With Joy Taylor, Assistant Editor at Kiplinger.com
IRS Audit Tops Fears List
Being audited by the IRS ranks at the top of the list of life’s greatest fears for many people. Joy Taylor of Kiplinger.com and a tax attorney in Washington D C reassures us that only a very small number of returns will ever be audited. In fact, in 2015 less than 1% of individuals received such unwelcome news from the IRS.
IRS Audit Red Flags
That being said, Joy says there are common errors that could land any of us in that less than 1% group. She’s particularly concerned about retirees, many of whom are living on fixed incomes, and points out some red flags that could give the IRS cause to place unwanted scrutiny on some returns. This list of common mistakes can teach you how to you to avoid IRS audits.
- Taking higher than average deductions on a return, deductions that are disproportionately larger than the income. This applies to all taxpayers, including retirees, and could include a large medical expense or charitable deduction. If there are those deductions, and they’re legitimate, make sure you have proper documentation.
- Not taking the RMD (required minimum distribution) from your IRA or 401k at age 70 ½ and older.
- Conversely, for early retirees, taking distributions before reaching a certain age, generally 59 ½.
- Declaring losses from rental properties which is not an allowable deduction. The exceptions are if you actively participate in renting your property, then you can deduct up to $25,000 of the loss against your other income that that amount does phase out. And if you’re a real estate professional, you can fully deduct your losses.
- Recreational gambling losses and winnings must be reported, but the deductions for the losses can’t exceed the amount of the winnings.
How to Avoid IRS Audit
Retirement should be a time when the stresses of your earlier working life are behind you, when you can enjoy your hard-earned money with a worry-free mind, without fearing an audit notification by the IRS will turn up in your mailbox. Paying attention to Joy Taylor’s red flags will show you how to avoid IRS audit and assure you that your next tax return will be in that vast percentage which never gets a second look.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: Many of us live in fear of getting a notice to come into the IRS for an audit. I decided to zero-in on the actual facts and maybe take away some of your concerns. Joy Taylor joins me. She’s from Kiplinger. She has worked as a tax attorney in Washington DC and has a master’s degree in tax law from New York University. Hi, Joy, welcome to the show.
Joy Taylor: Hi. Thank you for having me, Steve.
Steve Pomeranz: I want to talk today particularly towards retirees. How can retirees be aware of some of the red flags that may cause an IRS audit? What is the first thing that retirees should look for, to be careful of, in order to not get undue attention from the IRS?
Joy Taylor: First off, the IRS audits only a small number of individual returns every year. In 2015, it was less than 1% of all individual returns were audited. There are some red flags that could increase the chance that the IRS will give returns of retired taxpayers some more scrutiny. One of those is—and this applies to all taxpayers, but including retirees—are people that take higher than average deductions on their return. Essentially, if the deductions on their return are disproportionately large compared to their income, then the IRS may pull the return for review. For example, if there’s an extremely large medical expense or something like that or charitable deductions.
Steve Pomeranz: Well, you shouldn’t be afraid to claim it, if, in fact, it is all substantiated, right?
Joy Taylor: Oh, right. That’s true. If it’s substantiated, if you have the documentation, the receipt, etc., no one should be afraid of claiming a deduction because then if you’re ever audited by the IRS, you have your evidence, you have your substantiation. You show it to the agent, or you mail it in if it’s an audit by correspondence, and then generally you should be okay.
Steve Pomeranz: This, again, may cause the IRS to give your return a little bit extra attention. I guess their computer may pop it out, and they may have to look, and you may get a letter from the IRS. What is another red flag that retirees should be aware of?
Joy Taylor: Another one is, and it has to do with, again, higher than average deduction, is ones for charitable contributions. Again, if it the charitable contribution is disproportionately large with the income, it could raise a red flag. That’s because the IRS does know what the average donation is for folks at various income levels. If you’re donating valuable property, there are various substantiation rules that are required, including possibly an appraisal. For non-cash donations over $500, you have to attach an additional form to your return. There are many rules to substantiate charitable write-offs, and so the IRS is looking for that.
Steve Pomeranz: One of the monetary aspects of being a retiree is that, when you reach age 70 1/2, the government requires you to start taking money out of your IRA. I would think that not taking your required minimum distribution, also known as the RMD, would be a red flag. Is that so?
