12 IRS audit flags for 2012

Tax form iStockphoto

"IRS audit" is one of most-feared phrases in the English language. While the chance of being audited is pretty low (about one in 100), the chance of being touched by the IRS is on the rise, according to my colleague Kathy Kristof. You may be one of the unlucky two percent of taxpayers who are subjected to random audits, but most IRS inquiries arise for specific reasons. Here are the 12 audit flags for 2012. Remember, many of these are legitimate -- just make sure that you have all supporting documentation in case the IRS calls.

1. Not reporting income: Whoops -- forgot about that consulting gig? The IRS receives copies of all 1099s and W-2s you receive, so make sure you report all income on your return. If you receive an incorrect 1099, talk to the issuer and make sure that a corrected form is filed with the IRS.

2. A large change in income: The IRS computers have all of your historic data, so when there's a big change from the previous year, it can trigger a red flag.

3. Being self-employed: Self-employed workers take note: The IRS doesn't trust you, because so many of you are trying to game the system by under-reporting income and overstating deductions. This class of taxpayer must be well-prepared to defend all deductions and credits.

4. Taking higher-than-average deductions: If deductions on your return are disproportionately large compared with your income, your return may get flagged. To defend yourself, make sure you have documentation.

5. Large charitable contributions: I know that you'd like to have Mitt Romney's tax return, but claiming big contributions like Mitt will flag your return. Again, documentation will save you and don't forget to file form 8283 for donations over $500.

6. Small business losses: The IRS has plenty of experience with taxpayers who try to claim losses on a small business, when the activity is really a hobby. What's the difference? A business must be entered into and conducted with the reasonable expectation of making a profit.

7. Claiming rental losses: With the real estate market as it is, many homeowners are turning into reluctant landlords. Before you start claiming rental losses, you'll need to check out IRS passive loss rules and the two major exceptions for people who make less than $150,000 and real estate professionals.

8. A home office deduction: Are you sitting in your kitchen, checking your work e-mail? Well, that's not a home office, according to the IRS. To qualify for this widely abused deduction, the room must be for work-only. If you really do maintain a home office, you can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance and other costs.

9. Large business meal and entertainment deductions: Wouldn't it be nice to live in a "Mad Men" kind of world, where every meal and trip could be easily classified as a tax deduction? Before you channel your inner Don Draper, remember that big deductions for meals, travel and entertainment are big-time audit flags. Keep detailed records that document the amount, the place, the people attending, the business purpose and the nature of the discussion or meeting.

10. 100% business use of a vehicle: Claiming 100% business use of an automobile is not just a red flag, it's a red flag on steroids, because very few people use a car exclusively for business. No matter what percentage you're deducting, keep detailed mileage logs and precise calendar entries for the purpose of every road trip.

11. Large casualty losses: Did Hurricane Irene leave a wake of destruction in your life? If you suffered a significant casualty loss last year, read what the IRS has to say about casualty, disaster, and theft losses before you file.

12. Math errors: If you goof on your math, the IRS is going to get in your face, so double and triple-check your numbers before you file.

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    Jill Schlesinger, CFP®, is the Editor-at-Large for CBS MoneyWatch. She covers the economy, markets, investing or anything else with a dollar sign. Prior to the launch of MoneyWatch in 2009, Jill was the chief investment officer for an independent investment advisory firm. In her infancy, she was an options trader on the Commodities Exchange of New York.

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