It may seem like a good idea in the current real estate market. There are a number of issues to consider--both tax and nontax. The first tax consideration is that if you're going to eventually use the $250,000/$500,000 gain exclusion, you'll have to have used the property as your principal residence for 2 out of the last 5 years. The second tax issue is that you'll have to take depreciation on the property and your basis for depreciation will be the lower of your adjusted basis (generally, your cost plus improvements less any depreciation taken) or the fair market value at the time of conversion. That can be a no-win situation. If you bought the house years ago for very little, your basis will be cost; if you bought it recently and the market value is now below your cost, the market value will be your starting point. And keep in mind that you'll have to allocate your basis between the land and the building. Only the building (and certain land improvements) is depreciable.

Home office deduction

There are several requirements you must meet to deduct the expenses of a home office. The one that traps many taxpayers is the exclusive use test. To qualify under the exclusive use test, you must use a specific area of your home only for your trade or business. The area used for business can be a room or other separately identifiable space. The space does not need to be marked off by a permanent partition. You do not meet the requirements of the exclusive use test if you use the area in question both for business and for personal purposes. Sounds simple, but many people end up using the area for personal purposes. For example, you've got a separate room for your home office. You've got customer files, product literature, research material, records, a computer and a television and dvd player for watching training videos. Unfortunately, it's the only computer in the home and your children play video games on the television when you're not using the office. You don't meet the exclusive use requirement. In one Tax Court case the taxpayers used over 60% of their apartment for business--the bedroom closet shelves had accounting records, the living room had product literature and samples, etc. But the Tax Court disallowed the deduction noting that there was no area that was used exclusively for the business. You don't have to meet the exclusive use rule if you use part of your home for the storage of inventory or product samples or you use part of your home as a daycare facility. Be careful. The IRS may ask to see the office. You should consider taking pictures of the office at least once a year with a camera that will date them. They may provide enough evidence to sustain a deduction should you discontinue using the office or move.

On December 19, 2007, the House of Representatives approved the Senate-passed version of H.R. 3996, the "Tax Increase Prevention Act of 2007."

The Act increases 2007 exemptions for computing the federal Alternative Minimum Tax to $66,250 for married persons, filing jointly (was $62,550 for 2006), $33,125 for married persons, filing separately (was $31,275 for 2006) and $44,350 for single persons (was $42,500 for 2006).

The Act does not include any revenue offsets to pay for reducing the Alternative Minimum Tax.

This political football has made tax planning difficult, and will cause many errors on 2007 income tax returns, because the exemption amounts will be in error on the forms being published by the IRS.

Remember the exemption is phased out for high-income taxpayers, so the exemption will be zero when alternative minimum taxable income is $415,000 for married persons, filing jointly, $207,500 for married, filing separately, and $289,900 for singles.

The Act also allows certain nonrefundable credits to reduce the AMT for 2007.

No provision was made for the AMT exemptions for 2008.

 Avoiding an Audit

Why me? You just got the invitation to a "party" that you hoped you'd never attend -- an IRS audit.

How did this happen and how can you prevent it from happening again? We'll get to the how when we answer how to minimize the chances of an audit and how to survive one.

Rule 1: Check your arithmetic

Few audits are generated by mathematical mistakes alone. The Internal Revenue Service computers automatically correct both mathematical errors and mistakes where you have claimed deductions that exceed limits set by the tax code itself, such as the 7.5% adjusted gross income limitation on medical deductions. However, too many of these kinds of errors indicate a sloppy return, and that that may lead to a full audit.

While it may seem obvious, let's not give the IRS any additional reasons to look at your return.

But how do you get picked? An IRS computer program compares your deductions to others in your income bracket and weighs the differences. This secret IRS formula, called the DIF Score, is used to select returns with the highest probability of generating additional audit revenue.

For example, a taxpayer with a $50,000 salary would rarely have $10,000 in charitable contributions. This doesn't mean that, if you have only $50,000 in income and actually have $10,000 in charitable contributions, you shouldn't claim those deductions. It only means that if that is the case, be prepared to prove those deductions. The DIF formula considers not only your income and deductions, but where you live, the size of your family and your profession as well. Rarely will a family of five living in the Hamptons have an income of $30,000 or less. It may happen, but if it does, the IRS will want to know how. This leads to . . .

