GAO HOME MORTGAGE INTEREST DEDUCTION. Despite Challenges Presented by Complex Tax Rules, IRS Could Enhance Enforcement and Guidance

Transcription

1 GAO United Sttes Government Accountbility Office Report to the Joint Committee on Txtion July 2009 HOME MORTGAGE INTEREST DEDUCTION Despite Chllenges Presented by Complex Tx Rules, IRS Could Enhnce Enforcement nd Guidnce GAO

2 July 2009 Accountbility Integrity Relibility Highlights Highlights of GAO , report to the Joint Committee on Txtion HOME MORTGAGE INTEREST DEDUCTION Despite Chllenges Presented by Complex Tx Rules, IRS Could Enhnce Enforcement nd Guidnce Why GAO Did This Study Complex home-mortgge interest deduction rules crete problems for txpyers nd increse the potentil for noncomplince. For exmple, the rules involve mortgge debt limits nd how lon proceeds re used. GAO ws sked to (1) describe how IRS detects noncomplince with the deduction s rules nd wht IRS knows bout the extent of noncomplince; (2) identify problems txpyers fce in complying with the deduction s rules nd chllenges IRS fces in enforcing them; (3) ssess options to give IRS more informtion to ssist enforcement; nd (4) determine if IRS s guidnce to txpyers nd its exminers provides informtion to clculte the deduction properly. GAO nlyzed IRS enforcement dt nd interviewed IRS nd industry officils. GAO did not consider sttutory chnges. Wht GAO Recommends GAO recommends tht IRS revise its min reserch progrm s cseselection system to better detect debt-limit noncomplince; expnd informtion reporting on txpyers mortgges; revise tx forms, instructions, nd exminer trining; nd test outrech progrms. In commenting on drft of this report, IRS greed with five recommendtions nd sid it will study the recommendtions on expnding informtion reporting nd testing outrech progrms to reduce noncomplince. Wht GAO Found IRS enforcement nd reserch progrms do not provide n overll picture of mortgge interest deduction noncomplince. While its vrious complince nd reserch progrms provide evidence of some mortgge interest deduction complince problems, they leve gps in wht is known bout the extent nd specific nture of noncomplince. In prticulr, IRS knows little bout the extent of noncomplince with vrious debt limits nd rules regrding the use of home equity lons. The cse selection system of IRS s min reserch progrm lso my hve excluded possible noncomplint cses. IRS exminers prtly ttribute noncomplince to txpyers nd pid preprers not knowing deduction rules. Txpyers problems in complying with the mortgge interest deduction rules include the mny steps necessry to determine whether mortgge interest nd points re deductible nd the recordkeeping necessry to determine how the proceeds of home equity lons re used. The deduction s complexity lso poses chllenges to IRS. Although mortgge interest pyments bove threshold re reported to IRS, the informtion reported shows the dollr mount of interest txpyer pid in yer without regrd to the limits on the mount of debt imposed by lw. As result, IRS lcks informtion tht could help it efficiently detect noncomplince with deduction limits nd must rely on costly exmintions. Severl options exist for expnding informtion reporting on txpyers mortgges nd using privte sector dt to enhnce complince. Useful informtion would include property ddresses, debt blnces, nd n indictor of lon refinncing. This informtion would llow IRS to identify txpyers reporting mortgge interest exceeding the cquisition debt limit. Third prties who send informtion reports to IRS initilly my incur some dditionl costs to provide the dt, but those costs re likely to be one-time expenses. Additionl lon informtion from privte sector sources lso might help IRS detect home equity noncomplince. The schedule for reporting mortgge interest deductions does not explicitly stte tht the deduction is subject to limits. Further, IRS s guidnce for txpyers nd exminers provides different interprettion for the cquisition debt limit thn prior tx court ruling, nd the exminers guidnce lcks exmples of problem res cited by exminers nd prctitioners. The Complexity of Determining the Deductibility of Home Mortgge Interest nd Points View GAO or key components. For more informtion, contct Jmes R. White t (202) or [email protected]. Note: The steps in the tble do not reflect other complicting fctors, such s interest on home equity debt generlly not being deductible in lterntive minimum tx computtions. United Sttes Government Accountbility Office

3 Contents Letter 1 Bckground 3 IRS s Enforcement nd Reserch Progrms Do Not Provide n Overll Picture of Mortgge Interest Deduction Noncomplince 7 Txpyers Fce Vriety of Problems Trying to Comply with Mortgge Interest Deduction Rules, nd IRS Fces Chllenges in Detecting Noncomplince 10 Options Exist for Expnding Mortgge Informtion Reporting nd Using Privte Sector Dt to Enhnce Enforcement 14 IRS s Guidnce to Txpyers nd Trining Mterils for Exminers Did Not Indicte the Rnge of Possible Mortgge Interest Deduction Situtions 20 Tx Softwre Differed in the Ese of Nvigting Mortgge Interest Deduction Instructions 23 Conclusions 24 Recommendtions for Executive Action 24 Agency Comments nd Our Evlution 25 Appendix I Scope nd Methodology 27 Appendix II Schedule A, Itemized Deductions 30 Appendix III Exmintion Results Involving Mortgge Interest Deductions 31 Appendix IV Exmples Illustrting Mortgge Interest Deduction s Complexity 32 Appendix V Descriptive Dt on Home Mortgge Interest Deduction Clims nd Form 1098 Filings 36 Pge i

4 Appendix VI Mrgins of Error Tbles for Estimtes in Appendix V 45 Appendix VII SMR Reserch s Dt on Home Equity Debt nd How IRS Might Use Similr Dt for Enforcement 52 Appendix VIII Comments from the Internl Revenue Service 54 Appendix IX GAO Contct nd Stff Acknowledgments 58 Tbles Tble 1: Limittions on Mortgge Interest Deductibility by Type of Debt 4 Tble 2: Amounts of Mortgge Interest Deductions, Home Sles Prices, nd Home Equity Debt in 2001 nd Tble 3: Wht IRS s Min Reserch nd Enforcement Progrms Do nd Do Not Show bout Mortgge Interest Deduction Complince 9 Tble 4: Results of IRS s Fiscl Yer 2008 Exmintions of Schedule A, Line 10 for CIP nd non-cip Exmintions 31 Tble 5: IRS Worksheet to Figure Home Mortgge Interest 34 Tble 6: Number nd Dollr Totl of Schedule A, Line 10 Deductions per Number of Form 1098 Filings, 2004 through Tble 7: Distribution of Schedule A, Line 10 Deductions in Select Percentiles per Number of Form 1098 Filings, 2004 through Tble 8: Results of Compring Totl Schedule A, Line 10 Deduction Amounts to Amounts Reported on Form 1098, 2004 through Tble 9: Percentile Distributions for Schedule A, Line 10 Amounts Compred with Form 1098 Amounts nd the Difference between Schedule A, Line 10 Amounts nd Form 1098 Amounts, 2004 through Pge ii

5 Tble 10: Yer-to-Yer Chnges in Amount Deducted on Schedule A, Line 10, 2004 through Tble 11: Yer-to-Yer Chnges in the Number of Form 1098 Filings, with Distribution of Chnge Amounts on Schedule A, Line 10, 2004 through Tble 12: Numbers of Mtching Lon Account Numbers on Forms 1098, 2004 through Tble 13: Number of Individul Tx Returns with Schedule A Mortgge Interest Deductions nd Non-Schedule A Mortgge Interest Deductions, 2004 through Tble 14: Mrgins of Error for Number nd Dollr Totl of Schedule A, Line 10 Deductions per Number of Form 1098 Filings, 2004 through Tble 15: Mrgins of Error for Distribution of Schedule A, Line 10 Deductions in Select Percentiles per Number of Form 1098 Filings, 2004 through Tble 16: Mrgins of Error for Results of Compring Totl Schedule A, Line 10 Deduction Amounts to Amounts Reported on Form 1098, 2004 through Tble 17: Mrgins of Error for Percentile Distributions for Schedule A, Line 10 Amounts Compred with Form 1098 Amounts nd the Difference between Schedule A, Line 10 Amounts nd Form 1098 Amounts, 2004 through Tble 18: Mrgins of Error for Yer-to-Yer Chnges in Amount Deducted on Schedule A, Line 10, 2004 through Tble 19: Mrgins of Error for Yer-to-Yer Chnges in the Number of Form 1098 Filings, with Distribution of Chnge Amounts on Schedule A, Line 10, 2004 through Tble 20: Mrgins of Error for Number of Mtching Lon Account Numbers on Forms 1098, 2004 through Tble 21: Mrgins of Error for Numbers of Individul Income Tx Returns with Schedule A Mortgge Interest Deductions nd Non-Schedule A Mortgge Interest Deductions, 2004 through Tble 22: Types of Trnsctions Included in SMR Reserch s Home Equity Debt Clcultions 52 Figures Figure 1: IRS Chrt Illustrting How to Determine Whether Mortgge Interest Is Fully Deductible s Shown in Publiction Pge iii

6 Figure 2: Current Form 1098 Informtion Compred with Options for Additionl Mortgge Debt Informtion 16 Figure 3: Internl Revenue Service Schedule A on Which the Home Mortgge Interest Deduction Is Tken 30 Abbrevitions AIMS AMT CDW CIP EOAD IRS NRP SOI Audit Informtion Mngement System Alterntive Minimum Tx Complince Dt Wrehouse Complince Inititive Project Exmintion Opertionl Automtion Dtbse Internl Revenue Service Ntionl Reserch Progrm Sttistics of Income This is work of the U.S. government nd is not subject to copyright protection in the United Sttes. The published product my be reproduced nd distributed in its entirety without further permission from GAO. However, becuse this work my contin copyrighted imges or other mteril, permission from the copyright holder my be necessry if you wish to reproduce this mteril seprtely. Pge iv

7 United Sttes Government Accountbility Office Wshington, DC July 29, 2009 The Honorble Chrles B. Rngel Chirmn Joint Committee on Txtion House of Representtives The Honorble Mx Bucus Vice Chirmn Joint Committee on Txtion United Sttes Sente The home mortgge interest deduction is the third most expensive federl income tx expenditure, with the government expected to forgo bout $80 billion of revenue for the deduction in Subject to vrious limittions, txpyers my deduct interest on home-secured lons, such s mortgges, mortgge refinncings, nd home equity lons, including those tken s lump sum mounts nd home equity lines of credit. The rules tht txpyers must follow in determining the proper mount of mortgge interest to deduct cn be complex. For exmple, there re limittions on the mount of debt for which interest cn be deducted, specil rules for refinncing, situtions where lterntive minimum tx (AMT) considertions pply, nd rules on the deductibility of prepid interest mounts clled points. In generl, complex tx rules increse the potentil for noncomplince. You sked us to study the home mortgge interest deduction to determine if there re dministrtive issues tht need to be ddressed to improve txpyer complince nd Internl Revenue Service (IRS) enforcement. For this report, we (1) provide informtion on how IRS detects txpyers noncomplince with the home mortgge interest deduction rules nd wht it knows bout the extent of noncomplince; (2) identify the problems, if ny, txpyers fce in ttempting to comply with the deduction nd describe IRS s chllenges in detecting mortgge interest deduction noncomplince; (3) ssess options to give IRS more informtion to enforce 1 The most expensive income tx expenditures re reduced rtes of tx on dividends nd long-term cpitl gins (bout $148 billion of forgone revenue) nd the exclusion of employer contributions for helth cre, helth insurnce premiums, nd long-term cre insurnce (bout $127 billion). Pge 1

