By now many of us know about the notorious story of real estate mogul Leona Helmsley, who was infamously known for her tax-evasion scandal. Helmsley claimed some outlandish tax deductions, like a business expense deduction for renovations to her home, as well as a deduction for the luxurious furniture inside.
For claiming these deductions, as well as other tax schemes she engaged in, Helmsley was imprisoned and fined over $7 million. She was also ordered to pay restitution of nearly $2 million. To paraphrase hip-hop musician Drake, the IRS was all in her books getting its Matlock on. It’s no wonder she eventually got booked!
Helmsley is not alone in her actions. The IRS pursues approximately 3,000 criminal prosecutions annually against individuals who participated in a variety of tax schemes.
If you want to keep the IRS out of your books, learn how it selects taxpayers for further investigation and avoid these five filing errors that could potentially trigger an audit.
Audit selection process
There are many reasons why individuals are selected by the IRS for an audit. Sometimes, a return is randomly selected by a computer program the IRS uses called the Discriminant Inventory Function System (DIF). DIF assigns a score to a return. The higher the DIF score, the greater the error potential; thus, the greater the chance the return will be selected.
In addition to this reason, the IRS may also select your returns when there is a related issue or transaction with other taxpayers that raises a red flag with the IRS. Such issues are:
- Having business partners or investors whose returns are also being audited
- Including a transaction on your return that the IRS has deemed as abusive
- Including certain tax credits on your return
Five audit triggers
While in general IRS audits are done at random, the IRS normally announces what provision of the code it plans to increase its enforcement efforts. If your return includes any of the following five deductions or transactions, you should consult with your tax advisor immediately.
Monetized installment sales transactions
Over the past few years, deferred transactions have become attractive to real estate investors all over the world. The allure of deferring capital gains until the future has gotten even the most reluctant investors into the real estate game. While this is the case, some transactions are not as good as they look and can expose you to not only an IRS audit but also criminal penalties.
One major red flag for the IRS is a return that includes improper monetized installment sales transactions. While the intricacies of the arrangement can vary, typically the promoter gets a third party to purchase the property from the seller in exchange for a 30-year installment loan. The promoter then tells the seller that taxes will be deferred until the maturity date of the loan.
Then, the intermediary conveys the property to the buyer, and the buyer typically invests the sales proceeds and then partners with a lender to loan the proceeds back to the original seller, typically between 95% and 97%. Here lies one of the problems with this arrangement: The loan is deemed by the IRS to be a payment and thus income. That means it is not an installment sale, and the taxpayer cannot receive a Section 453 deferral.
After retaining most of the proceeds via a loan, the seller improperly delays the gain recognition on the appreciated property until the final payment on the installment. This is a short version, as these arrangements are quite complex, but in general, if you engage in this activity or are thinking about engaging in this activity, you will more than likely be flagged by the IRS.
Promoters of these arrangements promise investors a large tax deduction, but the investor will most likely get audited instead. Remember, if it sounds too good to be true, it probably is!
Note: Typically under Section 453, a gain is not recognized until the principal payments are made.
Syndicated conservation easements
Individuals who donate conservation land and claim the associated tax benefit have helped to conserve more than 33 million acres of land since the deduction became permanent in 1980. These philanthropic acts have made an immeasurable contribution to society.
Unfortunately, where there is good, there is also bad. Many promoters of syndicated conservation easements have lured investors into engaging in abusive transactions. These transactions have been so dubious that they have made the IRS’s Dirty Dozen list.
In short, a syndicated conservation easement is an arrangement created by promoters who sell shares of an undeveloped tract of land to investors. After purchasing the land, the investor will place money into a partnership with the intent of donating the land for conservation. This in turn will produce a substantial tax deduction for the donee. The problem with this arrangement is that the value of the land is most often inflated, and the tax deduction is fraudulently claimed based on an inflated value.
As with monetized installment sales, the goal of this arrangement is to produce large tax deductions, so the IRS has found this type of arrangement to be a tax avoidance scheme, not a legitimate tax strategy.
If you have engaged in this type of arrangement, the best bet is to contact the IRS to learn what your next steps should be. The IRS has promised to shut down all promotion of these abusive arrangements.
Note: On April 19, 2021, the IRS announced the establishment of a new Office of Promoter Investigations to investigate the promotion of abusive transactions (i.e., tax scams).
Micro-captive insurance arrangements
Another member of the IRS’s Dirty Dozen list is the micro-captive insurance arrangement. On their face, micro-captive insurance arrangements were created as an insurance product to guard against legitimate business risk. However, the IRS has found that many of these arrangements were created with the sole purpose of lowering the participants' taxable income, without any true insurance being offered to the participant. The IRS urges any participants in these arrangements to exit the arrangement immediately.
If you have included a deduction for this type of arrangement on your tax return, prepare to be audited, as the IRS has created 12 new examination teams to audit these arrangements.
Home office deduction
Next on our list is the home office deduction. After the surge of COVID-19, many workers resorted to working from a home office. If you claim this deduction, be aware of the rules for claiming a home office deduction. In general, you can claim a deduction for the business portion of real estate taxes, mortgage interest, rent, utility, insurance, depreciation, painting, and repairs.
Keep in mind that the portion of your home that is used for your home office must be used exclusively and regularly as a principal place for your trade or business. This means if you are an employee, you cannot claim the deduction, even if you work from home remotely. Claiming this deduction without meeting the specific requirements could trigger an audit.
Earned Income Tax Credit
Last but not least is the claim for the Earned Income Tax Credit (EITC). As of 2018, returns claiming EITC were audited at twice the rate of all individual income tax returns. As it relates to claims for the earned income tax credit, one of the major issues that lead to an audit is the marital status of the taxpayer. Married taxpayers who incorrectly file as single or head of household often receive more EITC than allowable, and this filing error could trigger an audit from the IRS.
So, if you are married but living separately and have a legitimate claim to the head of household filing status, be sure you can substantiate this with the IRS. If you are married and file as single, this is an improper filing status -- you are either married or single, never both at the same time.
The Millionacres bottom line
Filling out your tax return can be tricky, but don’t get caught up in the IRS’s Dirty Dozen. Pay attention to the tax deductions you claim and the business transactions you engage in.
If you need assistance, work with a tax advisor. Having your taxes done right can save you from the agony of having a lot of sleepless nights.