The dreaded IRS audit. A number of things – unsubstantiated deductions, missed income, massive business losses, failure to report cryptocurrency holdings – can get you in trouble with the tax authorities. In addition to these regular items, taxpayers with investments should also pay attention to investment-specific reasons for an audit.
But here’s the good news for most filers: Only 0.4 percent of all individual returns were flagged for an audit in fiscal year 2023, according to CNBC. Most of these were handled by mail, so the Hollywood-style conversation with a friendly tax agent is more of a movie nightmare than actual reality.
Here are some common reasons why individual investors may trigger an audit.
What can cause a tax audit?
The IRS typically sets its sights on filers with huge deductions relative to their income, business filers with extra or questionable write-offs, those claiming the income tax credit, or anything that looks unusual. Although investing is not the most common reason for an audit, it still happens.
One of the easiest ways to avoid a confrontation with the IRS is to accurately report all your income, as the IRS automates this part of the process and flags discrepancies.
“In recent history, the IRS has been underfunded and understaffed, so the trend in tax investigations has been to match the information returns provided to taxpayers (for example, Form 1099s) with what taxpayers report on their returns,” says Brett Cotler, a tax attorney at Seward & Kissel LLP.
Still, investors should be careful, especially if they make a lot of money.
“IRS audits typically follow the money,” says John Madison, CPA and financial advisor at Dayspring Financial Ministry in Ashland, Virginia. “Audits are more likely for higher-income individuals because the potential to deliver larger tax adjustments lies with that demographic.”
Of course, that’s not a license for low-income filers to tamper with their returns. Because returns are managed electronically, the IRS can quickly detect if something looks unusual.
“IRS audits are caused by a so-called discriminant function test. It compares the average deductions across many returns and determines whether your deductions are higher than the averages,” says Chris Cooper, a California-licensed professional fiduciary in San Diego.
The IRS tests “give a broad range for deductions versus income, and if something seems wrong, out of range, then you will be questioned,” said Morris Armstrong, an enrolled agent who represents clients with the IRS.
Investors should be wary of discrepancies in the following areas that could make the IRS sit up and take notice of their returns.
Top IRS Audit Triggers for Investments
1. Deductions on real estate
If you have invested in real estate and manage it yourself, write off the legitimate expenses associated with the rental property, such as repairs, depreciation and advertising costs. However, problems arise when property owners become aggressive, over-depreciating the property or claiming deductions that they should not be deducting.
With so many low-interest mortgages taken out between 2020 and 2023, “it would raise scrutiny if there were any large mortgage deductions that seemed excessive,” said Megan Gorman, managing partner at Checkers Financial Management in San Francisco.
Cooper emphasizes that taking a big loss on farmland can also be a potential red flag for the IRS.
Although the IRS gives landlords some leeway in claiming deductions, it is not carte blanche and real estate investors will have to substantiate the deductions if the IRS comes knocking on their door.
2. Missing dividends and interest
Forgot to include all dividends and interest from your banks and brokers? That can make the IRS curious, especially if the amount is material. But even if you’ve made a mistake, you may not need to sweat it.
“We’ve all received that notice from the IRS saying we left out some income on a return,” says Armstrong, “often an innocent mistake of overlooking a 1099 for bank interest or stock dividends. These are easy to correct.”
The IRS can simply correct the shortfall and deduct the extra amount from the return you filed, or if the tax is higher than your refund check, you’ll be asked to cough up more money.
But the IRS may not look kindly on a much larger 1099 that goes missing. “The unreported income could potentially trigger a further in-depth audit,” said Eric Bronnenkant, head of tax at Betterment, a robo-advisor.
3. Missing capital gains
If you sold a stock or other security and made a profit, congratulations, but you now have a capital gain. You owe tax on that benefit. The rate depends on whether you have held the security for more than one year and on your total taxable income.
Taxpayers usually record a capital gain on Schedule D of their returns, the form for reporting gains on losses on securities. If you don’t report the winnings, the IRS will immediately become suspicious. While the IRS can simply identify and correct a small loss and charge you the difference, a larger missing capital gain can set off alarm bells.
Although your brokerage firm will send you a tax form recording your gains and losses, you’re concerned about reporting them properly to the IRS. And it’s easy to forget to report them for accounts you don’t check often.