8 complince with the rules; (4) determine whether IRS s guidnce to txpyers nd its exminers guidnce nd trining on the deduction provide enough informtion to properly clculte the txpyers llowble mortgge interest deduction; nd (5) describe how tx-return preprtion softwre progrms hndle the deduction. You lso sked us to provide descriptive informtion on txpyers mortgge interest deductions nd mortgge interest pyments reported on Form 1098, Mortgge Interest Sttement. Appendix V provides this informtion. Considertion of sttutory chnges ws beyond the scope of our report. To ddress our objectives, we nlyzed IRS s efforts to determine txpyer complince with the mortgge interest deduction. This included exmining informtion on IRS s complince inititive projects tht focused on the deduction nd on IRS s other routine exmintion ctivities. 2 We lso nlyzed informtion from IRS s Sttistics of Income (SOI) Division nd Complince Dt Wrehouse (CDW) dtbses to compile informtion bout individuls yer-to-yer chnges in climing the deduction nd obtined sttisticl informtion from the privte sector on home equity lons, home equity lines of credit, nd refinncings. We reviewed relevnt studies nd publictions nd interviewed cogniznt IRS officils nd representtives from the tx preprtion nd mortgge bnking industries to obtin informtion on the issues surrounding dministrtion of the deduction. We determined whether IRS s guidnce to txpyers prominently mentioned the limittions on the mount of debt for which interest cn be deducted. To determine whether IRS exminers trining nd guidnce provided enough informtion on properly clculting the mortgge interest deduction, we compred IRS s exmintion trining nd guidnce with tx lw nd instructions. We lso nlyzed how severl tx preprtion softwre pckges tht re widely used by individul txpyers or pid preprers hndled the clcultion of the deduction by reviewing pproprite prts of the softwre to determine how they treted the debt limittions nd by interviewing compny officils. We performed tests tht determined the dt used in this report were relible for our purposes. Appendix I provides more detiled discussion of our scope nd methodology. 2 We use the term routine to cover exmintions tht include the mortgge interest deduction but re not prt of n IRS complince inititive project tht focused on it. Pge 2

9 We conducted this performnce udit from My 2008 through July 2009 in ccordnce with generlly ccepted government uditing stndrds. Those stndrds require tht we pln nd perform the udit to obtin sufficient, pproprite evidence to provide resonble bsis for our findings nd conclusions bsed on our udit objectives. We believe tht the evidence obtined provides resonble bsis for our findings nd conclusions bsed on our udit objectives. Bckground Txpyers hve been llowed to deduct mortgge interest pyments on their federl tx returns since Congress encted the federl income tx in At tht time, the deduction for home mortgge interest ws prt of the deduction llowed for ny interest pid. The Tx Reform Act of 1986 limited deductions for nonbusiness interest. 3 The 1986 ct specificlly disllowed deductions by individuls of personl interest but included limited exception for qulified mortgge interest. The 1986 ct ws mended the next yer to include dollr limits on the mount of home mortgge debt for which interest pyments cn be deducted. 4 Txpyers my deduct the interest they py on lons secured by qulified homes either their min home or their min home nd second home. These lons include first or second mortgges, home equity lons, nd home equity lines of credit. Bots nd recretionl vehicles my qulify s homes if they hve sleeping, cooking, nd toilet fcilities. As tble 1 shows, two kinds of debt my qulify for the mortgge interest deduction. The first kind is cquisition debt, which is debt incurred in cquiring, constructing, or substntilly improving qulified home nd tht is secured by the home. Txpyers my deduct ll of the interest pid on cquisition debt incurred on or before October 13, 1987, known s grndfthered debt. Txpyers interest deductions for debt on qulified homes purchsed fter October 13, 1987, is limited to the interest on $1 million of cquisition debt, reduced by ny grndfthered debt. 3 Pub. L. No (Oct. 22, 1986). 4 Omnibus Budget Reconcilition Act of 1987, Pub. L. No (Dec. 22, 1987). Pge 3

10 Tble 1: Limittions on Mortgge Interest Deductibility by Type of Debt Ctegory of limittion or deductibility Acquisition debt Home equity debt Dollr limittion on debt on which interest is deductible Limittion on use of lon proceeds on which interest is deductible Interest deductibility for lterntive minimum tx (AMT) purposes Limittion on the refinncing mount on which interest my be deducted Deductibility of points Limited to $1 million reduced by grndfthered debt Limited to cquiring, constructing, or substntilly improving home Generlly deductible Limited to the blnce of the old mortgge before refinncing; refinncing cnnot increse cquisition debt except to substntilly improve the home Deductible in the yer pid if vrious conditions re met nd the lon is used to buy, build, or improve txpyer s min home; if certin other tests re met, points re deductible over the life of the lon; when refinncing, except in sttes covered by the Eighth Circuit Court of Appels or when used to improve txpyer s min home nd certin conditions re met, points re deductible over the life of the lon Limited to lesser of (1) $100,000 or (2) home s fir mrket vlue minus cquisition debt nd grndfthered debt My be used for nything, including credit crd pyments, crs, tuitions, nd vctions Generlly not deductible unless proceeds re used to buy, build, or improve home Refinncing mount bove the cquisition debt blnce is home equity debt, up to the home equity debt limittion Deductible over the life of the lon Source: GAO nlysis of mortgge interest deduction rules. Note: Deductibility ssumes itemiztion of deductions, legl libility for the lon, nd mortgge secured by qulified home in which the txpyer hs n ownership interest. Acquisition debt nd home equity debt re limited to $500,000 nd $50,000, respectively, for mrried people filing seprtely. The second kind of qulified debt is home equity debt, which is ny noncquisition debt secured by the home. Its proceeds my be used for nything other thn to buy, build, or substntilly improve the home. For exmple, the proceeds my be used to py off credit crds or finnce crs or vctions. Home equity debt is limited to the home s fir mrket vlue minus the cquisition debt nd grndfthered debt, or to $100,000, whichever is less. Home equity debt for tx purposes should not be confused with wht is commonly clled home equity lon. The ltter my Pge 4

11 qulify s either cquisition debt or home equity debt depending on how the proceeds re used. 5 Tble 1 lso summrizes the deductibility of points. A point is term used to describe certin chrges pid in connection with obtining mortgge nd is clculted t 1 percent of mortgge s principl. Generlly, points re considered prepid interest, nd, s such, the deduction is usully llocted over the life of the lon. However, if vrious conditions re met, the txpyer my deduct the points in the yer pid. 6 Determining whether points re fully deductible in the yer pid my require tht txpyers go through s mny s 10 decision steps. Lending institutions nd other entities engged in trde or business tht receive $600 or more during the yer in mortgge interest nd certin points from n individul txpyer re required to file Form 1098, Mortgge Interest Sttement. Form 1098 reports re sent both to the txpyer nd IRS to show how much mortgge interest ws pid to the lender tht yer. Txpyers report their deductible mortgge interest informtion to IRS on lines 10 through 13 of Schedule A, the schedule itemizing deductions for the Form 1040 individul income tx return (see pp. II). Typiclly, the lrger deductible mounts re reported on line 10, which shows home mortgge interest nd points reported to txpyers on Form Lines 11 nd 12 of Schedule A re for climing mortgge interest nd points, respectively, not reported on Form 1098, 7 nd, strting in 2007, line 13 is used for deductible qulified mortgge insurnce premiums. Some interest pyments reported on Form 1098 my be deductible on other Form 1040 schedules, such s Schedule C for sole proprietorship businesses or Schedule F for frming. 5 According to informtion published in 2009 Federl Reserve Bulletin, homeowners used bout 40 percent of the equity borrowed from their homes in 2007 for home improvements. See Brin K. Bucks, Arthur B. Kennickell, Trci L. Mch, nd Kevin B. Moore, Chnges in U.S. Fmily Finnces from 2004 to 2007: Evidence from the Survey of Consumer Finnces, Federl Reserve Bulletin, vol. 95, Feb. 12, These conditions include whether the points were pid in connection with the purchse or improvement of the principl residence securing the mortgge, the pyment of points ws n estblished business prctice in the re where the lon ws mde, nd the mount pid for the points did not exceed the mount generlly chrged for points in tht re. 7 For instnce, the txpyer might hve pid home mortgge interest to the person selling the home, nd tht person did not hve to supply Form Pge 5

12 Chnges in the housing mrket over the yers my hve ffected the overll mount of home mortgge interest tht txpyers climed. Tble 2 shows the chnge in vrious indictors relted to the mortgge interest deduction from 2001 to The rise in home prices nd thus mortgge mounts, prtly ccount for the lrge increses in mortgge interest deductions climed by txpyers in 2006 compred to In 2006, the medin sles price for existing U.S. single-fmily homes ws up from Medin sles prices vried widely cross metropolitn res, with some loctions exceeding $700,000. The home equity lon totls reported by the Federl Reserve Bord lso incresed significntly from 2001 to According to the U.S. Census Bureu s 2006 Americn Community Survey, bout fifth of owner-occupied housing units with mortgge hd home equity lon. Also, ccording to the Joint Center for Housing Studies of Hrvrd University, 85 percent of homeowners who refinnced their mortgges in 2006 took csh out. Tble 2: Amounts of Mortgge Interest Deductions, Home Sles Prices, nd Home Equity Debt in 2001 nd 2006 Indictor relted to the mortgge interest deduction Txpyers Schedule A, line 10 deductions $323 billion $437 billion Number of returns with mounts climed on line million 39 million Averge line 10 deduction $9,000 $11,200 Medin home sles price $156,600 $221,900 Home equity lon mounts reported by the Federl Reserve Bord The prt of home equity tken out s csh bove the mount needed for the refinncing of prime, first-lien, conventionl mortgges, s reported by Freddie Mc $439 billion $1,019 billion $83 billion $318 billion Sources: IRS, Sttisticl Abstrct of the U.S., Federl Reserve Bord, Freddie Mc, nd GAO clcultions. Note: Numbers re rounded nd dollrs re not djusted for infltion. Mortgge interest deduction limittions hve not chnged with infltion. Pge 6

13 IRS s Enforcement nd Reserch Progrms Do Not Provide n Overll Picture of Mortgge Interest Deduction Noncomplince Although IRS s enforcement nd reserch progrms found some mortgge interest deduction complince problems, the methods leve gps in wht is known bout the extent nd specific nture of noncomplince. The four min progrms tht IRS uses to enforce or reserch mortgge interest deduction complince include the following. A computer mtching progrm designed to identify txpyers whose mortgge interest deduction exceeds mounts reported on Form 1098: Of the pproximtely 1.7 million mismtches the progrm identified bove certin threshold in 2005, the ltest yer vilble, IRS followed up on bout 135,000 nd chnged tx ssessments or refunds for bout 53, Tx ssessments totled bout $216 million, much more thn in previous yers, nd verged bout $4,300. IRS s Ntionl Reserch Progrm (NRP), the min ongoing study of txpyer complince bsed on exmintions of rndom smple of tx returns: IRS found tht between 12 nd 14 percent of individul txpyers who climed home mortgge interest on line 10 of Schedule A misreported the mount. The misreporting ws split bout evenly between txpyers underreporting the deduction nd txpyers overreporting it. Routine exmintions done by correspondence, in n IRS office, or on site: IRS does not mintin seprte exmintion results solely on line 10 issues. Most of the pproximtely 33,000 exmintions done in fiscl yer 2008 by IRS revenue gents nd tx complince officers tht included review of line 10 resulted in increses to the line 10 deduction (i.e., the deduction incresed) or in no recommended chnge. For cses involving line 10 where exminers recommended greter tx mounts, the medin tx owed for ll issues exmined including line 10 ws $4,612, ccording to our nlysis of IRS records. For cses closed in fiscl yer 2008 in which exminers decresed the line 10 mounts nd lowered txpyers deductions, the medin decrese in the line 10 mortgge interest deduction ws $6,430. Other results re listed in ppendix III. Two specil complince inititive projects (CIP) primrily exmining cquisition debt for limited segment of individul txpyers with high mortgge interest deductions or high djusted 8 Becuse of resource constrints nd expected return on the work, IRS does not pursue ll of the discrepncies it identifies. Pge 7

