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The  IRS is Scrutinizing You and Your Real Estate
 
 
Medicare Surtax of 3.8% on Home Sale Profits after 2012

The 3.8% Medicare surtax won’t apply to all home sale profits after 2012
Many readers tell us they’ve received e-mails or read newspaper articles asserting that gains on all home sales will be hit by a 3.8% tax. That is incorrect. Most gains on sales of primary residences will be exempt. Only the portion of profits that exceeds the $250,000 or $500,000 exclusion will be subject to the tax. And only higher-incomers will owe the surtax…singles with adjusted gross incomes over $200,000 or joint filers with AGIs above $250,000. The 3.8% surtax is levied on the smaller of the filer’s net investment income (including taxable capital gains or the excess of the taxpayer’s adjusted gross income over the threshold amounts. But profits on sales of rental properties and second homes will be hit by the surtax, assuming that the seller’s adjusted gross income in large enough.


Gifts of Real Estate

IRS is working on a major compliance initiative to sniff out gift tax cheats. It estimates that between 60% and 90% of taxpayers who transfer real estate for little or no consideration to family members fail to file Form 709 to report the gift. For starters, IRS is checking transfer records from 15 states: Conn., Fla., Hawaii, Neb., N.H., N.J., N.Y., N.C., Ohio, Pa., Tenn., Texas, Va., Wash., and Wis. So far, over 500 people have been audited or are under examination, and many more are in the pipeline. IRS is serious about this. When the Calif. Board of Equalization would not freely disclose the data, the Service went to court to try to make it comply. Even if gift tax isn’t due on the transfer, a return still has to be filed with the IRS if the amount of the gift exceeds the gift tax annual exclusion…currently $13,000.


Enforcement: Your Chances of Being Audited

Want to know your chances of being audited by the Revenue Service? IRS statistics give the details on audits of individuals in fiscal 2010. The overall exam rate for individual returns rose to 1.11%, the highest since 1997. Taxpayers with incomes of $1illion or more got the most scrutiny. The Service audited 8.36% of these filers. That’s one out of every 12 returns.
Three other classes of taxpayers experienced significant audit heat as well, with audit rates more than twice the average: Filers with incomes of at least $200,000 but less than $1 Million. Business returns with gross receipts of $25,000 and up, such as Schedule C filers. And returns where the earned income credit was claimed.
We have compiled a list of common audit triggers… a dozen ways your return may draw extra scrutiny.
 
JANUARY 2012
IRS Audit Red Flags: The Dirty Dozen

... a dozen ways your return may draw extra scrutiny.

         1.  Making Too Much Money

Although the overall individual audit rate is about 1.11%, the odds increases dramatically for higher-income filers. IRS statistics show that people with incomes of $200,000 or higher had an audit rate of 3.93%, or one out of slightly more than every 25 returns. Report $1 million or more of income? There's a one-in-eight chance your return will be audited. The audit rate drops significantly for filers making less than $200,000: Only 1.02% of such returns were audited during 2011, and the vast majority of these exams were conducted by mail.
 
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.
 
 
2.  Failing to Report All Taxable Income

The IRS gets copies of all 1099s and W-2s you receive, so make sure you report all required income on your return. IRS computers are pretty good at matching 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. If you receive a 1099 showing income that isn't yours or listing incorrect income, get the issuer to file a correct form with the IRS.
 
 
3.  Taking 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 IRS computers know 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 donations over $500, the chances of audit increase. And if you've donated a conservation easement to a charity, chances are good that you'll hear from the IRS. Be sure to keep all your supporting documents, including receipts for cash and property contributions made during the year, and abide by the documentation rules. And attach Form 8283 if required.
 
4.  Claiming the Home Office Deduction
Like Willie Sutton robbing banks (because that's where the money is), the IRS is drawn to returns that claim home office write-offs because it has found great success knocking down the deduction and driving up the amount of tax collected for the government. If you qualify, you can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance and other costs that are properly allocated to the home office. That's a great deal. However, to take this write-off, you must use the space exclusively and regularly as your principal place of business. That makes it difficult to successfully claim a guest bedroom or children's playroom as a home office, even if you also use the space to do your work. "Exclusive use" means that a specific area of the home is used only for trade or business, not also for the family to watch TV at night.

Don't be afraid to take the home office deduction if you're entitled to it. Risk of audit should not keep you from taking legitimate deductions. If you have it and can prove it, then use it


5. Claiming Rental Losses

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. But this $25,000 allowance phases out as adjusted gross income exceeds $100,000 and disappears entirely once your AGI reaches $150,000. A second exception applies to real estate professionals who spend more than 50% of their working hours and 750 or more hours each year materially participating in real estate as developers, brokers, landlords or the like. They can write off losses without limitation. But the IRS is scrutinizing rental real estate losses, especially those written off by taxpayers claiming to be real estate pros. The agency will check to see whether they worked the necessary hours, especially in cases of landlords whose day jobs are not in the real estate business.
 
