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The Top Five Tax Audit Red Flags

By Aleksandra Todorova

Published: February 1, 2007

EVERYONE CRINGES AT the thought of an IRS audit. The good news is,

Only a tiny slice of tax returns — just 1% in 2006 — get audited

Each year. The bad news? Audits are on the rise: up 6% in 2006,

compared with 2005. "Field audits," the most feared type of audit

where you actually sit down with an IRS officer, were up 23%,

according to IRS statistics.

So what can you do to slip under the IRS radar? Granted, what

singles out a specific tax return versus another is a

tightly-guarded IRS secret. But there are several red flags that tax

experts say are likely to attract unwanted attention. Here are five.

1. Home-office deductions

If you are self-employed and use part of your home as an office, you

may be able to deduct some of your home expenses, including a

portion of your utility bills, insurance and repair costs. The

problem is, the requirements for this deduction are very specific

and filers may claim it without being eligible, says Greg Rosica,

contributing author of the Ernst & Young Tax Guide 2007. As a

result, taking a home-office deduction, especially when you're

employed by someone other than yourself, may flag your return for

more careful inspection.

The deal-breaker for home-office deductions: Even if you work from

home regularly, you're out of luck if your employer provides you

with an office space. "You can't just set up a home office because

you want to," Rosica says. "It needs to be done because your

employer wants you to do that, for the convenience of the employer."

If you don't have an office space at work - say your company has an

arrangement with you to do your work remotely — then a home-office

deduction is legit. (Should the IRS want proof of that and it isn't

outlined in your contract, a letter from your employer will do.) You

are also eligible if you're self-employed and work from home. For

more details on claiming this deduction, read our story "Home Office

Deductions."

2. Business losses and hobbies

So you're venturing into photography as a sideline business but it

hasn't quite taken off yet. Can you deduct your losses? Be careful:

If you report a business loss, that may flag your tax return for an

IRS audit, says Eric Tyson, author of "Taxes 2007 for Dummies." "The

IRS is well aware of the fact that there are people out there

promoting the notion of engaging in a sideline business for the

purpose of generating tax deductions," he says.

A sideline business can provide you with a nice tax break; you can

declare a loss even if the business generated no income for that

year. But there's a catch: Your business has to be profitable in at

least three of the past five years to be considered legitimate.

Otherwise, the IRS will consider it a hobby, not a business, says

Mark Luscombe, principal federal tax analyst with tax publisher CCH.

The difference is, with a hobby you can only deduct losses up to the

amount of the income it brought in. If you do declare a loss, be

sure to keep all your receipts ready in case the IRS decides to

investigate.

3. Noncash charitable contributions

The rules of deducting charitable contributions are pretty

straightforward when you're giving cash: Keep your receipts or

canceled checks for anything below $250; for contributions of $250

or more, you'll need a letter from the charity. (More details in our

story "The Perks of Charitable Giving".)

But what if you're donating clothes or other noncash items? The IRS

is tightening the rules. For donations after Aug. 17, 2006, you

can't claim a deduction for used clothing or other household items

that are not in "good" condition or better. That applies to donating

furniture, appliances, clothes and similar items. So, now, more than

in previous years, the IRS is likely to examine closely tax returns

that contain noncash donations, says Donna LeValley, a tax attorney

and contributing editor to "J.K. Lasser's Your Income Tax 2007."

Needless to say, that doesn't mean you shouldn't claim a deduction

for legitimate charitable contributions. Just be sure not to inflate

the value of those old sweaters.

4. Excessive deductions

It's that simple: Deduct too much compared with people in your

income bracket, and you may find yourself audited by the IRS. "For

any item that you put on your return, the IRS has built into its

computers a range of what they consider reasonable values, based on

your income and the type of deduction," says CCH's Luscombe. While

the exact ranges are a closely-guarded secret, tax experts point to

averages as a guideline. If your income in 2004 was between $30,000

and $50,000, for example, the folks in your income group deducted an

average $2,100 in charitable contributions and $5,300 in medical

expenses. (The latest year for which the IRS provides statistics is

2004.) More details in the table below.

5. Earn too much... or too little

Statistically, you have a higher chance of getting audited if you

were a high-income earner. About one in every 16 millionaires (those

who earned $1 million or more for the year) was audited last year.

The IRS also audited more than 257,000 filers who earned $100,000 or

more, more than double the audits of that income group in 2001.

But there's one blip in that pattern. Claiming the earned income

credit — a tax break for low-income individuals — can be an audit

red flag, says Tyson. The income requirements for the earned income

credit are very stringent. You qualify if you have one child and

your adjusted gross income was less than $32,001 in 2006 ($34,001 if

you are married, filing jointly) or if you have more than one child

and earned less than $36,348 ($38,348 if married, filing jointly).

If you don't have children, your adjusted gross income needs to be

less than $12,120 (or $14,120 if married, filing jointly).

It's a tax break that can provide much-needed cash to those who need

it. This year, for example, the credit can go as high as $4,536 for

filers with more than one child. The problem is that the rules for

claiming the deduction are complicated and prone to errors, says

J.K. Lasser's LeValley. To make matters worse, she adds, there are

dishonest tax preparers out there who claim the deduction

fraudulently, often without the tax filer's knowledge. As a result,

the IRS may flag a return that claims the earned income credit.

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