14 gross incomes: About 9,000 exmintions were closed in fiscl yer 2008 for both projects. IRS recommended bout $95 million in tx chnges for cses closed in fiscl yers 2006 through Exminers decresed line 10 deductions for most cses closed in fiscl yer The medin decreses were bout $29,000 for the first project nd $28,000 for the second. For cses in which exminers incresed the tx owed, the medin increses in tx were bout $8,000 in both projects. IRS exminers ttributed the chnges to txpyers nd pid tx return preprers not knowing or ignoring the mortgge interest deduction rules nd to problemtic tx preprtion softwre. 9 Appendix III lso presents results from CIP exms. Tble 3 shows, for these four min progrms, tht gps exist in wht IRS cn mesure or enforce concerning txpyers mortgge interest deductions. 9 About 64 percent of tx returns with Schedule A, line 10 deduction were done by pid preprer in The mrgin of error for this estimte ws less thn 1 percent. Pge 8

15 Tble 3: Wht IRS s Min Reserch nd Enforcement Progrms Do nd Do Not Show bout Mortgge Interest Deduction Complince Progrm The progrm shows The progrm does not show Mtching progrm Situtions in which txpyers deduct more interest thn wht ws reported on Form Ntionl Reserch Progrm Popultion estimtes for misreported mortgge interest for Routine exmintions Adjustments to txpyers line 10 deductions nd other tx chnges for ech tx yer. CIPs Recent yers djustments to line 10 deductions nd other tx chnges for select group of txpyers with high djusted gross incomes or high mortgge interest deductions; focus ws on cquisition debt. Noncomplince in which txpyers should hve deducted less interest thn the mount shown on Form Discrepncies tht fll under IRS thresholds for follow-up. Recent noncomplince informtion; complete results from IRS s ongoing complince studies re not expected to be vilble for more thn 2 yers. Noncomplince in which txpyers deductions nd Form 1098 mounts mtch. NRP utomticlly excluded returns from further considertion if the Form 1098 mounts mtched the Schedule A mounts, unless nother problem ws found. Noncomplince tht exminers miss becuse exmintion selection methods do not consider possible noncomplince with home equity debt limits. Noncomplince by txpyers beyond the nrrowly defined groups exmined in the projects. All of the bove Informtion tht IRS cn use to ctegorize the resons tht misreporting occurred. For exmple, none of the progrms compile dt tht isolte misreporting becuse of violtions of the limits on cquisition or home equity debt. Source: GAO nlysis of IRS interviews nd dt. Of the four min progrms, only NRP projects the mount of mortgge interest deduction misreporting to the popultion of individul txpyers. However, becuse NRP utomticlly excluded ny Schedule A deduction where the Form 1098 mounts mtched the Schedule A mounts, it my hve underestimted mortgge interest deduction misreporting relting to the home equity nd cquisition debt limits. Pge 9

16 Txpyers Fce Vriety of Problems Trying to Comply with Mortgge Interest Deduction Rules, nd IRS Fces Chllenges in Detecting Noncomplince The mortgge interest deduction rules crete complince problems for txpyers, reflecting the deduction s complexity. The effects of the problems, however, re uneven. Although mny txpyers might encounter few problems, others could fce mny more. Problems cited by tx prctitioners nd in our review of rticles on deducting home mortgge interest included the following: Txpyers need to distinguish between cquisition nd home equity debt but did not lwys do so. Txpyers deducted interest on lons exceeding the limittions, including the cquisition, home equity, nd two-home limits. Txpyers who were subject to the AMT nd thus not eligible to deduct home equity interest climed it nonetheless. Tx prctitioners lso missed the limittions nd did not comply with the AMT rules. Depending on the circumstnces, some txpyers nd prctitioners fced extensive recordkeeping nd clcultions relted to such mtters s refinncing, the AMT, business use of the home, other uses of lon proceeds, nd the periodic use nd repyment of home equity lines of credit. One prctitioner told us tht completing worksheets ws the quick nd esy prt of work relted to the mortgge interest deduction; the most difficult nd most time-consuming prt ws getting txpyers to locte nd provide the proper informtion on wht kind of debt ws involved nd how lon proceeds were used. Typiclly, txpyers provided records piecemel over time nd fter mny phone clls. Txpyers my hve been unwre tht they might need documenttion on mtters such s how proceeds of home equity lons re spent to properly determine the mount of the mortgge interest deduction on their tx returns. Mortgge interest deduction limits bsed on debt mounts re not directly comprble with the informtion on Form 1098, which lists interest pid. If txpyers debts exceed the limits, txpyers must clculte how much interest they cn deduct. The complexity of the lws tht govern the mortgge interest deduction re evident in the guidnce IRS hs published. Figure 1 is the flowchrt in IRS s 16-pge instructions to txpyers Publiction 936: Home Mortgge Pge 10

17 Interest Deduction tht help txpyers determine if their mortgge interest is fully deductible. 10 It leds txpyers through s mny s seven decision points nd still sometimes requires them to consult nother prt of the publiction. Appendix IV provides two exmples of the mortgge interest deduction s complexity. 10 Deprtment of the Tresury, Internl Revenue Service, Publiction 936: Home Mortgge Interest Deduction: For Use in Prepring 2008 Returns. Pge 11

18 Figure 1: IRS Chrt Illustrting How to Determine Whether Mortgge Interest Is Fully Deductible s Shown in Publiction 936 Source: Deprtment of the Tresury, Internl Revenue Service, Publiction 936: Home Mortgge Interest Deduction: For Use in Prepring 2008 Returns. Pge 12

19 Addressing Complince Problems nd Complexity Would Likely Require Policy Chnges To llevite the problems nd complexity fcing txpyers complying with the mortgge interest deduction rules, policy mkers likely would hve to chnge tx lws. For exmple, we noted in the pst tht shifting mortgge interest deduction limits from debt mounts to n interest-limit cp could simplify dministrtion of the deduction. 11 Under n interest-limit cp, IRS could more esily compre the mounts reported on Schedule A nd Form 1098 to the cp nd identify cses for udit or follow-up. Similrly, txpyers would hve only to report the mount of Form 1098 interest tht fell under the cp nd would not hve to figure out which property qulified or how to ccount for debt limits, depending on how ny new legisltion ws written. However, chnging the tx code for qulified residentil mortgge interest deductions could hve significnt tx policy implictions. For exmple, n interest-pid cp could cuse txpyers living in res with high housing prices to be disdvntged compred with txpyers with similr incomes living in res with low housing prices. A cp could lso disdvntge those who borrowed during periods of high interest rtes. Assessing such policy chnges nd whether such consequences would be pproprite re beyond the scope of this report. Becuse Mortgge Interest Reported on Form 1098 Is Not Directly Comprble to Legl Debt Limits, IRS Must Use Costly Methods to Detect Certin Noncomplince Becuse the Form 1098 informtion report shows the dollr mount of interest txpyer pid in yer without regrd to the limits on the mount of debt imposed by lw, IRS s computer mtching progrm compring Form 1098 nd tx return mounts will not detect certin noncomplince. For exmple, s lredy discussed, txpyers cnnot clim deduction for interest exceeding the $1 million cquisition debt limit or other limittions. However, the nnul informtion report for txpyer with $1.5 million cquisition mortgge would show the interest pid on the entire mortgge insted of the interest on the $1 million under the nnul debt limit. Becuse of this, the informtion IRS receives from third prties on Form 1098 cnnot be used by itself to determine if txpyers improperly climed interest on debt in excess of the legl limittions. However, the wy to overcome this problem using exmintions to detect noncomplince is expensive compred to utomted mtching 11 GAO, Tx Policy: Mny Fctors Contributed to the Growth in Home Equity Finncing in the 1980s, GAO/GGD (Wshington, D.C.: Mr. 25, 1993). Pge 13

20 progrms, nd its pyoff in incresed revenue is low. For exmple, ccording to IRS exminers, pinpointing which tx returns hve homeequity debt noncomplince issue is very lbor intensive. As shown erlier, for non-cip line 10 exmintions by revenue gents nd tx complince officers closed in fiscl yer 2008, the medin decrese to line 10 ws $6,430, ccording to our nlysis of IRS dt. At the highest individul tx rte of 35 percent nd ssuming no offsetting fctors, the resulting increse in tx revenue would be bout $2,250. Although not n exct comprison, the verge tx ssessment IRS recommended for field exmintions of individul txpyers ws bout $19,150 per txpyer. Given the non-cip exmintions reltively low pyoff, some prctitioners we interviewed sid the tx code s it reltes to the home mortgge interest deduction is unenforceble in prcticl sense. Options Exist for Expnding Mortgge Informtion Reporting nd Using Privte Sector Dt to Enhnce Enforcement Additionl informtion bout txpyers mortgges could help IRS identify the most productive cses to exmine nd determine whether txpyers re climing the correct mount of mortgge interest deduction. IRS could obtin more helpful informtion bout txpyers mortgges by expnding informtion collected on Form IRS officils sid tht in implementing certin dditionl reporting requirements, the gency would need to meet the terms of the Pperwork Reduction Act, which requires gencies to minimize the pperwork burden they impose on the public nd mximize the prcticl utility of the informtion they collect. 12 IRS officils lso sid ttention would need to be pid to the dded costs tht expnsion would impose on third prties nd IRS, such s updting computer systems. Any computer progrmming chnges for IRS nd third prties would likely be done only once to ccommodte the new informtion. Form 1098 could be revised to collect the following informtion: ddress of the property secured by the mortgge to which the interest on the form reltes; 12 Pperwork burden is defined s the time spent reding nd understnding request for informtion, s well s the time spent developing, compiling, recording, reviewing, nd providing tht informtion. Pge 14

21 outstnding mortgge debt blnces on the property; n indictor if the mortgge interest is for lon tht ws refinnced during the yer; nd n indictor of whether the mortgge interest reltes to n cquisition lon or home equity lon. Figure 2 shows wht Form 1098 might look like if revised to collect ny of this informtion. We found tht some compnies tht submit Form 1098 sttements to IRS lredy provide some of this informtion with the Form 1098 sttements they send to borrowers. These options could be considered singly or in combintion. Further, chnges to Form 1098 reporting requirements would need to pply only to future reports to give filers sufficient time to djust their computer systems to collect nd clculte the dditionl informtion. Pge 15

22 Figure 2: Current Form 1098 Informtion Compred with Options for Additionl Mortgge Debt Informtion 8181 VOID CORRECTED RECIPIENT S/LENDER S nme, ddress, nd telephone number OMB No Mortgge Interest Sttement Current Form 1098 RECIPIENT S federl identifiction no. PAYER S socil security number PAYER S/BORROWER S nme Street ddress (including pt. no.) City, stte, nd ZIP code Account number (see instructions) Form Mortgge interest received from pyer(s)/borrower(s) $ 2 Points pid on purchse of principl residence $ 3 Refund of overpid interest $ 4 Mortgge insurnce premiums $ 5 Copy A For Internl Revenue Service Center File with Form For Privcy Act nd Pperwork Reduction Act Notice, see the 2008 Generl Instructions for Forms 1099, 1098, 5498, nd W-2G. 6 Address of secured property 7 Beginning nd ending principl blnces Possible dditions to Form 1098 $ $ 8 Refinncing this yer? Yes No 9 Lon Type Acquisition Home equity Form 1098 Ct. No K Deprtment of the Tresury - Internl Revenue Service Do Not Cut or Seprte Forms on This Pge Do Not Cut or Seprte Forms on This Pge Source: GAO nlysis of IRS informtion. Adding the Address of Mortgged Property to Form 1098 If the ddress relting to txpyers mortgge interest deductions were on the Form 1098 (see fig. 2, box 6) nd electroniclly cptured in IRS dtbses, IRS could use n utomted process to determine whether the mortgge interest txpyers climed corresponded to qulified residence nd ws eligible for the deduction. For exmple, IRS could see if n Pge 16

