You’ve filed your tax return by now, right? Congratulations. Probably the last thing you want to hear about now is Internal Revenue Service audits.

However, it’s useful for all taxpayers — especially self-employed real estate professionals, to understand what the chances are of being audited. You may be surprised to discover that the odds that the average real estate professional will be audited are higher than those for corporations with millions of dollars of assets.

First of all, you may be happy to know that IRS audits are not nearly as common as they used to be. In 1963, an incredible 5.6 percent of all Americans had their tax returns audited. In 2010, only 0.9 percent of all Americans were audited. There are several reasons for the change:

  • Between 1997 and 2006, the IRS workforce declined by 14 percent.
  • The IRS workload increased.
  • Starting in the mid-1990s, the IRS began to emphasize taxpayer service rather than enforcement.
  • Congress enacted laws in 1998 to prevent perceived abuses by IRS agents and auditors. These new protections also made it more difficult for the IRS to go after tax cheats.

Partly as a result of these changes, the "tax gap" — the difference between what taxpayers owe and what they actually pay — has grown. The IRS estimates that the tax gap exceeds $300 billion per year. The IRS also claims that nearly one-third of the tax gap is due to underreporting of income by small businesses.

To help close the tax gap, the IRS has increased its compliance efforts in recent years. And it appears to be targeting small businesses. Indeed, audit rates for small businesses have gone up for the last five years. Since most real estate professionals run small businesses, they are affected more than most.

So, what are the odds that a real estate professional will be audited? It depends on your income and whether you’ve formed a business entity.

The vast majority of real estate professionals are sole proprietors. They run a one-person business and file Schedule C tax forms. In 2010, the audit rates for all sole proprietors were as follows:

Income less than $25,000    1.2% audit rate
$25,000 to $100,000    2.5% audit rate
$100,000 to $200,000    4.7% audit rate
More than $200,000    3.3% audit rate

If you’ve formed a partnership, limited liability company (LLC), or S corporation, the audit rates are much lower: In 2010, only 0.4 percent of all such business entities were audited.

The audit rates for regular C corporations were as follows:

Assets less than $250,000 0.8% audit rate
$250,000 to $1 million 1.4% audit rate
$1 million to $5 million 1.7% audit rate
$5 million to $10 million 3% audit rate

The data shows that sole proprietors are in the IRS’s crosshairs: In 2010, 4.7 percent of sole proprietors earning $100,000 to $200,000 were audited. Not even corporations with assets worth between $5 million to $10 million were audited as often.

In 2010, a total of 277,945 sole proprietors had their returns audited. This amounted to over 16 percent of all IRS audits for the year.

These statistics undoubtedly reflect the IRS’s belief that sole proprietors habitually underreport their income, take deductions to which they are not entitled, or otherwise cheat on their taxes.

Such audits can hurt. In 2010, the average recommended additional tax for an audit of a sole proprietor earning $25,000 to $100,000 was $8,776. For those earning $100,000 to $200,000, it was a whopping $31,979.

The lesson these numbers teach is that you need to take the IRS seriously. This doesn’t mean that you shouldn’t take all the deductions you’re legally entitled to take, but you should understand the rules and be able to back up the deductions you do take with proper records.

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