8 IRS Audit Red Flags

You’re worried about an IRS Audit?

As you prepare to file your 2022 federal tax return, you may be concerned about the possibility of an IRS audit. Most folks can rest easy because the great majority of individual tax returns aren’t audited by the IRS. In fact, over the last few years, under 1% of all income tax returns have been audited, and many of these examinations have been completed by mail.

This means that the vast majority of taxpayers have never met with an Internal Revenue agent in person. Year after year, the number of audits has been decreasing.

However, there are some aspects that could catch the attention of IRS agents. Refusing to file 1099s and W-2s on tax returns obviously increases the chances of being audited. Math errors may elicit an IRS examination, albeit they’re unlikely to result in a full-fledged review. Applying for certain tax deductions may also cause your return to be investigated.

Other activities and actions can increase the likelihood of an audit. To avoid risk, retirees should look for these 8 red flags that could boost the odds of the IRS giving your return an unwelcome examination.

Making a fortune - IRS Audit
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1. Making a Fortune

We already said that the audit rates are generally low, but the chances of an IRS Audit increase substantially as your income increases too. Such as if you sell an expensive piece of property or receive a large payout from a retirement plan.

On top of that, the IRS has been criticized for overly scrutinizing low-income taxpayers who qualify for refundable tax credits while forgetting about wealthy taxpayers. As a consequence of this criticism, very wealthy Americans are once again in the sights of the IRS Audit.

And if President Biden has his way, more high-income individuals are likely to be audited. He intends to allocate billions of dollars for the IRS so the agency can take the necessary steps to go after large corporations, LLCs, and wealthy individuals. According to the Treasury Department, the president’s approach will not result in higher audit rates for taxpayers who earn less than $400,000.

Congressional Democrats want to give the IRS Audit $80 billion over a period of 10 years for its initiatives, but right now this bill is currently blocked in the Senate due to Democrats’ infighting.

We’re not suggesting you should try to make less money – I mean, everyone wants the exact opposite. Just keep in mind that the more money you make, the more likely is it for you to be on IRS’s radar.

2. Failing to File Your Income Tax Return 

Failing to file your income from Social Security benefits, IRA distributions, dividends, pensions, wages, and other sources will most likely result in unwelcome attention from the IRS.

All 1099s and W-2s you get are forwarded to the IRS. This means that the IRS gets transcripts or copies of the 1099-R (reporting payments from retirement plans such as pensions, profit-sharing plans, 401(k)s, and IRAs), the 1099-SSA (listing Social Security benefits), and 1099-K (reporting payments made via PayPal, Airbnb, etc.).

The IRS’s computers are quite great at checking if the numbers on the forms are matching your income tax return. A mismatch can definitely turn into a red flag causing the IRS computers to issue a bill.

This being said, you should report all income. No matter if you give guitar lessons, drive for Uber, or tutor young children, if you got paid, you’ll have to report the money you receive.

3. Missing Your Required Minimum Distribution Deadline

If you own an IRA or if you have a 401(k) or other retirement plans, you should properly take and report your required minimum distributions (RMDs) to avoid an IRA Audit. The agency is aware that some people aged 72 years or over are failing to take their annual RMDs, and the IRA agents are inspecting this closely.

Failing to take the required amount may lead to a penalty of 50% of the shortfall. The IRA’s eyes are also on those who make IRA withdrawals before reaching age 59½ and who aren’t eligible for penalty-free exceptions.

Individuals 72 and older are required to withdraw RMDs annually from their retirement savings accounts. There is, however, a grace period for the year you turn 72: you can postpone the distribution until April 1 of the following year.

A special procedure applies to individuals who are still employed at the age of 72 or older: if your current employer is offering you a 401(k) plan, you can actually delay taking the required minimum distributions until after you retire (IRAs don’t have this kind of exception).

The amount of the annual withdrawal depends on the balance of the account as of December 31 of the previous year and the life-expectancy tables stated in the IRS Publication 590-B.

