14 IRS Audit Red Flags for Retirees
Seniors beware: Your actions can increase the chances of the IRS giving your tax return a closer look.
As you're getting ready to file your 2021 federal tax return, you may be wondering about your odds of an IRS audit. Most people can breathe easy because the vast majority of individual returns escape the IRS audit machine. In recent years, the IRS has been auditing significantly less than 1% of all individual tax returns, and the vast majority of these exams were conducted by mail, meaning most taxpayers never met with an IRS agent in person. The trend has been towards fewer audits from year to year.
That said, your chances of being audited or otherwise hearing from the IRS escalate depending on various factors. Obviously, failing to report income shown on 1099s and W-2s will increase your audit chances. Math errors may draw IRS inquiry (although they'll rarely lead to a full-blown exam). Claiming certain tax deductions is something else that can trigger a closer look at your return. Other actions or activities can boost the odds of an audit, too. So, to be on the safe side, retirees should check out these 14 red flags that could increase the chances that the IRS will give your return unwelcome attention.
Making a Lot of Money
While the overall individual audit rates are extremely low, the odds increase significantly as your income goes up, as it might if you sell a valuable piece of property or get a big payout from a retirement plan. Plus, the IRS has been lambasted for putting too much scrutiny on lower-income individuals who take refundable tax credits and ignoring wealthy taxpayers. Partly in response to this criticism, very wealthy individuals are once again in the IRS's crosshairs.
And if President Biden gets his way, more upper-income individuals will be audited. He wants Congress to give the IRS billions of dollars for the agency to step up its enforcement efforts against wealthy individuals, large corporations and passthrough entities, such as partnerships and LLCs. The Treasury Department says that the president's proposal won't cause audit rates to rise for individuals with incomes below $400,000. Congressional Democrats have proposed in their Build Back Better bill to give the IRS $80 billion over 10 years for enforcement and other activities, but that bill is now stalled in the Senate amid infighting among Democrats.
We're not saying you should try to make less money — everyone wants to be a millionaire. Just understand that the more income shown on your return, the more likely it is that you'll be hearing from the IRS.
Failing to Report All Taxable Income
Failing to report taxable income from wages, dividends, pensions, IRA distributions, Social Security benefits and other sources will almost certainly draw unwanted attention from the IRS.
The IRS gets copies of all the 1099s and W-2s you receive. This includes the 1099-R (reporting payouts from retirement plans, such as pensions, 401(k)s and IRAs), 1099-SSA (reporting Social Security benefits), and 1099-K (reporting online payment sources such as PayPal, Airbnb, etc.). The IRS's computers are pretty good at cross-checking the numbers on the forms with the income shown on your return. A mismatch sends up a red flag and causes the IRS computers to spit out a bill.
So, be sure to report all income, whether or not you receive a form such as a 1099. For example, if you got paid for tutoring, giving piano lessons, driving for Uber or Lyft, dog walking, house sitting or pet sitting, or selling crafts through Etsy, the money you receive is taxable.
Taking Higher-Than-Average Deductions
If deductions on your return are disproportionately large compared with your income, the IRS may pull your return for review. A large medical expense could send up a red flag, for example. But if you have the proper documentation for your deduction, don't be afraid to claim it. There's no reason to ever pay the IRS more tax than you actually owe.
Deducting Large Losses
Reporting a big loss from the sale of rental property or other investments can also spike the IRS's curiosity, especially if the loss offsets income from wages, pensions, or other sources. Also on the IRS's radar are deductions taken for bad debt and worthless securities, especially if you report the amount as an ordinary loss.
Claiming Large Charitable Deductions
We all know that charitable contributions are a great write-off and help you feel all warm and fuzzy inside. However, if your charitable deductions are disproportionately large compared with your income, it raises a red flag.
That's because the IRS knows what the average charitable donation is for folks at your income level. Also, if you don't get an appraisal for donations of valuable property, or if you fail to file Form 8283 for noncash donations over $500, you become an even bigger audit target.
Be sure to keep all your supporting documents, including receipts for cash and property contributions made during the year.
Donating a Conservation or Façade Easement
If you've donated a conservation or façade easement to charity, or if you are an investor in a partnership, LLC or trust that made such a donation, chances are very good that you'll hear from the IRS. Battling abusive syndicated conservation easement deals is a strategic enforcement priority of the tax agency. Revenue agents are targeting promoters, taxpayers, preparers and advisers. As a result of the IRS clamping down, there are about 100 syndicated easement cases on the Tax Court docket.
Not Taking Required Minimum Distributions
The IRS wants to be sure that owners of IRAs and participants in 401(k)s and other workplace retirement plans are properly taking and reporting their required minimum distributions (RMDs). The agency knows that some folks age 72 and older aren't taking their annual RMDs, and it's looking at this closely. Those who fail to take the proper amount can be hit with a penalty equal to 50% of the shortfall. Also on the IRS's radar are early retirees and others who take payouts before reaching age 59½ and who don't qualify for an exception to the 10% penalty on these early distributions.
Individuals age 72 and older must take RMDs from their retirement accounts by the end of each year. However, there's a grace period for the year in which you turn 72: You can delay the payout until April 1 of the following year. A special rule applies to those still employed at age 72 or older: You can generally delay taking RMDs from your current employer's 401(k) until after you retire (this rule doesn't apply to IRAs). The amount you have to take each year is based on the balance in each of your accounts as of December 31 of the prior year and the life-expectancy factor found in IRS Publication 590-B.
