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IRS Audit: How to Avoid One

This article was updated on March 7, 2011.

No matter how fastidiously you file your receipts or how professionally your accountant fills out the forms, you probably still fear an IRS audit. And thanks to a flurry of tax changes this year, there are more audit red flags than usual.

In fact, the IRS has a top-secret, obsessively guarded computer program that targets certain tax returns for closer examination. It’s called Discriminant Inventory Function System (DIF) and it means that some deductions and credits are more likely to attract the government’s attention than others. If you don’t know about these red flags, noted below, you might be asking for an audit.

Some recent tax-law changes may not have made it into the DIF formula yet, but they will still be on the IRS’s compliance radar. In fact, the IRS has said it will closely examine most returns claiming the first-time homebuyer credit.

Keep in mind that only 1 percent of individual returns are audited (3 percent, on average, for individuals with incomes over $200,000). So it’s generally foolish not to take a legitimate write-off just because you think it might up the odds of your return being pulled. Your strategy shouldn’t be to skip deductions on the IRS’s hit list, but to handle them with care and be sure you have documentation to back them up.

1. Business Use of Your Car

Don’t guess how much you drove your car for work. You can base your deduction on your actual expenses or use the IRS’s standard mileage rate of 50 cents a mile — but either way, the IRS could ask you for records of your business mileage and an accounting of the purpose of every trip claimed. GPS devices and precise calendar entries can be very effective in bolstering your claim.

2. Home Office Deductions

You can claim a home office deduction for a percentage of your mortgage, utilities, phone bills, insurance, and maintenance allocated to space used “exclusively and regularly” as a principal place of business. A lawyer who occasionally writes briefs in a study that is also used as the family’s TV room will have trouble claiming the space as an office.

3. High Itemized Deductions for Your Income

Don’t try to claim $25,000 in charitable contributions if your income is $125,000. “The IRS has a range in which they consider certain deductions reasonable,” says David Vishnia, a CPA in New York. “If your return doesn’t fit the IRS’s profile, the computer kicks it out, and a human being looks at it.” The average charitable contribution is $3,790 for people with adjusted gross incomes of $100,000 to $200,000 who claimed charitable donations, according to the most recent IRS statistics.

4. Non-Cash Charitable Contributions

These could be clothes, household goods, artwork, a car, or any kind of property. The IRS requires you to file Form 8283 for donations over $500. “That form alone is a red flag,” says Vishnia. The key is having all the supporting documents. Make sure you have an itemized receipt for contributions to Goodwill, Salvation Army or a church clothing drive. If you’re given a blank form to list your donations, make sure you fill it out and have the charity sign and date it.

5. Investment Income Discrepancies

Your bank, broker, and mutual funds send the IRS statements listing every penny they paid you. But financial institutions make mistakes. For example, if you make your 2010 IRA contribution between January 1 and April 18, 2011, your broker might inadvertently report the tax year as 2011. “All he has to do is check the wrong box,” says Vishnia. “When you make the contribution, be sure to get a receipt from the brokerage stating the tax year.”

6. Math Errors

This is a gimme for the taxman, so check your numbers. Then check them again. It doesn’t matter if you underpay your taxes because you added the numbers wrong, any underpayment will be due, with interest — currently 4 percent compounded daily, though it's set to decrease to 3 percent for tax year 2011. You will even owe a penalty of one-half percent of the tax owed for each month the tax remains unpaid, up to 25 percent, although the IRS might waive it. The IRS has three years to find the error and notify you, and all the while interest and penalty accumulate. Every day.

7. Home Buyer Credit

The homebuyer tax credit (up to $8,000 for first-time buyers and $6,500 for those trading up, down or sideways) requires all documentation for these write-offs accompany your return. This means you must file your 1040 on paper, not electronically. First-time buyers must attach Form 5405 and a copy of the settlement statement or a dated certificate of occupancy. The credit is available to eligible taxpayers who closed on their home purchase on or before Sept. 30, 2010 (under a binding contract in place before May 1, 2010). Homeowners need evidence they’ve lived in the house they sold for at least five consecutive years of the last eight, and that it was used as a primary residence. Proof could include mortgage interest statements, property tax records or homeowners' policy statements. If any documentation is missing, your credit could be disallowed.

8. Reporting a Small Business Loss

Maybe you were downsized during the recession and decided to take the plunge of starting your own business. Little did you realize that when you own a small business, not only do you assume the general risk that comes with ownership, but you are also now a glaring target for the IRS. The reason? Far too many taxpayers run personal losses through their businesses. If you do get audited, whether the venture is your full-time or part-time job, be prepared to prove that your business has been established to make money —not as a repository for your car lease and cell phone bill.

MoneyWatch editor-at-large Jill Schlesinger contributed to this article.

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