3 IRS Red Flags That Could Lead to a Tax Audit

By Matthew Frankel Markets Fool.com

The IRS began accepting 2016 tax returns on Jan. 23, and the fear of being audited is on the minds of many Americans. A tax audit is unlikely, as fewer than 1% of tax returns are audited each year, but there are some factors that could make your tax return more likely to attract the IRS's attention. Here are three major red flags you should be aware of.

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Business income and expenses that don't look quite right

Small business tax returns tend to get a closer look from IRS auditors, simply because there are a lot of ways the allowable business deductions can potentially be abused.

As one example, according to Dave DuVal, chief consumer advocacy officer at TaxAudit.com, "a taxpayer might catch the eye of the IRS if he or she reports thousands of miles driven for business when their occupation doesn't typically require travel."

Other frequently abused business deductions include meals and entertainment expenses, and the home office deduction. To qualify, there must be a defined space in your home that is only used as a home office. In other words, don't think you can deduct the entire square footage of your living room simply because you have a computer cart in the corner that you use to do work.

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Or, if a business reports a loss for several consecutive years, the IRS might grow suspicious. If a "business" doesn't make any money, it could be considered a hobby by the IRS, and losses from a hobby aren't deductible.

Higher-than-average deductions

To be perfectly clear, the IRS knows what the average taxpayer in your income level donates to charity and pays in mortgage interest each year. The same can be said for all the other potential tax deductions. If any of your deductions are unusually high for your income level, it may trigger an audit to make sure you're actually entitled to such a large amount.

DuVal says that while there are no specific deductions that increase the chance of the audit, oversized amounts can draw attention. "For example, if a taxpayer earns $50,000 and reports $35,000 in unreimbursed employee expenses, the IRS might just notice."

As a common example, consider that the average taxpayer with an adjusted gross income (AGI) between $100,000 and $200,000 claims a $4,130 charitable deduction. So if your AGI is $150,000 his year, and you claim charitable contributions of $4,000, it may not attract the IRS's attention. If you claim $40,000, however, it's much more likely the IRS will want to have a word with you.

It's also worth mentioning that many deductions are only taken by a relatively small group of taxpayers. Claiming one of these "rare" deductions for several years in a row could be an audit trigger as well. For instance, in a recent tax year, 2.5% of returns contained deductible moving expenses. If you're claiming a deduction five years in a row that applies to fewer than three in 100 people each year, it could warrant a closer look.

Inflated rental property expenses

Another red flag the experts at TaxAudit.com want you to know about is reporting inflated expenses associated with a rental property. For example, many expenses you report on IRS Schedule E must be depreciated, not deducted all at the same time.

Sustained losses (for more than a year or two) that you're using to substantially lower your other income can draw the IRS's attention as well. From the IRS's point of view, the reason it takes a closer look is the same as the reason it looks at continuous business losses -- simply put, there's no good reason people would continue to sink money or time into a losing business or investment year after year.

Abnormally high losses in any single year could also raise eyebrows at the IRS. That's not to say that legitimate real estate losses aren't possible -- they certainly are -- but controlling abuse is a big IRS priority, so they may want to take a closer look.

The bottom line

This is by no means an exhaustive list of audit triggers. For instance, if two people (such as two divorced parents) claim the same dependent, it could be an audit trigger. Use of the head-of-household filing status also tends to get a closer look.

Also, it's important to mention that you should absolutely claim every penny of tax deductions to which you are entitled, even if they make you more likely to get audited. Just be sure you're being 100% truthful and are prepared to back up your claims, if asked. As a final reminder from DuVal, "remember that actual receipts and records must be kept to prove eligibility for every deduction or credit."

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