23 ddress reported on Form 1098 mtched the ddress tht the txpyers listed on their Form Tx preprers told us tht requiring the property ddress lso would help them prepre returns more ccurtely becuse they could use the informtion to determine if the property securing the debt is the txpyer s qulified home. Some IRS officils responsible for exmintion policy whom we interviewed greed the property ddress would be useful in selecting returns for exmintion nd in cses where txpyers hve more thn one home. We previously recommended tht IRS revise Form 1098 to collect the ddress of the property whose mortgge is reported on Form In response, IRS greed to consider implementing our recommendtion, citing the burden the requirement could plce on third prties. Representtives of the mortgge bnking industry told us tht it would be fesible to report property ddress informtion on Form 1098 becuse mortgge lenders lredy mintin this informtion. We lso found n exmple of lender tht provided ddress informtion with Form 1098 informtion tht it sent to borrowers. Adding Mortgge Blnce Informtion to the Form 1098 If the beginning nd ending mortgge debt blnces or verge nnul debt blnces were provided on Form 1098, IRS could electroniclly identify txpyers with more thn $1 million in mortgge debt (see fig. 2, box 7) or identify txpyers whose mortgge interest deductions ppered out of proportion to their debt mounts. IRS officils sid tht debt blnce informtion would be prticulrly helpful in selecting returns for exmintion if combined with the ddress informtion becuse the dditionl informtion would help disentngle mortgge interest deductions of txpyers with multiple homes. According to mortgge industry representtive, Form 1098 filers could provide debt blnce informtion. We found exmples of compnies tht provided informtion on mortgge blnces on the Form 1098 sttements they sent to borrowers. However, industry representtives further stted tht compnies do not necessrily hve ccurte blnce informtion t prticulr point in time nd tht verge blnces would be esier for the 13 This procedure would not be useful for determining whether txpyers correctly deducted mortgge interest on second home. 14 GAO, Tx Gp: Actions Tht Could Improve Rentl Rel Estte Reporting Complince, GAO (Wshington, D.C.: Aug. 28, 2008). Pge 17

24 industry to report thn blnces pegged to ny specific dy, especilly for home equity lines of credit. For compnies tht do not keep verge blnce informtion now, they would incur the ssocited set-up costs of collecting the informtion in the future. Adding Check Box to the Form 1098 to Indicte Refinncing Form 1098 could be redesigned with check box for filers to show whether mortgge ws refinnced (see fig. 2, box 8). This would help IRS identify txpyers who might be noncomplint with rules specific to refinncing, such s the rule to mortize points pid on the mortgge. A mortgge industry representtive sid tht the burden of refinncing check box could be reduced if the rule were only to complete the box in the yer tht the lon ws mde, eliminting the need for Form 1098 filer to trck over time whether refinncing hd occurred. Also, Form 1098 filers do not uniformly keep ny indiction in their records s to whether lons re cquisition lons or refinncing. However, becuse the deductibility of the interest on the csh tken out in refinncing depends in prt on how the money is spent, identifying refinncing would not necessrily eliminte the need for IRS to exmine returns. It lso would be helpful to IRS if Form 1098 filers could show whether csh ws tken out in refinncing, but such chnge might not be ble to include the mount of csh. The mortgge industry representtive sid tht ny informtion on the csh tken out would be unrelible nd burdensome for Form 1098 filers to get. Form 1098 filers hve estimtes on csh tken out, not the finl figures vilble to the closing gent. The industry representtive lso sid tht Form 1098 filers do not mintin informtion on whether lon proceeds exceeded the mount of the lon tht ws refinnced. 15 However, IRS exminers could more esily see if csh were tken out t refinncing nd investigte whether rules on refinncing were followed if Form 1098 hd ddress, mortgge debt, nd refinncing check box, becuse they could see whether increses in the lon blnces over time for prticulr home took plce. 15 The mortgge bnking industry representtive lso sid tht Form 1098 filers would need guidnce to know how to report lon modifictions in which lon terms re chnged to void foreclosure nd which re not considered refinncing by the industry but could be by IRS. Pge 18

25 Adding n Indictor to the Form 1098 to Distinguish between Home Equity nd Acquisition Debt Tx forms do not require txpyers or Form 1098 filers to report the types of debt on which mortgge interest deductions re bsed, even though the mortgge debt limittions for deducting interest re different for cquisition nd home equity debt. If Form 1098 filers were required to identify the type of debt ssocited with the deduction (see fig. 2, box 9), IRS might more esily discern whether txpyer s deduction exceeded the cquisition or home equity debt limit, especilly if combined with reports of the debt mounts. Hving Form 1098 filers identify debt types, however, would crete chllenges. A mortgge industry representtive told us tht Form 1098 filers do not lwys hve informtion bout debt types, especilly if the lons hve been sold nd re-sold or the originl lon hs been refinnced. Form 1098 filers do not know whether mortgge refinncing proceeds were used for home improvements, which could qulify s cquisition debt or home equity debt, depending on how the money ws used. The representtive lso sid tht if home-equity debt reporting requirement were instituted, the industry would hve to introduce costly nd burdensome systems. Privte Sector Dt Might Be Useful to IRS in Detecting Mortgge Interest Noncomplince IRS lredy contrcts with privte firm to obtin informtion bout txpyers for routine exmintion purposes. Other privte sector dt might lso be useful to IRS in detecting mortgge interest noncomplince. For exmple, we obtined informtion from SMR Reserch, one of severl compnies tht nlyze lon informtion tht IRS might find useful in determining txpyer complince with rules governing the deduction of interest on home equity lons. By compring homeowners current mortgge debt for prticulr property with erlier debt, SMR Reserch estimted tht up to severl million homeowners hd lons tht might hve exceeded the home equity debt limittion. In the ggregte, these homeowners debts over the debt limittion were severl hundred billion dollrs. 16 SMR Reserch s dt do not show whether txpyers correctly reported deductions bsed on home equity lons. IRS would still hve to check the returns. Given informtion underlying the trnsctions in SMR Reserch s dtbse nd shown in ppendix VII, IRS could test the use of this or similr privte-sector dtbses to: 16 See ppendix VII for the types of trnsctions tht SMR Reserch included in its estimte. Pge 19

26 pinpoint txpyers for exmintion, initite correspondence to txpyers, or conduct outrech to pid preprers. Some IRS CIP exminers told us they hd significnt findings relted to home equity debt, indicting tht follow-up might be productive. IRS s Guidnce to Txpyers nd Trining Mterils for Exminers Did Not Indicte the Rnge of Possible Mortgge Interest Deduction Situtions Tken s whole, IRS txpyer guidnce Schedule A nd its instructions, Publiction 17, Your Federl Income Tx, nd Publiction 936, Home Mortgge Interest Deduction generlly informed txpyers tht mortgge interest deductions re subject to limits. Even though the guidnce ws generlly sufficient, Schedule A does not explicitly mention the limittions. As shown in ppendix II, Schedule A, line 10 sks txpyers for the Home mortgge interest nd points reported to you on Form Sometimes, s when n cquisition lon exceeds $1 million, this wording could be problemtic becuse txpyer or preprer would need to look beyond the Form 1098 to determine the proper line 10 mount. 17 Using the sme mount of spce on Schedule A s now, line 10 could esily be revised to mention limittions by deleting reported to you nd using wording such s Unless limited, home mortgge interest nd points on Form Another wy to revise Schedule A would be to dd something bout mortgge interest deduction limittions to the mrgin ner line 10. Other possibilities for chnging Schedule A to highlight limittions lso exist, but would entil trdeoffs. For exmple, check box could be dded to the Schedule sking txpyers if either the $1 million or the $100,000 limittion pplies to their lons. Mking such chnge not only would help txpyers prepring their own returns but lso might prompt pid preprers to more thoroughly interview their clients. However, with the mortgge interest deduction, these types of chnges would dd some 17 It is uncler how mny txpyers re ffected by the $1 million debt limit. 18 Although (1) Schedule A note ner line 10 sys to See pge A-5 of the instructions, (2) Form 1098 hs n sterisk sying tht the Form s interest mount might not be fully deductible, nd (3) most txpyers might not be ffected by the limittions, chnging the wording on Schedule A could enhnce complince. Pge 20

27 burden to txpyers whose deductions re not ffected by the debt limits. The effectiveness of such chnge is lso uncler. Txpyers might not red IRS guidnce when prepring returns. To counter this possibility but lso be mindful of preprtion, miling, nd txpyer service costs involved, IRS could test whether corresponding with some txpyers would cost-effectively reduce misreporting. Added outrech through seminrs or communictions with stkeholders such s pid preprers, tx return softwre providers, nd industry groups could communicte key rules nd common mistkes nd be trgeted to txpyers, such s those reporting the deduction bove certin level. Sending correspondence directly to txpyers lso could help inform pid preprers of rules nd common mistkes becuse the txpyers would likely shre it with their preprers, ccording to representtives of the tx return preprtion industry. 19 IRS hs used outrech progrms on mortgge interest deductions in recent yers. For instnce, IRS s tx tips covered deducting refinncing costs. IRS s guidnce on the cquisition debt limit is inconsistent with prior tx court ruling. Currently, Publiction 936 guides the txpyer to tret ny qulified mortgge debt bove the $1 million cquisition debt limit s home equity debt subject to the $100,000 limit, regrdless of the lon s use. In prctice, this mens tht the txpyer cn deduct the interest on up to $1.1 million in cquisition debt (treting the mount bove $1 million s home equity debt even if used to cquire the home). However, 1997 U.S. Tx Court cse ruled tht the cquisition debt limit is $1 million nd no dditionl deduction cn be tken bove the $1 million limit unless the txpyer truly hs home equity debt. 20 One tx softwre compny officil cited the 1997 cse s support for the compny s decision to chnge the guidnce in its softwre to llow interest deductions only up to $1 million in cquisition debt, rther thn follow the guidnce in Publiction 936. In 2008, IRS Chief Counsel begn reviewing the inconsistency in the debt limit llownces. However, completion dte for this work is uncertin. 19 IRS could tell txpyers tht (1) lck of knowledge bout mortgge interest deduction limittions hs come to its ttention, (2) they should lern if the limittions pply to them nd if they hve been complint, (3) they should mend returns if wrrnted, nd (4) IRS will spot-check some txpyers to ensure complince. To be credible, IRS would ctully need to check some returns. If this pproch were considered too onerous on the public, communiction with txpyers nd prctitioners could be strictly prospective, providing guidnce on wht to consider when filing the next return. 20 Pu v. Commissioner, T.C. Memo Pge 21

