5 Ways to Avoid an Audit

If you think you have to be caught stowing away cash in an offshore bank account to trigger an audit, think again. One tiny error on your tax return can have the IRS knocking on your door.

There’s good reason to be meticulous this year: According to the most recent data, in 2007 the IRS audited approximately 1.4 million returns, a 7% increase from 2006 and the highest number on record since 1998. And this year, it's unlikely that number will fall, says Mark Luscombe, a principal analyst at CCH Tax and Accounting.

So what will make the IRS question your return? Here are five common red flags that the IRS will be on the lookout for this tax season.

The worst mistake a taxpayer can make is to fail to report all of his or her income.

In addition to salary and bonuses, make sure to include proceeds from sales of stocks and bonds, dividend earnings, brokerage and bank accounts and any other interest-earnings investments. Also, if you received unemployment income, that needs to be included, too.

Investors who sold stock, bonds or mutual funds in 2008 need to show how much they gained or lost between the date they bought and the date they sold their investments. Many brokerage firms don’t provide this information -- instead their statements will just include the price at which you sold -- so the taxpayer will have to find the paperwork from when they first bought an investment. Also, even if your investment declined in value, you may still have to pay taxable income, says Maureen McGetrick, accountant and partner at New York-based BDO Seidman. (See our story for more on investment gains and losses.)

Just because a credit-card company (or other lender) agreed to reduce your debt doesn’t mean you’re off the hook from paying taxes on it. Make sure to include the forgiven debt in your tax return. For example, a consumer who got his credit-card debt reduced from $10,000 to $6,000 will still be expected to pay taxes on that $4,000 of forgiven debt.

Debts are not taxable income in cases where the taxpayer proves that his debts surpass his assets or when debts get discharged through bankruptcy – be it Chapter 7 or 11. (Read our story for more on taxes and debt forgiveness.)

Small-business owners who report losses have been on the IRS’s audit radar in recent years, says McGetrick. To avoid raising suspicions, show proper documentation, including bank account statements (it’s always best if the business accounts are separate from the personal ones), receipts and invoices. So if you take a client out to dinner and foot the bill, don't write it off on your tax return unless you have the receipt to prove it.

If your small business shut down last year, be as accurate as possible when claiming that a fixed asset like a computer has depreciated in value, says McGetrick.
(Read our story here for more tips on the documents small businesses need to keep.)

Home-office deductions are often abused and therefore big red flags for the IRS, says Brittney Saks, a partner at PricewaterhouseCoopers.

In order to qualify for this deduction, the office must be your principal place of business and used exclusively for business. So, you won't be eligible for a deduction if you use the office for business during the day and as a family room at night or if your employer is offering you work space at the company office.

Whether you lost your home to foreclosure or managed to eke out a gain on a sale, you'll need to include the transaction on your tax returns.

Because a primary residence is a personal asset, homeowners can’t claim a deductible on their tax return if they sold their home at a loss, says Saks. In many instances, the real estate investor who sold an apartment building at a loss will make off with more from the IRS. He or she can claim a deductible, but will need to show the price they bought and sold it for and the amount of money they pumped into the building, whether it be for maintenance or repairs.

Meanwhile, those fortunate few homeowners who made money on the sale of their home will need to report that gain.

There is some good news for those who underwent a foreclosure last year: The Mortgage Forgiveness Debt Relief Act of 2007 does not require homeowners who lost their home to pay taxes on the forgiven mortgage debt. This applies only to individuals who lost their primary residence due to foreclosures that occur through 2012. Individuals who lost a rental property to foreclosure will, however, have to pay taxes.

Click here for more on homeowner tax breaks.