Claiming Rental Losses
Claiming a large rental loss can command the IRS's attention. Normally, the passive loss rules prevent the deduction of rental real estate losses. But there are two important exceptions. If you actively participate in the renting of your property, you can deduct up to $25,000 of loss against your other income. This $25,000 allowance phases out at higher income levels. A second exception applies to real estate professionals who spend more than 50% of their working hours and more than 750 hours each year materially participating in real estate as developers, brokers, landlords or the like. They can write off rental losses.
The IRS actively scrutinizes large rental real estate losses. If you're managing properties in your retirement, you may qualify under the second exception. Or, if you sell a rental property that produced suspended passive losses, the sale opens the door for you to deduct the losses. Just be ready to explain things if a big rental loss prompts questions from the IRS.
Running a Business
Schedule C is a treasure trove of tax deductions for self-employed people. But it's also a gold mine for IRS agents, who know from experience that self-employed people sometimes claim excessive deductions and don't report all their income. The IRS looks at both higher-grossing sole proprietorships and smaller ones. Sole proprietors reporting at least $100,000 of gross receipts on Schedule C, cash-intensive businesses (hair salons, restaurants and the like), and business owners who report a substantial loss and have income from other sources such as wages have a higher audit risk.
Writing Off a Loss for a Hobby
Your chances of "winning" the audit lottery increase if you file a Schedule C with large losses from an activity that might be a hobby, such as dog breeding, jewelry making, or coin and stamp collecting. Your audit risk grows if you have multiple years of hobby losses and you have lots of income from other sources. IRS agents are specially trained to sniff out those who improperly deduct hobby losses. So be careful if your retirement pursuits include trying to convert a hobby into a moneymaking venture.
To be eligible to deduct a loss, you must be running the activity in a business-like manner and have a reasonable expectation of making a profit. If your activity generates profit three out of every five years (or two out of seven years for horse breeding), the law presumes that you're in business to make a profit, unless the IRS establishes otherwise. The analysis is trickier if you can't meet these safe harbors. That's because the determination of whether an activity is properly categorized as a hobby or a business is then based on each taxpayer's facts and circumstances. If you're audited, the IRS is going to make you prove you have a legitimate business and not a hobby. Be sure to keep supporting documents for all expenses.
Failing to Report Gambling Winnings or Claiming Big Losses
Whether you're playing the slots or betting on the horses, one sure thing you can count on is that Uncle Sam wants his cut. Recreational gamblers must report winnings as other income on the 1040 form. Professional gamblers show their winnings on Schedule C. Failure to report gambling winnings can draw IRS attention, especially because the casino or other venue likely reported the amounts on Form W-2G.
Claiming large gambling losses can also be risky. You can deduct these only to the extent that you report gambling winnings. Writing off gambling losses but not reporting gambling income is sure to invite scrutiny. Also, taxpayers who report large losses from their gambling-related activity on Schedule C get an extra look from IRS examiners, who want to make sure that these folks really are gaming for a living.
Neglecting to Report a Foreign Bank Account
You may be traveling more in retirement, but be careful about sending your money abroad. The IRS is intensely interested in people with money stashed outside the U.S., and U.S. authorities have had lots of success getting foreign banks to disclose account information.
Failure to report a foreign bank account can lead to severe penalties. Make sure that if you have any such accounts, you properly report them. This means electronically filing FinCEN Form 114 (FBAR) by April 18, 2022, to report foreign accounts that total more than $10,000 at any time in 2021. And those with a lot more financial assets abroad may also have to attach IRS Form 8938 to their timely filed income tax returns.
Claiming Day-Trading Losses on Schedule C
People who trade in securities have significant tax advantages compared with investors. The expenses of traders are fully deductible and are reported on Schedule C (expenses of investors are nondeductible), and traders' profits are exempt from self-employment tax. Losses of traders who make a special section 475(f) election are deductible and are treated as ordinary losses that aren't subject to the $3,000 cap on capital losses. And there are other tax benefits.
But to qualify as a trader, you must buy and sell securities frequently and look to make money on short-term swings in prices. And the trading activities must be continuous over the full year and not just for a couple of months. This is different from an investor, who profits mainly on long-term appreciation and dividends. Investors hold their securities for longer periods and sell much less often than traders.
The IRS knows that many filers who report trading losses or expenses on Schedule C are actually investors. It's pulling returns and checking to see that the taxpayer meets all of the rules to qualify as a trader.
Engaging in Virtual Currency Transactions
The IRS is on the hunt for taxpayers who sell, receive, trade or otherwise deal in bitcoin or other virtual currency and is using pretty much everything in its arsenal. As part of the IRS's efforts to clamp down on unreported income from these transactions, revenue agents are mailing letters to people they believe have virtual currency accounts. The agency went to federal court to get names of customers of Coinbase, a virtual currency exchange. And the IRS has set up teams of agents to work on cryptocurrency-related audits. Additionally, all individual filers must answer on page 1 of their Form 1040 whether they have received, sold, exchanged or otherwise disposed any financial interest in virtual currency.
The tax rules treat bitcoin and other cryptocurrencies as property for tax purposes. The IRS has a set of frequently asked questions that address selling, trading and receiving cryptocurrency, calculating gain or loss, figuring tax basis when the currency is received by an employee or someone else for services, donating or gifting cryptocurrency, and much more.