28 Until IRS completes its determintion, txpyers will clculte their deductions using different debt limits depending on whether they, their tx preprers, or their tx softwre follow the guidnce in Publiction 936 or the tx court interprettion. Depending on IRS s determintion, some txpyers my not be optimizing their deduction or IRS could be losing revenue from txpyers overdeducting. IRS Exminer Guidnce nd Trining Mterils Addressed Mortgge Interest Deduction Limittions but Lcked Instructive Exmples of Some Relevnt Situtions IRS s exminers guidnce nd trining mterils included informtion for identifying nd clculting home-equity nd the cquisition-debt limittions. Overll, exminers we interviewed were stisfied with trining nd guidnce on the mortgge interest deduction. However, IRS s guidnce nd trining mterils did not cover problems tht my rise in some rel-life situtions. For exmple, the guidnce does not mention problem tht n exminer sid she commonly found: txpyers owning third home, witing to sell one of their first two, nd deducting the interest pid on ll three. Neither does the guidnce ddress situtions tht tx professionls described s chllenging for IRS to enforce, such s multiple refinncings, mortgges, or home equity lines of credit. 21 The bsence of such exmples could impede exminers who do not del with mortgge interest deduction issues regulrly. An IRS trining officil told us tht updting trining mterils with relevnt exmples could be done esily. Also, IRS s exminer trining mterils reflect the txpyer guidnce with regrd to the llowble cquisition debt limit. For exmple, ccording to one IRS trining exercise, txpyers could deduct interest on up to $1.1 million in mortgge debt even if they used the $1.1 million just to cquire home, contrdicting the 1997 tx court ruling, discussed bove. The difference my led exminers to inconsistently clculte the tx owed, becuse some my clculte the cquisition debt limit s $1 million bsed on the tx court determintion nd others my llow deductions on up to $1.1 million s instructed by the trining. As previously mentioned, IRS Chief Counsel s office is reviewing the inconsistency between the IRS guidnce nd the tx court ruling. IRS officils sid tht they hve 21 Txpyers with home-bsed businesses lso hve complex returns when mortgge interest pyment deductions pper prtly on Schedule A nd prtly on business return like Schedule C. Pge 22

29 procedures to ensure tht once the review is complete, exminers will be told of ny clrifiction. Tx Softwre Differed in the Ese of Nvigting Mortgge Interest Deduction Instructions The three compnies tx preprtion softwre for individuls tht we nlyzed differed from ech other in how they treted the limittions on the mount of debt for which interest cn be deducted. 22 These softwre pckges were mong the most widely used by individuls. 23 One compny s initil softwre screen contining mortgge interest deduction instructions mentioned possible deduction limittions, sending users to Publiction 936 for clcultions. One of the other compnies mde chnges to its mortgge interest deduction displys in its 2008 version fter considering our input on its 2007 version. These chnges give more prominence to the deduction limittions nd how Publiction 936 my be used for clcultions. The third compny s on-line softwre hd informtion on the limittions, but users would not find this informtion unless they looked under frequently sked questions. This softwre lso led the user to tke mounts directly off Form For 2008, the softwre dded question to its frequently sked questions re bout wht txpyers should do if interest nd points exceeded the mount they could deduct. If txpyers were to click on this question, they would find informtion bout the limittions nd the clcultion needed. IRS does not know how frequently softwre pckges re ssocited with misreporting. Such informtion could help IRS in its complince efforts. We recently recommended tht IRS require softwre compnies to include softwre identifiction number tht specificlly identifies the softwre 22 In 2007, over 39 million (or 28 percent) of the pproximtely 138 million individul income tx returns filed were prepred by individuls using tx softwre. 23 We limited our dt nlysis to the top three softwre compnies TxACT, TxCut, nd TurboTx becuse they ccount for 88 percent of ll returns filed electroniclly by individuls nd ccepted by IRS. We lso reviewed severl tx softwre pckges for pid preprers. However, unlike the softwre for the generl public, these progrms re not designed to led users through different clcultions. Insted the preprer softwre is designed for those with professionl expertise. Pge 23

30 pckge used to prepre tx returns. IRS plns to implement softwre identifiction system in October Conclusions Becuse IRS hs little informtion on txpyers mortgge debts, it cnnot esily detect when txpyers re not complying with the deduction limits. Insted, to ensure txpyer complince with the sttutory requirements, IRS must conduct exmintions tht re more costly to use thn other enforcement methods, such s mtching progrm. The bsence of specific informtion bout the resons for noncomplince lso prevents IRS from mking efficient decisions on how to select cses for exmintion. Simultneously, the complexity of mortgge interest deduction rules cretes problems with some txpyers trying to comply. These problems re compounded by n inconsistency between IRS guidnce nd tx court ruling on cquisition debt limits. Becuse the limits cusing complexity re written in lw, sttutory chnges my be the most direct wy to ddress the chllenges of dministering the deduction nd llevite the complince problems. However, considertion of sttutory chnges ws beyond the scope of this report. Nonetheless, within the current sttutory frmework, opportunities exist for IRS to mitigte some of the problems we identified. Recommendtions for Executive Action We re mking seven recommendtions. Specificlly, we recommend tht the Commissioner of Internl Revenue revise NRP s cse selection system so tht tx return s mortgge interest deduction is not utomticlly excluded s n exmintion issue if it mtches informtion reported on Form 1098; revise Form 1098 to require third prties to provide informtion on mortgge blnces, the ddress of home securing mortgge, nd n indictor of whether the mortgge is for current yer refinncing; investigte whether using informtion from privte sources would be productive in detecting mortgge interest noncomplince, especilly for home equity debt; 24 GAO, Tx Administrtion: Mny Txpyers Rely on Tx Softwre nd IRS Needs to Assess Associted Risks, GAO (Wshington, D.C.: Feb. 25, 2009). Pge 24

31 revise the wording on Schedule A to clerly stte tht the mortgge interest deduction is subject to limittions; conduct test to evlute whether mortgge interest deduction-relted outrech progrms to txpyers nd tx return preprers could be cost-effective wy to reduce noncomplince; outrech might include sending correspondence covering key rules nd common mistkes or promoting seminrs on common types of misreporting; set dte to complete the Chief Counsel determintion on whether the cquisition debt limit is $1 million or $1.1 million when used in combintion with the home equity debt limit; nd revise exminer trining mterils by dding exmples cited s common problems by uditors nd pid tx return preprers, such s those involving multiple homes or home-bsed businesses, nd fter the Chief Counsel s finl determintion on the cquisition limit, revise exminer trining nd the worksheet in guidnce to reflect the project s outcome. Agency Comments nd Our Evlution We received written comments from the Internl Revenue Service on July 23, 2009 (for the full text of the comments, see pp. VIII). IRS greed with five of our recommendtions nd greed to study the other two. It cknowledged tht without informtion bout txpyers mortgge debts, it cnnot esily detect txpyer noncomplince with the mortgge interest deduction limits. IRS lso sid tht the bsence of informtion bout noncomplince prevents it from efficiently deciding how to select cses for review nd tht the complexity of the rules cuses problems for some txpyers. Regrding our recommendtion to revise Form 1098 to include more informtion on txpyer mortgges, IRS greed to study the issue, sying it does not hve enough dt to support revisions t this time. Becuse IRS cknowledged in its comments tht it does not hve informtion bout txpyers mortgge debts to esily detect noncomplince, we believe tht our recommended revisions to Form 1098 would be cost-effective wys to provide IRS with dditionl useful informtion to help it detect noncomplince. Concerning our recommendtion to conduct test to evlute whether mortgge interest deduction-relted outrech progrms could be cost-effective wy to reduce noncomplince, IRS sid it will study the fesibility of such test. As greed with your office, unless you publicly nnounce its contents erlier, we pln no further distribution of this report until 30 dys fter its Pge 25

32 dte. At tht time, we will send copies to the Secretry of the Tresury, the Commissioner of Internl Revenue, nd other interested prties. This report will lso be vilble t no chrge on GAO s Web site t For further informtion regrding this report, plese contct me t (202) or t [email protected]. Contcts for our Offices of Congressionl Reltions nd Public Affirs my be found on the lst pge of this report. Individuls mking key contributions to this report my be found in ppendix IX. Jmes R. White Director, Tx Issues Strtegic Issues Tem Pge 26

33 Appendix I: Scope Appendix I: Scope nd Methodology To provide informtion on how IRS detects txpyers noncomplince with the home mortgge interest deduction rules nd wht IRS knows bout the extent of noncomplince nd to identify problems, if ny, tht txpyers fce in ttempting to comply with the deduction nd describe IRS s chllenges in detecting mortgge interest deduction noncomplince, we reviewed IRS documents nd interviewed gency officils to determine how IRS checks txpyers complince with deduction rules nd if there were issues ffecting its bility to detect noncomplince. This included reviewing informtion on IRS s complince inititive projects tht focused on the mortgge interest deduction nd interviewing IRS exminers from four widely dispersed prts of the country who were involved in the projects. The exminers were selected by IRS officils for their mortgge interest deduction expertise; obtined informtion from IRS s 2001 Ntionl Reserch Progrm (NRP) complince study of individul txpyers nd dt for 2006 through 2008 from its Exmintion Opertionl Automtion Dtbse (EOAD) nd Audit Informtion Mngement System (AIMS) to determine exmintion results bout individul txpyers complince with mortgge interest deduction rules; nd conducted literture serch of relevnt tx publictions nd interviewed non-government experts to enhnce our understnding of mortgge interest deduction complince issues ffecting txpyers nd IRS. To ssess options to give IRS more informtion to enforce complince with mortgge interest deduction rules, we surveyed literture nd interviewed industry representtives bout third-prty informtion reporting options tht would give IRS useful informtion to improve its bility to enforce mortgge interest deduction rules while minimizing burden on third prties. We discussed the options, including their pros nd cons, with industry representtives from orgniztions such s the Mortgge Bnkers Assocition nd the Americn Institute of Certified Public Accountnts nd with others such s scholrs who hve expertise in this re. We lso met with IRS officils to obtin their views on the fesibility of the options to improve complince. Considertion of sttutory chnges ws beyond the scope of the request. To determine if IRS could benefit from using privte sector informtion to detect noncomplince with home equity rules, we obtined sttisticl informtion bout home equity lons, home equity lines of credit, nd Pge 27

34 Appendix I: Scope nd Methodology csh-out refinncings tht hve exceeded $100,000 from SMR Reserch, one of severl compnies tht compile nd nlyze mortgge dt. According to its Web site, SMR Reserch is the ntion s lrgest publisher of industry nd mrket reserch studies on the home mortgge business, home equity lending, nd other consumer lon subjects. We did not study the informtion of ny of the other compny with extensive mortgge dt becuse our purpose ws only to gther dt on the type of informtion tht might be vilble from privte sector sources tht potentilly could benefit IRS in detecting home equity noncomplince. To ssess the relibility of the SMR Reserch dt, we discussed the controls over the dtbse with responsible compny officil nd reviewed documenttion of the controls used to gther the dt. We lso used informtion from the Americn Housing Survey for the United Sttes: 2007, prepred by the U.S. Deprtment of Housing nd Urbn Development nd the U.S. Census Bureu, to confirm the resonbleness of SMR Reserch informtion. We found the SMR dtbse relible for our purposes. To find whether IRS s guidnce to txpyers provided enough informtion to properly clculte the mortgge interest deduction, we reviewed the guidnce to determine whether it mentioned the limittions prominently, i.e., whether the limittions were mentioned directly s opposed to the user being directed to nother plce. To determine whether IRS s exminers trining nd guidnce provided enough informtion on properly clculting the mortgge interest deduction, we compred exminer trining nd guidnce documents with IRS publictions nd instructions on mortgge interest deductions, s well s the pplicble tx lws. To describe how tx return preprtion softwre progrms nd IRS s Free File progrm hndle the mortgge interest deduction, we checked how the three softwre pckges used by 88 percent of individuls filing electroniclly treted the debt limittions. We did this by logging on to the softwre nd reviewing the screens pertining to the home mortgge interest deduction. We lso discussed our findings with compny officils. We reviewed tx yer 2007 versions of ech of the softwre pckges nd included the versions used for IRS s Free File progrm. Our results re limited to the versions of the softwre pckges we reviewed nd cnnot be generlized to others. Free File offers free federl tx return preprtion nd electronic filing services through these compnies nd others. In ddition, we reviewed documenttion showing how softwre widely used by pid tx return preprers for millions of txpyers throughout the country hndles the mortgge interest deduction. Pge 28

