It was just a regular day: I opened my mailbox, grabbed the pile of what I assumed was a combination of junk mail and bills, and then I saw it—an envelope from the IRS.
At first glance, it looked like a bill, a big one. But as I scrutinized the letter more carefully, I realized it was much worse: I was going to be audited by the IRS.
IRS audits are the stuff of nightmares, but I’m here to tell you that I survived. In fact, although I was terrified at the time, the process wasn’t nearly as frightening as I thought it would be. In an effort to help demystify this process, here’s a reality check on all things auditing-related, from who gets audited to how to cope if it happens to you.
The good news about audits
Here’s the good news: “Audits, in general, have been going down year over year,” says Mike Savage, CPA and CEO of 1-800Accountant in New York City. “They don’t happen as much as people think they do, and the full-blown audit is something of the past.”
“[The number of audits] is below 1%,” says Francine Lipman, a tax law expert and professor at the University of Nevada, Las Vegas.
Tax audits may drop even more in the coming year. The Tax Cuts and Jobs Act of 2017, which went into effect for the 2018 tax year, significantly increased the standard deduction. This means that most homeowners are going to take it rather than itemize. According to Lipman, this lowers the chances of being audited, since the standard deduction is the same for all who take it, rather than being calculated based on your expenses.
What triggers an audit?
Certain red flags on a tax return may prompt the IRS to take a closer look. Here are some of the most common.
The home office deduction
When it comes to the home office deduction, “the rules are complicated and strict,” says Savage. “Most people mess them up. Your [home] office has to be 100% for business. You can’t even share the computer with your kids or use that space for anything at all other than your business.” So if you take this deduction, do so with care—and here are some suggestions for avoiding the mistakes people often make.
This is one of the areas most scrutinized by the IRS. “About one-third of all audits are on the earned-income tax credit,” says Lipman.
Tax credits are a powerful way to reduce your tax bill. Unlike tax deductions, which lower the amount of income on which you will be taxed, tax credits are deducted from the amount of tax that you owe.
For example, if you owe the IRS $5,000 for a given tax year, and you qualify for a $4,000 tax credit, your tax bill will be reduced to $1,000. Some common tax credits include the child tax credit, which could offer a tax credit of up to $2,000 per child, the child and dependent tax credit, which is a credit based on day care expenses, and the earned-income tax credit, which is a tax credit of up to $6,000.
When it comes to tax credits, the burden of proof is on the taxpayer. This means that if the IRS isn’t sure whether you qualify, it’s up to you to provide the proof.
Proceeds from a home sale
If you purchased your home for $200,000 and you later sold it for $250,000, that $50,000 profit would be subject to capital gains tax. Many home sellers qualify to exclude those proceeds from their taxes, but watch out—once again, the burden of proof is on you.
“You can exclude a significant amount of gain on the sale of your residence,” says Lipman, “but you have the responsibility of proving that you qualified for that exclusion.”
You can exclude up to $250,000 of capital gains on real estate if you’re single, and up to $500,000 of capital gains if you’re married and filing jointly, provided that you meet the IRS requirements, which include:
- Having owned the home for at least two of the five years before the date of the sale.
- Having used the home as your primary residence for at least two of the five years before the date of the home sale.
- Not having used this exclusion for another home sale within two years of the sale date.
When it comes to rental property, it can qualify as either an investment or a business for tax purposes. If it qualifies as a business, you can take advantage of the many tax deductions associated with this, including what you spend on advertising, maintaining the property, and insurance.
According to Lipman, for your rental property to qualify as a trade or business, you need to spend 250 hours or more on the property. A hands-on, multiunit property may qualify as a trade or business, but renting out a single-family home may not, so make sure you know where you fall.
Not passing the ‘smell test’
According to Lipman, the “smell test” is whether your tax return makes sense. For example, if you’re a sole proprietor and you have significant losses and no other income, how are you paying your bills? Charitable donations should also line up with your income. According to Michael Raanan, president of Landmark Tax Group and an enrolled agent in Irvine, CA, taxpayers tend to claim about 3% of their income on average as charitable donations.
These aren’t the only triggers, of course. Ultimately, it comes down to the secret formula that the IRS uses to screen tax returns for discrepancies.
If you get an IRS audit notice, how should you respond?
The first step in dealing with an IRS notice: Don’t panic. The notices may give the impression that the IRS has already come to a conclusion. It may look like a bill, but that doesn’t mean you should just pay it.
For example, I carefully read through my audit notice. It looked as if there was a discrepancy with my business expenses as a freelance writer, and the IRS felt that I owed more (a lot more).
For the tax year I was being audited for, I had prepared my own taxes using software. I wasn’t going to deal with the IRS alone, though. So I scoured the internet to find a certified personal accountant who not only had stellar ratings and reviews, but was an “enrolled agent”—meaning that they’ve passed an IRS-administered test about tax laws and regulations.
When I met with her, she was no-nonsense and didn’t seem fazed at all by the IRS notice. She got right down to business and had me gather all my tax documentation, including receipts. I printed out my bank account statements for anything I didn’t have a receipt for and highlighted the relevant expenses.
Once I’d gathered all the right paperwork, my CPA submitted an amended return on my behalf that addressed the issue in question. At the end of the day, I still owed the IRS, but it was a three-figure bill rather than the heart-stopping five-figure one I’d received initially.
And while some audits still involve a visit to your place of residence or work, I was able to handle mine through the mail. It wasn’t the scary, interrogation-room scene I had been expecting.
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