 
6.  Deducting Business Meals, Travel and Entertainment

Schedule C is a treasure trove of tax deductions for self-employed. But it's also a gold mine for IRS agents, who know from experience that self-employed sometimes claim excessive deductions. History shows that most under-reporting of income and overstating of deductions are done by those who are self-employed. And the IRS looks at both higher-grossing sole proprietorships and smaller ones.
 

Big deductions for meals, travel and entertainment are always ripe for audit. A large write-off here will set off alarm bells, especially if the amount seems too high for the business. Agents are on the lookout for personal meals or claims that don't satisfy the strict substantiation rules. To qualify for meal or entertainment deductions, you must keep detailed records that document for each expense the amount, the place, the people attending, the business purpose and the nature of the discussion or meeting. Also, you must keep receipts for expenditures over $75 or for any expense for lodging while traveling away from home. Without proper documentation, your deduction is toast.
 
 
7.  Claiming 100% Business Use of a Vehicle

Another area ripe for IRS review is use of a business vehicle. When you depreciate a car, you have to list on Form 4562 what percentage of its use during the year was for business. Claiming 100% business use of an automobile is red meat for IRS agents. They know that it's extremely rare for an individual to actually use a vehicle 100% of the time for business, especially if no other vehicle is available for personal use. IRS agents are trained to focus on this issue and will scrutinize your records. Make sure you keep detailed mileage logs and precise calendar entries for the purpose of every road trip. Sloppy recordkeeping makes it easy for the revenue agent to disallow your deduction. As a reminder, if you use the IRS' standard mileage rate, you can't also claim actual expenses for maintenance, insurance and other out-of-pocket costs. The IRS has seen such shenanigans and is on the lookout for more.
 
 
8.  Writing off a Loss for a Hobby Activity

Your chances of "winning" the audit lottery increase if you have wage income and file a Schedule C with large losses. And if the loss-generating activity sounds like a hobby -- horse breeding, car racing and such -- the IRS pays even more attention. Agents are specially trained to sniff out those who improperly deduct hobby losses. Large Schedule C losses are always audit bait, but reporting losses from activities in which it looks like you're having a good time all but guarantees IRS scrutiny.

You must report any income you earn from a hobby, and you can deduct expenses up to the level of that income. But the law bans writing off losses from a hobby. For you to claim a loss, your activity must be entered into and conducted with the 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 IRS establishes otherwise. If you're audited, the IRS is going to make you prove you have a legitimate business and not a hobby. So make sure you run your activity in a businesslike manner and can provide supporting documents for all expenses.
 
 
9.  Running a Cash Business
Small business owners, especially those in cash-intensive businesses -- think taxis, car washes, bars, hair salons, restaurants and the like -- are a tempting target for IRS auditors. Experience shows that those who receive primarily cash are less likely to accurately report all of their taxable income. The IRS has a guide for agents to use when auditing cash-intensive businesses, telling how to interview owners and noting various indicators of unreported income.
 

10. Failing to Report a Foreign Bank Account

The IRS is intensely interested in people with offshore accounts, especially those in tax havens, and tax authorities have had success getting foreign banks to disclose account information. The IRS has also used voluntary compliance programs to encourage folks with undisclosed foreign accounts to come clean -- in exchange for reduced penalties. The IRS has learned a lot from these programs and has collected a boatload of money ($4.4 billion so far).

Failure to report a foreign bank account can lead to severe penalties, and the IRS has made this issue a top priority. Make sure that if you have any such accounts, you properly report them when you file your return.


11.  Engaging in Currency Transactions
The IRS gets many reports of cash transactions in excess of $10,000 involving banks, casinos, car dealers and other businesses, plus suspicious-activity reports from banks and disclosures of foreign accounts.

A report by Treasury inspectors concluded that these currency transaction reports are a valuable source of audit leads for sniffing out unreported income. The IRS agrees, and it will make greater use of these forms in its audit process. So if you make large cash purchases or deposits, be prepared for IRS scrutiny. Also, be aware that banks and other institutions file reports on suspicious activities that appear to avoid the currency transaction rules (such as persons depositing $9,500 in cash one day and an additional $9,500 in cash two days later)
            
12.  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. 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.


Reproduced from the December 2011 edition of the Kiplinger Tax Letter and from Kiplinger on line.