35 Appendix I: Scope nd Methodology In ddition, to respond to your request, we nlyzed dt from IRS s Sttistics of Income (SOI) Division nd the Complince Dt Wrehouse (CDW) to compile informtion bout yer-to-yer chnges in txpyers mortgge interest deductions nd Form 1098 filings for tx yers 2004 through Our nlyses focused on the dollr mounts listed on Schedule A, line 10; whether mortgge interest deductions on Schedule A, line 10 mtched Form 1098 mounts; frequency of pid preprer use by those climing Schedule A, line 10 deduction; lon ccount numbers; nd mounts of mortgge interest deduction tken on forms other thn Schedule A to which we hd ccess, including Schedule C for sole proprietorship businesses, Schedule E for supplementl income nd losses, Schedule F for frms, nd Form 4835 for frm rentl income nd expenses. 2 For prt of our nlysis, we used the SOI dtbse to identify pnel of txpyers from tx yer 2004 nd then collected tx informtion bout them from the CDW dtbse for tx yers 2004 through These nlyses re in ppendix V, nd mrgins of error for these tbles re provided in ppendix VI. We found the IRS dtbses we used NRP, EOAD, AIMS, SOI, nd CDW relible for the purposes of this report. NRP, AIMS, SOI nd CDW re lso dt sources tht we hve tested for previous enggements. For EOAD, we reviewed documenttion on dtbse procedures, interviewed IRS officils, rn electronic checks, nd compred output to other vilble informtion for resonbleness purposes. We conducted this performnce udit from My 2008 through July 2009 in ccordnce with generlly ccepted government uditing stndrds. Those stndrds require tht we pln nd perform the udit to obtin sufficient, pproprite evidence to provide resonble bsis for our findings nd conclusions bsed on our udit objectives. We believe tht the evidence obtined provides resonble bsis for our findings nd conclusions bsed on our udit objectives. 1 The SOI nlysis discussed here ws not prt of the SOI sttistics presented in tble 2, which includes dt obtined from published SOI mterils. 2 Form 8829, Expenses for Business Use of Your Home, lso cn be used to report mortgge interest deduction, but mortgge interest reported on this form is not included in the SOI dtbse nd consequently ws not prt of our nlysis. Pge 29

36 Appendix II: Appendix II: Schedule A, Itemized Itemized Deductions Deductions Figure 3: Internl Revenue Service Schedule A on Which the Home Mortgge Interest Deduction Is Tken Mortgge interest deductions Source: IRS. Pge 30

37 Appendix III: Results Involving Mortgge Interest Deductions Appendix III: Exmintion Results Involving Mortgge Interest Deductions The following tble compres exmintion results of IRS s complince inititive projects (CIP) on the mortgge interest deduction with results from its routine exmintions (non-cip). Tble 4: Results of IRS s Fiscl Yer 2008 Exmintions of Schedule A, Line 10 for CIP nd non-cip Exmintions Exmintion result First CIP Second CIP Non-CIP Type of chnge to the line 10 deduction Number of exmintions Decrese to the line 10 deduction 1,012 6,982 11,971 Increse to the line 10 deduction ,279 No line 10 chnge ,306 Totl 1,158 8,006 32,556 Type of chnge to the tx mount Number of exmintions Increse to the tx mount 994 6,648 26,625 Decrese to the tx mount ,748 No tx chnge 122 1,125 3,183 Totl 1,158 8,006 32,556 Medin chnge to the line 10 deduction or to the tx mount Dollr mount of the medin chnge Medin decrese to the line 10 deduction $29,359 $27,940 $6,430 Medin increse to the tx mount $7,673 $8,012 $4,612 Source: GAO nlysis of IRS dt. Note: This tble includes only exmintions done by revenue gents or tx complince officers. Pge 31

38 Appendix IV: Mortgge Interest Deduction s Complexity Appendix IV: Exmples Illustrting Mortgge Interest Deduction s Complexity As shown in the exmples in this ppendix, to determine the mounts of mortgge interest tht is deductible on Schedule A, txpyer or his or her tx return preprer might need to follow mny steps. First, the txpyer must find ll his or her records pertining to the property s cquisition nd determine if the October 13, 1987, cutoff dte pplies, then locte records of refinncing rrngements ffecting cquisition debt, nd clculte the pproprite verge nnul blnce. Second, the txpyer must determine home equity indebtedness, properly trcking, for instnce, the use of proceeds from home equity lines of credit, nd determining verge blnces nd home equity mounts not deductible for AMT purposes. Third, the txpyer must know when lon proceeds finnce business use of the home, prtly rented home, or personl, business, investment, or municipl bond expenditures becuse how the lon proceeds re used determines the deductibility of the lon interest on the tx return. The Americn Institute of Certified Public Accountnts gve us detils of the following scenrio in which mrried homeowners refinnced their house: In 1990, mrried couple borrowed $150,000 to buy house. By Jnury 1, 2008, they hd mde principl pyments of $50,000, leving n cquisition debt of $100,000. On Jnury 1, 2008, their house s fir mrket vlue ws $500,000, nd they refinnced their originl lon for $400,000. The new $400,000 mortgge would be llocted s follows: The first $100,000 would be considered home cquisition debt, nd the interest on it would be deductible for the regulr tx nd for the AMT. The next $100,000 would be considered home equity debt, equl to the home equity limittion nd, therefore, deductible for the regulr tx but not for AMT unless it ws used to cquire, construct, or improve min or second home. The lst $200,000 would be subject to interest trcing rules, with deductibility depending on how the money ws used for instnce, if used for personl or municipl bond purposes, the interest would not be deductible. However, if used for business or investment purposes, the interest my be deductible. Pge 32

39 Appendix IV: Exmples Illustrting Mortgge Interest Deduction s Complexity The exmple would hve been more complicted if not for the following simplifying ssumptions tht we mde: The couple owned only one house nd never borrowed money to improve it. They bought it fter the October 13, 1987, the grndfther dte when rules chnged regrding the mount of cquisition debt for which interest is deductible. This ws the first time they refinnced the house. The refinncing ws done on the first dy of the yer nd $1,000 in principl ws repid ech month, mking monthly mortgge blnces esily clculted throughout the yer. 1 They hd no home equity lons other thn home equity prt of the refinncing nd hd not used home equity line of credit, the use of whose proceeds they would hve hd to hve trcked. They never used the house for business or rented ny prt of it. We used the fcts nd ssumptions of this exmple to complete the 13 steps in tble 5, which is ptterned fter worksheet in Publiction 936. Tble 5 trcks the pth txpyers would follow in figuring their deductible home mortgge interest. 1 Publiction 936 lso hs n exmple of consistent principl pyments per month, but we recognize tht principl pyments often differ from month to month. Pge 33

40 Appendix IV: Exmples Illustrting Mortgge Interest Deduction s Complexity Tble 5: IRS Worksheet to Figure Home Mortgge Interest # Computtion ction Prt I Qulified lon limit 1 Enter verge blnce of grndfthered debt 2 Enter verge blnce for ll your home cquisition debt 3 Enter $1 million ($500,000 if mrried filing seprtely) Dollr mount 4 Enter the lrger of #1 or #3 1,000,000 5 Add #1 nd #2 100,000 6 Enter the smller of #4 or #5 100,000 7 Enter the smller of $100,000 ($50,000 if mrried filing seprtely) or homes fir mrket vlue minus cquisition debt minus grndfthered debt ($500,000 - $100,000 0 = $400,000) 8 Add #6 + #7 = qulified lon limit 200,000 Prt II Deductible home mortgge interest 9 Enter totl of verge blnces of ll mortgges on ll qulified homes ($400,000 + $388,000)/2 = $394,000; continue with this tble if #8 is less thn #9 10 Enter interest you pid, including the mount from Form Divide #8 by #9, rounding to 3 plces Multiply #10 by #11 nd enter result here nd on Schedule A Comments $0 The simplifying ssumption ws tht the house ws not bought before October 14, ,000 The txpyers hd to find records of their originl debt nd how much principl they hd repid t the time of the refinncing; if there hd been second nd third mortgges, previous refinncings, dditions to the home, or seller-finnced mortgges with no finncil institution involved, they would hve to be considered; under verge blnce rules for refinncings tht include home cquisition nd home equity components, principl pyments for the refinncing hd not yet reduced the $100,000 home cquisition debt 1,000,000 The txpyers were filing joint return 100,000 The txpyers were filing joint return; they would determine the fir mrket vlue nd retin it for use in ny future yers clcultions. 394,000 Ech month, the sme mount of the principl $1,000 ws repid for the only house involved; this clcultion would be more complicted if the refinncing hd occurred fter Jnury 1, or if nother mortgge lso were incurred, especilly since it likely would hve begun t different time of the yer 20,000 The mount from Form 1098 is the mount tht some txpyers might enter directly onto Schedule A 10,160 This is the home mortgge interest deduction for now, but where home equity debt is involved, there could be home mortgge interest djustment tht would hve to be clculted for AMT purposes Pge 34

41 Appendix IV: Exmples Illustrting Mortgge Interest Deduction s Complexity # Computtion ction Dollr mount Comments 13 Subtrct #12 from #10 9,840 This is the portion of your home mortgge interest tht is not deductible on Schedule A. Other rules might hve to be consulted on the deductibility of this interest, depending on whether the pplicble lon proceeds were used, for instnce, for trde or business, n investment, municipl bond, personl purposes, or combintion of these; if the txpyer used his home for business or rented prt of it out, mortgge interest could pper in different prts of the tx return Source: Deprtment of the Tresury, IRS, Publiction 936: Home Mortgge Interest Deduction: For Use in Prepring 2008 Returns; GAO nlysis. A professionl tx preprer lso gve us the following exmple to illustrte the complexity of the mortgge interest deduction. This exmple my be typicl but reflects more complicted cse thn the previous exmple. The client hd more thn one home, mortgge greter thn $1 million, refinncing, nd home equity debt. In this cse, the prctitioner sid tht it took over 4 hours of trcing trnsctions to clculte the cquisition nd home equity debt for one house, using n Excel spredsheet to enter mounts from closing sttements for ech of multiple refinncings. Home equity debt hd to be trcked seprtely becuse interest on llowble home equity debt is generlly not deductible for AMT purposes unless the proceeds re used to buy, build, or improve home. Acquisition debt fter refinncing hd to only include the cquisition debt prt of the previous lon nd closing costs. A deductible interest spredsheet hd to consider beginning nd ending lon blnces, how lon proceeds were originlly used, nd totl interest pid. Pge 35

42 Appendix V: Dt on Home Appendix V: Descriptive Dt on Home Mortgge Interest Deduction Clims nd Form 1098 Filings Mortgge Interest Deduction Clims nd Form 1098 Filings This ppendix presents nlyses of Sttistics of Income (SOI) Division nd Complince Dt Wrehouse (CDW) dt focusing on Schedule A, line 10 deductions nd Form 1098 filings. Tbles 6 through 12 use SOI-derived pnel of txpyers from 2004 through 2006, combined with CDW dt on Form 1098 filings, nd tble 13 uses SOI dt exclusively. Tble 6 shows tht for returns reporting Schedule A, line 10 deduction for ll three yers of the study period, bout hlf hd mortgge interest from one Form For exmple, in 2006, 42.6 percent of txpyers reporting mortgge interest deduction hd one Form 1098, totling bout $126.5 billion in Schedule A, line 10 deductions. Tble 6 lso shows tht some txpyers reported mortgge interest deduction on Schedule A, line 10. This might men tht the txpyer improperly filled out line 10 on Schedule A or tht IRS hd not received corresponding Form 1098 for tht prticulr txpyer. The number of Form 1098 filings does not reflect the number of homes txpyer hs becuse, for exmple, txpyers would receive multiple Form 1098 filings in given yer if they sold home or if their existing mortgge ws sold in the secondry mrket. The mrgins of error for the tbles in this ppendix pper in pp. VI. Pge 36

