mind that The Tax Cuts and Jobs Act repealed the alimony deduction for new divorce agreements after December 31, 2018.2
If you claim rental losses, you had better be a real estate professional. Passive loss rules prevent deductions of losses on rental real estate, except in the event that you are actively participating in a property’s management as a developer, broker, or landlord (the deduction is limited to $25,000 and begins to phase out when adjusted gross income exceeds $100,000) – or devoting more than 50% of your working hours to this activity. This is a deduction to which the I.R.S. pays keen attention.2
Wisdom Wealth Strategies encourages taxpayers to be fully educated on the way our tax system works. The more you know, the better you’re able to manage your tax situation and avoid situations that increase the risk of an audit.
Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.