10 Red Flags for IRS Audits

While the overall IRS audit rate has been at historical lows, it’s expected to increase due passage of the Inflation Reduction Act. Provisions of the new law include $45.6 billion earmarked for enforcement. This means the addition of new agents—which in turn will likely increase the rate of IRS audits.

The exact number of agents that will be hired remains to be seen. However, some have cited a 2021 Treasury Department estimate of 87,000 new positions (not all of which would necessarily agents) necessary to cover its needs. So it’s more important than ever to follow the rules and minimize your chances of being audited.

Thankfully, there are measures you can take to help avoid scrutiny. Watch for these 10 red flags that can trigger an IRS audit:

1. Large charitable donations. The IRS can reference data providing average charitable deductions based on various income levels. If you’re above average for your category, you might call attention to yourself. This is especially true if you’ve deducted charitable gifts of appreciated property. So make sure your donations are all properly substantiated, including by independent appraisals if required.
2. Gambling losses. Generally, you can deduct losses up to the amount of your winnings on your personal return. However, you must have proof to back up your claims. If your gambling activities rise to the level of professional gambler, you might be able to deduct a loss from other income—but the IRS often contests this tax treatment. Recognize the risks.
3. Unreported income. It’s easy to miss income that might fall through the cracks, such as interest and dividends as well as nonemployee compensation from Form 1099-NEC. If you fail to report this income, the IRS might uncover a discrepancy with the forms it receives. Be sure to provide your tax professional with all forms you receive.
4. Rental income and deductions. You don’t want the IRS to find that you played fast and loose with the rules for rental properties. Showing a loss for the year despite a high rental rate could trigger an inquiry. Generally, you can use up to $25,000 of loss to offset income from nonpassive activities. But you must meet specific participation requirements. Check with your tax advisor to see if you’re on firm ground.
5. Home office deductions. If you use a portion of your home regularly and exclusively for your business, you may be able to deduct the expenses and depreciation associated with the space. Usually, the greater the business percentage claimed for use of the home, the greater the audit risk. Employees who work from home (as opposed to self-employed people) currently can’t claim a home office deduction. Now that more people are working from home, the IRS may look for taxpayers trying to bend the rules.
6. Casualty losses. Despite recent legislative changes restricting casualty loss deductions, you can still write off losses to personal property sustained in a federally designated disaster area. But be aware that the IRS may scrutinize appraisals to determine if you’re inflating a disaster-area loss.
7. Business vehicle expenses. The IRS often flags returns with large deductions for business vehicles, especially if they reflect double-digit depreciation allowances. You’re required to keep a contemporaneous log of your driving activities, along with proper substantiation. Collect all the proof needed to withstand an IRS audit.
8. Cryptocurrency transactions. This is a relatively new potential audit target. The IRS now specifically asks on your return if you’ve bought or sold cryptocurrency. If you’ve answered yes, be prepared to substantiate the transaction information.
9. Day trading activities. Most taxpayers offset capital gains and losses from securities sales on Schedule D of their personal tax returns. But claiming to be a day trader may help you benefit from favorable tax provisions, including deductions for specific expenses. If you do this, consult with your tax advisor to ensure you’re ready to respond to any IRS inquiries.
10. Foreign bank accounts. Checking the box on Schedule B that indicates you have a foreign bank account could increase your chances of an audit. But failing to check the box when you should could do this as well. The IRS matches up information it receives on foreign bank accounts; a discrepancy could potentially trigger an IRS audit. Generally, a taxpayer must file a Report of Foreign Bank and Financial Accounts (FBAR) if the aggregate value of assets in foreign bank accounts exceeded $10,000 during the prior year.

Of course, this isn’t the end of the list. There are many other potential red flags depending on your particular situation. Also keep in mind that some IRS audits are done on a random basis. So even if you have no common areas of concern on your return, you still could be subject to an audit (although those chances are lower).

With proper reporting and help from an experienced tax CPA, you can reduce the likelihood of triggering an IRS audit. And if you still end up being subject to one, proper documentation can help you withstand it with little or no negative consequences.

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