Rule 2: Arrange your finances so they don't stand out

If you think you may be audited, see if your situation is likely to attract the tax man's attention. Here are groups that often do invite inquiries:

The self employed If you are self-employed, you have more opportunity to either "hide" your income or "create" deductions by converting personal expenses into business expenses. If so, be prepared to substantiate your expenditures as deductible expenses. The IRS is aware of the myriad "business vehicles" that go away to college every September, and the probability of your being audited is enhanced.

The audit rate for 2005 was 0.92%, up from 0.77% in 2004 and 0.65% in 2003.

Those who get their income in cash. The IRS has specific audit programs aimed at specific professions and occupations. Because they receive much of their income in cash, people who work in the gaming industry, waiters and even doctors are prime audit targets. The more cash you receive and the higher your income potential, the more likely the IRS is to find additional tax dollars by reviewing your return.

There are a number of kinds of areas of potential abuse that attracts the IRS. In recent years, the IRS has been targeting these areas for audit:

• Offshore credit card users

• High risk, high income taxpayers

• Investors in abusive schemes and promotions

• High income non-filers

• Unreported income

Rule 3: Substantiate. Substantiate. Substantiate.

In the audit itself, the IRS will focus on those items where taxpayers have historically failed to keep the required substantiation. Traditionally, auto, travel, meals and entertainment have been the areas most audited. To deduct auto expenses, you must establish the percentage of business use as well as the actual expenses incurred. I ask my clients to keep a mini-cassette recorder in their cars to record the business mileage and purpose. Kept contemporaneously, it is acceptable as sufficient substantiation of business use. Alternatively, a written diary of miles used for business would also be accepted.

You must have a receipt for all expenditures of $75 or more for meals and entertainment. The rule is simple: no receipt, no deduction. If the expense is less than $75, a diary notation is sufficient. However, both the receipt and the diary notation must have all of the following information:

• The amount paid

• The name and location of the restaurant or entertainment facility

• The person you entertained

• That person's business relationship with you

• The business discussion related to the entertainment

Unless you talk business, before, during or after the meal, your deduction won't be allowed. Remember, with the IRS, paper rules! With any and all expenses, deductions will be more easily allowed if you have a piece of paper to back them up.

Here's another piece of advice: Don't come in with a carton of miscellaneous receipts. The more "organized" your receipts and the more paper you produce, the easier it is for an IRS agent to conclude that you are organized, have full substantiation and owe no additional taxes.

One more point about how you're selected for an audit. The IRS computer selects many returns for audit on a random basis. Your income, deductions or where you live are irrelevant. Your number just came up -- you won the audit lottery. A student making $3,000 a year is just as likely to be selected as an accountant making $300,000. You just got "lucky."

The IRS can audit you for three years after you file your return. In reality, however, most returns are audited within 18 months of filing. This gives the IRS time to do the review and request the appropriate substantiation before the statute of limitations (usually the three-year period) ends. Once the statute has run out, the IRS normally cannot audit your return, and your expenses are insulated from examination. It has been claimed that the later you file, the less likely it is the IRS will pick your return to be examined. The IRS still insists that agents are not graded or evaluated on the amount of money they collect until -- surprise! -- congressional testimony reveals that policy is not the same as practice.

Rule 4: Know when to file

I recommend that you have your return prepared early. If you have a big refund and are unconcerned with audit issues, file early and get your money back. If you have taxes due, and no penalty for underpayment, don't file until April 15. Don't ever pay a federal tax bill before it is due. It's an interest-free loan to the IRS.

On the other hand, if you are concerned about a potential audit, never file until the last minute. It won't hurt and can only decrease your chances of being selected.

Rule 5: Plan your taxes to preempt an audit

I highly recommend the use of pre-audit strategies. If, say, you have a huge medical deduction for a year that you feel would increase your chances of being audited, attach copies of your medical bills to your return.

Alternatively, if you made an unusually large charitable contribution, attach a copy of the check or receipts to your return. The IRS computer will still kick out your return, but when a real person looks at it, the reviewer will recognize that you know the rules. It may actually reduce your odds of a full audit.

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