Joy Taylor: That is a red flag. As you said, the IRS wants to be sure that owners of traditional IRAs and participants in 401ks that are retired, that they’re properly taking and reporting their required minimum distributions. Those who fail to take the proper amount can be hit with a penalty. People who are aged 70 1/2 and older need to start taking their distributions from their accounts. In addition, also on the IRS’s radar, are early retirees or others who are taking payouts from their retirement account before they reach the age of 59 1/2. In addition to the fact that not taking required minimum distributions can lead to a penalty, the same thing occurs if you take distributions before you reach a certain age and that age is 59 1/2. There are various exceptions.
Steve Pomeranz: There are exceptions, but you’re subject to the 10% penalty.
Joy Taylor: You are.
Steve Pomeranz: Again, are you talking about making sure that you declare this distribution that you’ve taken from your 401k or your IRA?
Joy Taylor: Yes. You have to declare the amount, in addition. Many people will declare the amount; actually, that isn’t the issue. The people will declare the amount. What IRS has seen, though, in compliance projects that they’ve done on this is there’s a large number of people that are not, that would otherwise have to pay the 10% penalty on the early distribution or the early payout, but they’re not doing so. They don’t qualify for an exemption, so they’ll include the amount in their income, but they forget about the 10% additional tax.
Steve Pomeranz: Retirees also are looking for extra income, so many of them may own rental properties. What red flags can be created if you own a rental property? What should you be careful to do?
Joy Taylor: Rental properties in which you’re getting lots of income, those generally are not really looked up at IRS. Now, however, if you’re reporting losses from rental properties—and many people do because of taking depreciation, etc., on the rental homes—those do draw IRS’s attention. That’s because rental losses are normally prohibited. You normally cannot take rental losses. They’re two important exceptions. If you actively participate in renting your property, you can deduct up to $25,000 of the loss against your other income that that amount does phase out. Also, if you’re what’s considered to be a real estate professional, that means you put in lots of time on real estate activities, including rentals, then you can fully deduct your losses. The IRS has had a project going on for years where they’re actively scrutinizing rental real estate losses, especially those taken by people who have other large sources of income.
Steve Pomeranz: My guest is Joy Taylor with Kiplinger.com and we’re talking about red flags for retirees, what to look out for, what to make sure of. Have you substantiated everything and then you don’t really raise any serious outliers with regards to filing your taxes. Many retirees, in their spare time, will gamble. They’ll go to the local reservation. They’ll go to casinos, and the like. They’ll travel to Vegas and so on. How should they handle their gambling losses in order not to raise the red flag?
Joy Taylor: Generally, I mean, recreational gamblers, they have to report their winnings as income on their return, and then they’re able to deduct their losses on schedule A of the return, if they itemize, only up to the amount of their winnings.
Steve Pomeranz: Doesn’t seem fair. That never seemed fair to me. If I don’t have any losses, I have to declare my winnings, but if I have losses, I can only deduct them against my winning. Just not fair. I’m just going to say that. Continue, please.
Joy Taylor: Yeah, no, that’s all right. Some people try, I guess, in order to claim losses, or maybe they feel like they’re gambling a lot, so maybe they try and consider themselves as professional gamblers.
Steve Pomeranz: Professionals. Yeah. Okay, so how does that work?
Joy Taylor: To be a professional gambler, you do have to put in much more time. You report your income and your losses on schedule C. You’re able to deduct the losses if you’re a professional gambler. In addition, you’re able to deduct your travel too, let’s say you go to Las Vegas, you’re able to deduct your plane, your hotel, etc., provided you have the substantiation.
Steve Pomeranz: You’re treating it like a small business, so you get to deduct all of these things on schedule C, and so on. I guess as a gambler, you’ll know if you’re a professional or not. Don’t pretend to be one, if you actually are not one, because that’ll probably really raise the red flag and maybe raise the ire of the IRS. My guest is JoyTaylor. She’s with Kiplinger.com, and she was here to talk about raising the red flag. Be careful of those red flags when it comes to putting in your tax return. Thanks, Joy.
Joy Taylor: Thank you.