5 Common & Costly Tax Mistakes

Every year, the average American spends more money on taxes than they do on food, clothing, and shelter combined.  Why is this the case? As a CPA, I hate to say this, but one of the biggest reasons why taxpayers lose a ton of money to Uncle Sam is because they receive bad advice.

During my years as a tax strategist, I have reviewed countless tax returns. Here's the truth: A lot of taxpayers lose out and overpay the IRS because their tax preparers make mistakes on their returns. So as we head towards the 2011 tax deadline, I want to share the five most common and costly tax mistakes with all of you.

Mistake #1: Deducting Expenses in the Wrong Place

One of the most common mistakes we see involves tax deductions being taken in the wrong places. Take the example of a client, "Tony," who is a pilot. Tony also has a small business where he sells nutritional products. For all of Tony’s travel costs, his tax preparer took those deductions on his Schedule A as unreimbursed employee business expenses. Based on his income level and the limitations on Schedule A, he was unable to benefit from any of his $20,000 of travel costs. Had he correctly reported these travel costs as part of his business expenses (on his business tax return or Schedule C), he would have been able to increase his tax refund by close to $10,000. So make sure you are taking your tax deductions on the right forms and schedules!

Mistake #2:  Limited by Passive Loss Rules

Here is common situation that I see time and time again. "Carol" is a retired teacher who operates a health food business with her friend Joyce. After speaking with a tax advisor, Carol and Joyce correctly formed a partnership to jointly run the business. As with many businesses, 2010 was a not a good year for them, and the business suffered losses of around $30,000.

After meeting with their tax preparer, Carol was shocked to learn that she still owed taxes to the IRS.We reviewed her tax return and discovered that her CPA incorrectly prepared Carol’s individual tax return showing her to be a passive investor in the partnership rather than an active business owner. This error took $30,000 of tax write-offs on the table! Fortunately for Carol, it was easy for us simply to check a box on the tax return for her to claim that $30,000 tax write-off. So if you are a business owner or someone who receives a K-1 from any of your businesses or investments, make sure you speak to your tax preparer to ensure you are not erroneously being limited on your tax write-offs by the passive loss limitation rules.

Mistake #3: Real Estate Professional Status

Real estate professional status is by far the biggest mistake that I see made by real estate investors -- and it's a mistake that cannot be undone.

Here's an example: "Lynne" has been working with a CPA for many, many years and was always told she has been benefiting from the tax deductions as a real estate professional. When I reviewed her tax return two months ago, however, I had to be the bearer of bad news and let her know that her CPA prepared her taxes wrong and cost her a $20,000 tax refund. The worst part of this was that there was nothing I could do after the fact to get that money back for her.

So what exactly is "real estate professional status?" It actually has nothing to do with your education or professional licenses. Rather, the IRS looks to what you do for a real estate business and how much time you spend in your real estate activities. As a real estate professional, you get to take advantage of an unlimited amount of real estate deductions each year on your tax return. Contrary to popular belief, however, real estate professional status is not simply a matter of indicating your occupation on your tax return. It is not a specific form to fill out or even a particular box to check. Rather, it is an election that must be attached to your tax return at the time you file it. If you invest in real estate, make sure you speak to your tax preparer to ensure that election is in place before you send off that tax return.

Mistake #4:  Missing Carryforward Tax Benefits

There are a lot of things on our tax returns that move with us from year to year. These are commonly referred to as “carryforwards”. For example, if you had certain types of tax deductions, losses, or tax credits that you were not able to use in the past for any reason, these generally get “carried forward” on your tax returns from one year to the next.

One of the most common mistakes we see is carryforward tax benefits being lost between years. For example, a new client, "Brandon," sold his business in 2009 and had a nearly $40,000 carryforward loss on his tax return. However, his over-worked CPA somehow “lost” that carryforward when he prepared Brandon’s 2010 tax return. It was a small but potentially expensive mistake that could have cost Brandon close to $18,000!

Mistake #5:  Lack of Proactive Planning and Analysis

There is no doubt that the best way to minimize your tax liability is with proactive tax planning and analysis. Proactive and frequent planning sessions with your tax advisor allow you to take advantage of opportunities that can significantly diminish your tax liability.

Here is an example of an opportunity that I just went through with a new client. "Sherri" has two sons who are currently in college. After a review of her previous year’s tax returns, I noticed her tax preparer did not claim an education tax credit of $2,500 each for her sons. Sherri’s tax preparer told her that due to her high income level, she is not able to claim these credits. Now although this is correct (there is an income limitation for claiming the education tax credits), there was a loophole that the preparer overlooked. I determined that Sherri’s sons could have filed their own tax returns, and they could have benefited from the $2,500 education tax credits! With a little strategy and analysis, Sherri and her sons were able to increase their overall tax refund by $5,000 per year just by taking advantage of the education credit.

As you can see, not all tax deductions are created equal -- and not all tax preparers are created equal. So start now: Be proactive this year and don’t wait until tax deadline day before meeting with your tax advisor!