Finally, don’t assume that you can skip reporting a capital gain because the agent’s year-end tax return report was delivered late. If you file your taxes too early and don’t report the gain, you will have to file an amended return and explain to the IRS what happened.
4. Failure to report cryptocurrency
Cryptocurrency is a big area for enforcement right now, says Brian R. Harris, tax attorney at Fogarty Mueller Harris, PLLC in Tampa. So if you trade, own or use cryptocurrency, you could be a target for an audit or compliance check, he says.
Annual tax returns now require you to declare whether you’ve traded digital assets, and the question is at the top of Form 1040, so it’s hard to say you haven’t seen it. If you don’t report that you own or trade digital currency or NFT, you could get into trouble.
But other crypto-related matters can also put you in conflict with the law. For example, you may have to pay taxes on any capital gains you made, even if you simply spent digital currency on goods and services and did not actually trade them.
You need to be extra vigilant because many brokers or exchanges may not be diligent when sending 1099 forms reporting gains and losses to the IRS. And if you spend crypto, you may need to keep your own records and calculate your tax liability.
Here are the other things you need to know about cryptocurrency and taxes.
5. Improperly filed employer stock options
The tax issues surrounding stock options for employers can be tricky, to say the least. In many cases, employees report little to no profit, which may lead them to believe they don’t need to report it. In fact, it is common for the taxpayer to not report the sale, but that’s a big no.
This is what often happens: an employee can get options as a perk. When employees want to exercise these options, they put in the money and buy the shares at the agreed upon price. Often employees will simply turn around and sell the stock. However, they often fail to state the exercise price of the options, which is the correct cost basis for calculating taxable profit.
“This common options strategy still requires a sale to be reported on tax returns even if there is little to no gain or loss,” Bronnenkant says. “While this is an issue that can be resolved by ultimately reporting the correct cost basis, the IRS may initially assume that all sales proceeds are short-term gains even though they may not be taxable at all.”
If you don’t report the cost basis, the IRS assumes the basis is $0 and so the stock sale proceeds are fully taxable, perhaps even at a higher short-term rate. The IRS may think you owe thousands or even tens of thousands in additional taxes and wonder why you haven’t paid.
6. Filing late
The IRS wants to get paid, and it wants to get paid on time. That can sometimes be difficult for investors, especially when some investments can be complicated or when year-end statements arrive late in tax season. In fact, it’s not uncommon for some companies to report tax data into April or even after the typical April 15 tax deadline.
Although an investor’s tax returns can be more complicated than the average return, the IRS still wants on-time filing. And by requiring them to do so, you stay off their radar and attract less attention.
What can investors do if they are contacted by the IRS?
If the IRS contacts you, the first thing you can do is remain calm. “Keep in mind that just because you are subject to an audit does not mean your return is incorrect,” says Gorman.
In addition to conscientiously filing their returns and reporting all their income, investors have other steps they can take to avoid the tax authorities calling.
“Simple things can keep you from filing an audit, such as paying taxes on time, filing returns on time and acting immediately on an IRS return,” says Paul T. Joseph, founder of Joseph & Joseph Tax and Payroll.
“The IRS appears to be focusing on items that may seem contradictory at first glance,” says Madison. But mere contradiction is no reason not to claim a legitimate deduction.
Madison suggests that taxpayers with unusual circumstances “can attach an explanation letter to the return. It is of course not foolproof audit protection, but it will initiate the documentation process that can prevent an audit before it even begins.”
For those investing in real estate, keep track of all your rental costs and deductions, Bronnenkant advises.
And finally, just because you have a large deduction doesn’t mean you shouldn’t claim it, even if you think it looks a little unusual. “You need to be able to back up the numbers you reported to the IRS,” says Gorman. “Substantiation is the key to winning an audit.”
This can be more difficult for real estate than for listed shares. Although equity losses are reported on a broker’s tax return, that is not always the case for real estate expenses. You will probably need to keep receipts from different stores or independent contractors.
In short
Each deduction or new source of income creates another potential focus for the IRS. So in addition to the usual sources of concern, such as general deductions and missing income, investors must also conscientiously consider the income from their stocks, bonds and real estate, among other things. But like all taxpayers, they also want to do the little things that keep the IRS from suspecting something is wrong.