43 Appendix V: Descriptive Dt on Home Mortgge Interest Deduction Clims nd Form 1098 Filings Tble 6: Number nd Dollr Totl of Schedule A, Line 10 Deductions per Number of Form 1098 Filings, 2004 through Number of Form 1098 filings Number of tx returns (millions) Percentge Line 10 mounts for tx returns (billions of dollrs) Percentge $ or more Totl $ Number of Form 1098 filings Number of tx returns (millions) Percentge Line 10 mounts for tx returns (billions of dollrs) Percentge $ or more Totl $ Number of Form 1098 filings Number of tx returns (millions) Percentge Line 10 mounts for tx returns (billions of dollrs) Percentge $ $ or more Totl $ Source: GAO nlysis of IRS dt. Note: Percentges my not dd to 100 percent becuse of rounding. Tble 7 breks down the pttern of Schedule A, line 10, deduction mounts compred with the number of Form 1098 filings. For exmple, in 2006, 75 percent of txpyers with two Form 1098 filings hd deduction mounts of $14,325 or less. Pge 37

44 Appendix V: Descriptive Dt on Home Mortgge Interest Deduction Clims nd Form 1098 Filings Tble 7: Distribution of Schedule A, Line 10 Deductions in Select Percentiles per Number of Form 1098 Filings, 2004 through Schedule A, line 10 deduction distribution by certin percentiles in dollrs Number of Form 1098 filings 5th 10th 25th 50th 75th 0 $184 $435 $2,262 $5,248 $8, ,265 2,158 3,905 6,093 8, ,705 3,678 5,568 8,121 11, ,494 4,598 6,788 9,986 14,978 4 or more 4,378 5,883 8,405 12,520 19, Schedule A, line 10 deduction distribution by certin percentiles in dollrs Number of Form 1098 filings 5th 10th 25th 50th 75th 0 $243 $505 $2,271 $5,140 $8, ,342 2,217 3,994 6,211 9, ,900 3,917 5,908 8,666 12, ,287 5,543 7,743 11,229 16,682 4 or more 5,704 6,875 9,819 14,630 22, Schedule A, line 10 deduction distribution by certin percentiles in dollrs Number of Form 1098 filings 5th 10th 25th 50th 75th 0 $249 $490 $2,638 $5,692 $9, ,435 2,379 4,229 6,657 9, ,170 4,366 6,475 9,524 14, ,589 5,825 8,298 12,372 18,957 4 or more 5,659 7,533 10,766 16,654 26,085 Source: GAO nlysis of IRS dt. Tble 8 shows the results of compring Schedule A, line 10, deduction mounts on tx returns to mounts reported to IRS by third prties on Form As the tble shows, bout 65 percent to 67 percent of the comprisons resulted in mtch in ll 3 yers. However, in some situtions, our nlysis showed tht txpyers deductions lso were greter or less thn the mounts on Forms Over the three-yer period, 8.2 percent to 11.1 percent of tx returns deductions exceeded the Form 1098 mount. This cn occur legitimtely when, for exmple, property is co-owed nd one of the owners climing the deduction does Pge 38

45 Appendix V: Descriptive Dt on Home Mortgge Interest Deduction Clims nd Form 1098 Filings not receive Form It cn lso occur becuse of txpyer or Form 1098 filing errors. Deductions cn be less thn the Form 1098 mounts when txpyers debts hve exceeded the deduction limits or by error. Tble 8: Results of Compring Totl Schedule A, Line 10 Deduction Amounts to Amounts Reported on Form 1098, 2004 through 2006 Results of comprison Totl number of tx returns (millions) Percentge Mtch $ Deduction exceeds Form 1098 mount $9,229.0 Deduction less thn Form 1098 mount ,962.2 No Form ,280.3 Totl $ Schedule A, line 10 mount (billions of dollrs) Difference between Form 1098 mounts nd line 10 mounts (millions of dollrs) Results of comprison Totl number of tx returns (millions) Percentge Mtch $ Deduction exceeds Form 1098 mount $7,452.0 Deduction less thn Form 1098 mount ,240.5 No Form ,903.2 Totl $ Schedule A, line 10 mount (billions of dollrs) Difference between Form 1098 mounts nd line 10 mounts (millions of dollrs) Results of comprison Totl number of tx returns (millions) Percentge Mtch $263 - Deduction exceeds Form 1098 mount $7,033.0 Deduction less thn Form 1098 mount ,641.5 No Form ,300.0 Totl $ Schedule A, line 10 mount (billions of dollrs) Source: GAO nlysis of IRS dt. Note: Percentges my not dd to 100 percent becuse of rounding. Difference between Form 1098 mounts nd line 10 mounts (millions of dollrs) Pge 39

46 Appendix V: Descriptive Dt on Home Mortgge Interest Deduction Clims nd Form 1098 Filings Tble 9 shows both the distribution of Schedule A, line 10 deduction mounts nd the distribution of the differences between Schedule A, line 10 nd Form 1098 sttements filed for txpyers who reported Schedule A, line 10 deduction. For exmple, in 2006, the medin (50th percentile) difference between Form 1098 nd Schedule A mounts for txpyers whose deduction exceeded the Form 1098 mount ws $727. Tble 9: Percentile Distributions for Schedule A, Line 10 Amounts Compred with Form 1098 Amounts nd the Difference between Schedule A, Line 10 Amounts nd Form 1098 Amounts, 2004 through 2006 Schedule A, line 10 mount Difference between Schedule A, line 10 nd Form 1098 mounts 2004 Percentiles in dollrs Output of comprison 5th 10th 25th 50th 75th Mtch $1,725 $2,778 $4,651 $7,129 $10,544 Deduction exceeds Form 2,506 3,501 5,614 8,740 13, mount Deduction less thn Form 1098 mount 1,874 2,872 4,686 7,523 11,777 No Form ,262 5,248 8,570 Mtch..... Deduction exceeds Form , mount Deduction less thn Form ,428 3, mount No Form ,262 5,248 8,570 Schedule A, line 10 mount Difference between Schedule A, line 10 nd Form 1098 mounts 2005 Percentiles in dollrs Output of comprison 5th 10th 25th 50th 75th Mtch $1,926 $2,981 $4,970 $7,588 $11,427 Deduction exceeds Form 2,333 3,494 5,659 8,834 13, mount Deduction less thn Form 1098 mount 1,999 3,129 5,379 8,511 13,400 No Form ,271 5,140 8,691 Mtch..... Deduction exceeds Form , mount Deduction less thn Form ,761 4, mount No Form ,271 5,140 8,691 Pge 40

47 Appendix V: Descriptive Dt on Home Mortgge Interest Deduction Clims nd Form 1098 Filings Schedule A, line 10 mount Difference between Schedule A, line 10 nd Form 1098 mounts 2006 Percentiles in dollrs Output of comprison 5th 10th 25th 50th 75th Mtch $2,091 $3,200 $5,324 $8,245 $12,728 Deduction exceeds Form 2,754 3,891 6,193 9,918 15, mount Deduction less thn Form 1098 mount 2,161 3,448 5,716 9,173 14,937 No Form ,638 5,692 9,555 Mtch..... Deduction exceeds Form , mount Deduction less thn Form 1098 mount ,939 5,180 No Form ,638 5,692 9,555 Source: GAO nlysis of IRS dt. Note: No vlues re shown for mtches between Form 1098 nd Schedule A, line 10 mounts when the vlue ws $3 or less, to ccount for rounding errors. Our nlysis lso exmined the chnge in mortgge interest deduction mounts from 2004 through 2006, for those txpyers who reported deduction in ll 3 yers. Tble 10 shows the mount of chnge from 2004 to 2005 nd then from 2005 to For exmple, the medin (50th percentile) chnges for tx returns tht hd increses from both 2004 to 2005 nd 2005 to 2006 were $1,496 nd $1,691, respectively. Tble 10: Yer-to-Yer Chnges in Amount Deducted on Schedule A, Line 10, 2004 through 2006 Number of Percentile of chnge of line 10 deduction mounts in dollrs returns Yer 5th 10th 25th 50th 75th Increse ll yers 8,148, $103 $216 $584 $1,496 $3, ,691 4,157 Increse, then 5,586, ,378 3,946 lower ,291 Lower, then 5,294, ,904 increse ,399 3,743 Lower, ll yers 8,530, Source: GAO nlysis of IRS dt. Pge 41

48 Appendix V: Descriptive Dt on Home Mortgge Interest Deduction Clims nd Form 1098 Filings Tble 11 shows the comprison of the yer-to-yer chnge in the number of Forms 1098 txpyers received with the dollr mount of chnge on Schedule A, line 10, for the corresponding yers. Only those txpyers with tx returns filed in ll 3 yers of our study re included in this nlysis. For exmple, the tble shows tht 581,950 tx returns hd declining number of Form 1098 filings from both 2004 to 2005 nd 2005 to 2006 ( Down ll yers ). For those txpyers, the dollr mount of their deductions declined by $2,471 from 2004 to 2005 for those t the 50th percentile nd decresed by $1,834 from 2005 to An increse in deduction dollr mounts cn occur when Form 1098 filings decresed, for exmple, s in the yer fter txpyer sells one of his two homes, nd purchses new home tht hs lrger mortgge interest deduction mount thn the previous two homes combined. Tble 11: Yer-to-Yer Chnges in the Number of Form 1098 Filings, with Distribution of Chnge Amounts on Schedule A, Line 10, 2004 through 2006 Number of returns Down ll yers 581,950 Down, then up 1,374,241 Down, then the sme 3,272,246 More, then fewer 3,499,626 Up ll yers 742,782 Up, then the sme 1,791,402 Sme, then fewer 1,362,878 Sme, then up 2,959,900 Sme, then the sme 12,121,270 Percentile distribution of chnge in dollr mounts Yer 5th 10th 25th 50th 75th ,834 4, ,608 4, ,000 5, ,307 3, , ,822 4, ,731 4, ,735 4, ,305 3,508 8, ,328 3, ,386 3, ,370 3, ,268 3, , ,530 3, , ,130 Source: GAO nlysis of IRS dt. Pge 42

49 Appendix V: Descriptive Dt on Home Mortgge Interest Deduction Clims nd Form 1098 Filings Tble 12 shows n nlysis of Form 1098 by mortgge lon ccount numbers. We performed this nlysis to show more precisely how frequently txpyers deducted mortgge interest on the sme lon from yer to yer, ssuming the sme lon number in different yers referred to the sme lon. For exmple, from 2004 nd 2005, bout 25 million txpyers hd one mtching ccount number on their Forms The third chrt shows txpyers who hd mtching ccounts throughout the 3- yer period. For exmple, 574,173 txpyers hd 3 mtching ccount numbers on their Forms 1098 in 2004, 2005, nd Txpyers with zero mtching ccount numbers likely mens tht they deducted interest on different lons in different yers. Tble 12: Numbers of Mtching Lon Account Numbers on Forms 1098, 2004 through 2006 Account number mtches, Number of returns Percentge 0 12,937, ,779, ,081, ,005, or more 460, Account number mtches, Number of returns Percentge 0 11,002, ,773, ,625, ,228, or more 634, Number of mtching ccount numbers in ll Number of returns Percentge yers 0 21,249, ,929, ,284, , or more 228, Source: GAO nlysis of IRS dt. Note: Tbles percentges my not dd to 100 percent becuse of rounding. Pge 43