Retirement hobby
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4. Writing Off Your Losses for a Hobby

Let’s say you have a hobby such as jewelry or any other craft making, dog breeding, bookselling, or coin collecting, and you’ve decided to turn it into a small business that’s taking a loss at the moment.

If your business has multiple years of large losses, IRS classifies it as just a hobby. BUT, your audit risk increases considerably if you have many years of hobby losses and a high income from other sources.

Basically, IRS agents are actively hunting those who unfairly deduct hobby losses. So you should be cautious trying to convert a retirement hobby into a profitable venture.

To qualify for a loss deduction, it’s mandatory for you to use a business-like approach when it comes to running your activity. Also, you should be able to prove that you do intend to run a profitable business. If your activity turns profit three out of every five years, the law assumes that you’re doing this to make money, unless the IRS Audit shows otherwise.

The examination becomes more challenging if you can’t meet these requirements. This is because the decision of whether an activity is legally classified as a business or a hobby depends on each taxpayer’s situation and facts.

5. Failure to Report a Foreign Bank Account

Traveling while being retired is a marvelous thing. But be cautious when sending money abroad. The IRS is quite interested in individuals who stashed away their money outside the US, while US authorities have had many favorable outcomes in obtaining account information from foreign banks.

Neglecting to report such an account may result in serious consequences and I’m sure you’d want to truly enjoy your golden years. That said, if you own foreign bank accounts, ensure you properly report each of them. Those who have more financial assets abroad may additionally be required to file IRS Form 8938 when they regularly file their income tax return.

Cryptocurrencies and IRS Audit
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6. Engaging in Virtual Currency Transactions

Those who are selling, receiving, or trading cryptocurrencies are constantly in the IRS’ crosshairs. To stop and prevent unreported virtual currency income, its agents are mailing letters to individuals they suspect have cryptocurrency accounts.

Also, the IRS turned to the federal court to obtain a list of customers’ names of Coinbase, a cryptocurrency trading platform. On top of that, the IRS has established teams of revenue agents to deal with virtual currency-related audits.

But that’s not all. All single filers must state on the first page of their Form 1040 whether they have sold, exchanged, or received any financial interest in cryptocurrency.

Basically, bitcoin and other virtual currencies are classified as property for US tax purposes. The IRS has a list of commonly asked questions that cover topics such as trading, selling and receiving virtual currency, figuring gain or loss, gifting or donating cryptocurrency, and so on.

7. Running A Self-Employed Business

Schedule C is a business income tax form for self-employed people. For some of these people, this tax form may be a treasure trove. But IRS agents know from experience that sole proprietors sometimes tend to claim extra deductions while not reporting all their income. The IRS analyzes both top-grossing sole traderships and smaller ones.

Here’s a list of the most common situations that could trigger an IRS Audit:

  • Self-employed people who declare at least $100,000 of the company’s gross sales on Schedule C
  • Cash-intensive businesses (retail stores, restaurants, cigarette distributors and the like)
  • Sole traders who have income from other sources but still report a substantial loss.

8. Claiming Rental Losses

Claiming a substantial rental loss can draw the IRS’s attention. Usually, the passive loss rules prohibit deducting rental real estate losses. However, there are major exceptions. You can deduct up to $25,000 of rental losses per year as long as you have a consistent involvement in your property’s renting process. This $25,000 limit phases out as the income levels are getting higher.

The second exception has to do with real estate professionals who dedicate more than half of their working hours as brokers, landlords, developers, and so on. Basically, by doing this, they are able to deduct rental losses.

The IRS agents are constantly looking after substantial rental real estate losses. You may be eligible for the second exception if you’ve decided to manage properties in your golden years. You can also deduct the losses after selling a rental property that generated suspended passive losses. Just keep in mind that you have to be prepared for an IRS Audit.

Want to know more about taxes in retirement? Here’s an article that may give you the answers you were looking for: 7 Questions Retirees Need To Ask Themselves.


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