50 Appendix V: Descriptive Dt on Home Mortgge Interest Deduction Clims nd Form 1098 Filings Tble 13 shows the distribution of txpyers mortgge interest deductions on Schedule A nd on other schedules. Non-Schedule A interest deductions my relte to forms such s Schedule C for smll business, Schedule E for rentl property, nd Schedule F for frming. Tble 13: Number of Individul Tx Returns with Schedule A Mortgge Interest Deductions nd Non-Schedule A Mortgge Interest Deductions, 2004 through Mortgge interest deduction types Number of tx returns Percentge Number of tx returns Percentge Number of tx returns Percentge Only Schedule A 33,531, ,239, ,341, Only non-schedule A 2,313, ,297, ,248, Schedule A nd non-schedule A 3,360, ,477, ,574, No mortgge interest 88,871, ,021, ,720, Totl 128,077, ,036, ,884, Source: GAO nlysis of IRS dt. Note: Percentges my not dd to 100 percent becuse of rounding. Pge 44

51 Appendix VI: Error Tbles for Estimtes Appendix V Appendix VI: Mrgins of Error Tbles for Estimtes in Appendix V The following tbles provide the mrgins of error for the corresponding sttistics reported in the previous ppendix. For exmple, tble 14 corresponds with tble 6 in pp. V. Tble 14: Mrgins of Error for Number nd Dollr Totl of Schedule A, Line 10 Deductions per Number of Form 1098 Filings, 2004 through 2006 Number of Form 1098 filings or more Totl Number of tx returns (millions) 2004 Line 10 mounts for tx returns Percentge (billions of dollrs) 0.85 $ Number of Form 1098 filings or more Totl Number of tx returns (millions) 2005 Line 10 mounts for tx returns Percentge (billions of dollrs) 0.68 $ Number of Form 1098 filings or more Totl Number of tx returns (millions) 2006 Line 10 mounts for tx returns Percentge (billions of dollrs) 0.63% $ Source: GAO nlysis of IRS dt. The vlues of these mrgins re less thn Pge 45

52 Appendix VI: Mrgins of Error Tbles for Estimtes in Appendix V Tble 15: Mrgins of Error for Distribution of Schedule A, Line 10 Deductions in Select Percentiles per Number of Form 1098 Filings, 2004 through Schedule A, line 10 deduction distribution by certin percentiles in dollrs Number of Form 1098 filings 5th 10th 25th 50th 75th 0 $75 $83 $437 $399 $ or more Schedule A, line 10 deduction distribution by certin percentiles in dollrs Number of Form 1098 filings 5th 10th 25th 50th 75th 0 $56 $59 $313 $242 $ or more Schedule A, line 10 deduction distribution by certin percentiles in dollrs Number of Form 1098 filings 5th 10th 25th 50th 75th 0 $72 $87 $280 $355 $ or more Source: GAO nlysis of IRS dt. Pge 46

53 Appendix VI: Mrgins of Error Tbles for Estimtes in Appendix V Tble 16: Mrgins of Error for Results of Compring Totl Schedule A, Line 10 Deduction Amounts to Amounts Reported on Form 1098, 2004 through 2006 Result of comprison Mtch Deduction exceeds Form 1098 mount Deduction less thn Form 1098 mount No Form 1098 Totl Totl number of tx returns (millions) 2004 Schedule A, line 10 Difference between Form mount (billions of 1098 nd line 10 mounts Percentge dollrs) (millions of dollrs) 0.58 $ $1, $ Result of comprison Mtch Deduction exceeds Form 1098 mount Deduction less thn Form 1098 mount No Form 1098 Totl Totl number of tx returns (millions) 2005 Schedule A, line 10 Difference between Form mount (billions of 1098 nd line 10 mounts Percentge dollrs) (millions of dollrs) 0.42 $ $1, $ Result of comprison Mtch Deduction exceeds Form 1098 mount Deduction less thn Form 1098 mount No Form 1098 Totl Totl number of tx returns (millions) 2006 Schedule A, line 10 Difference between Form mount (billions of 1098 nd line 10 mounts Percentge dollrs) (millions of dollrs) 0.41 $ $ , $ Source: GAO nlysis of IRS dt. The vlues of these mrgins re less thn Pge 47

54 Appendix VI: Mrgins of Error Tbles for Estimtes in Appendix V Tble 17: Mrgins of Error for Percentile Distributions for Schedule A, Line 10 Amounts Compred with Form 1098 Amounts nd the Difference between Schedule A, Line 10 Amounts nd Form 1098 Amounts, 2004 through 2006 Schedule A, line 10 mount Difference between line 10 nd Form 1098 mounts 2004 Percentiles in dollrs Output of comprison 5th 10th 25th 50th 75th Mtch..... Deduction exceeds Form 1098 mount $290 $227 $192 $281 $613 Deduction less thn Form 1098 mount No Form Mtch..... Deduction exceeds Form 1098 mount Deduction less thn Form 1098 mount No Form Schedule A, line 10 mount Difference between line 10 nd Form 1098 mounts 2005 Percentiles in dollrs Output of comprison 5th 10th 25th 50th 75th Mtch..... Deduction exceeds Form 1098 mount $228 $253 $184 $232 $442 Deduction less thn Form 1098 mount No Form Mtch..... Deduction exceeds Form 1098 mount Deduction less thn Form 1098 mount No Form Schedule A, line 10 mount Difference between line 10 nd Form 1098 mounts 2006 Percentiles in dollrs Output of comprison 5th 10th 25th 50th 75th Mtch..... Deduction exceeds Form 1098 mount $217 $203 $199 $264 $583 Deduction less thn Form 1098 mount No Form Mtch..... Deduction exceeds Form 1098 mount Deduction less thn Form 1098 mount No Form Source: GAO nlysis of IRS dt. Pge 48

55 Appendix VI: Mrgins of Error Tbles for Estimtes in Appendix V Tble 18: Mrgins of Error for Yer-to-Yer Chnges in Amount Deducted on Schedule A, Line 10, 2004 through 2006 Increse ll yers Increse, then lower Lower, then increse Lower, ll yers Percentile of chnge of line 10 deduction mounts in dollrs Yers Number of smple tx returns 5th 10th 25th 50th 75th , $16 $20 $30 $64 $ , , , , , , , Source: GAO nlysis of IRS dt. Tble 19: Mrgins of Error for Yer-to-Yer Chnges in the Number of Form 1098 Filings, with Distribution of Chnge Amounts on Schedule A, Line 10, 2004 through 2006 Down ll yers Down, then up Down, then the sme More, then fewer Up ll yers Up, then the sme Sme, then fewer Sme, then up Sme ll yers Percentile distribution of chnge in dollr mounts Yers Number of tx returns 5th 10th 25th 50th 75th $69 $119 $179 $424 $1, , , , , , , , , , , Source: GAO nlysis of IRS dt. Pge 49

56 Appendix VI: Mrgins of Error Tbles for Estimtes in Appendix V Tble 20: Mrgins of Error for Number of Mtching Lon Account Numbers on Forms 1098, 2004 through 2006 Account number mtches, 2004 to 2005 Number of tx returns Percentge 0 1, , , or more Totl 1, Account number mtches, 2005 to 2006 Number of tx returns Percentge 0 1, , , or more Totl 1, Number of mtching ccount numbers in ll yers Number of tx returns Percentge 0 1, , or more Totl 1, Source: GAO nlysis of IRS dt. The vlues of these mrgins re less thn Pge 50

57 Appendix VI: Mrgins of Error Tbles for Estimtes in Appendix V Tble 21: Mrgins of Error for Numbers of Individul Income Tx Returns with Schedule A Mortgge Interest Deductions nd Non-Schedule A Mortgge Interest Deductions, 2004 through Number of Number of Number of tx returns Percentge tx returns Percentge tx returns Percentge Only Schedule A 1, % 1, Only non-schedule A Schedule A nd non Schedule A No mortgge interest 2, , , Totl 1, , , Source: GAO nlysis of IRS dt. The vlues of these mrgins re less thn 0.01 Pge 51

58 Appendix VII: SMR Dt on Home Appendix VII: SMR Reserch s Dt on Home Equity Debt nd How IRS Might Use Similr Dt for Enforcement Equity Debt nd How IRS Might Use Similr Dt for Enforcement Tble 22 describes the three types of home equity lons lump sum home equity lons, home equity lines of credit, nd refinncings tht SMR Reserch included in its clcultions of home equity lon debt tht exceeded $100,000, the home equity debt limittion. 1 Tble 22: Types of Trnsctions Included in SMR Reserch s Home Equity Debt Clcultions Type of trnsction Lump sum home equity lons of greter thn $100,000 Home equity lines of credit greter thn the mount on which the verge mount borrowed would yield $100,000 Refinncings in which csh of more thn $100,000 ws tken out beyond the homeowner s originl lon mount Comment bout the type of trnsction These lons exclude second mortgges tken out t the time of purchsing house. These lines of credit exclude second mortgges tken out t the time of purchsing house. According to SMR Reserch, the verge drw-down rte for home equity lines of credit ws percent t June 30, Bsed on tht rte, the line of credit tht would result in drw-down mount more thn the $100,000 limit for deductible interest would be $199,362. Becuse the $100,000 limittion for deducting interest on home equity debt refers in refinncing to $100,000 more thn the outstnding mortgge principl blnce nd becuse the originl lon mount often exceeds the outstnding blnce, SMR Reserch cptured only some of the csh mounts tken out t refinncing tht exceeded the limittion. SMR considered ll of homeowner s outstnding refinncings nd compred the sum of them to the lon mount tht the homeowner originlly borrowed. Source: GAO nlysis of SMR Reserch informtion. Although SMR Reserch dt do not include Socil Security numbers useful in dt mtching, its dt include (1) homeowner nmes nd ddresses; (2) lon dollr mounts useful for determining if lon limittions for deductible interest were exceeded; nd (3) other informtion useful in udit selection or other complince ctivities. An 1 Another source of informtion showing there re potentilly lrge numbers of home equity lons bove the $100,000 limit for deducting interest is the Americn Housing Survey for the United Sttes: 2007, prepred by the U.S. Deprtment of Housing nd Urbn Development nd the U.S. Census Bureu. The Survey shows 197,000 owner-occupied housing units were refinnced in which owners received csh of $100,000 or more t settlement. These homeowners hd situtions similr to the third type of trnsctions in tble 14 refinncings with more thn $100,000 tken out. The Survey dt compred the most recent lon refinncing to the previous lon mount, not to the originl lon mount, if other refinncings hd occurred. SMR Reserch s dt ccount for the possibility tht homeowners refinnced more thn once, ech time tking csh out nd dding to their totl home equity debt. Pge 52

59 Appendix VII: SMR Reserch s Dt on Home Equity Debt nd How IRS Might Use Similr Dt for Enforcement exmple of this other SMR Reserch informtion tht might be useful for complince purposes is informtion showing tht more thn third of the csh-out refinncing dollr mounts nd the home equity lon dollr mounts not known to be ssocited with lines of credit were in just 14 counties. Pinpointing homeowners with the lrgest home equity lons or who live in one of few counties with txpyers hving lrge proportions of the ntion s home equity lon dollr vlue might ese IRS s burden in mtching lrge mounts of informtion to its own dtbses. However, we recognize tht mtching dtbses using nmes nd ddresses is much more difficult thn using Socil Security numbers nd tht its vibility would hve to be tested. For instnce, IRS could run nme nd ddress mtch for prticulr geogrphic loction nd follow up with only those txpyers whose informtion mtched without extensive effort. If the test were to show low return on investment or did not deserve higher priority thn competing efforts, it could be bndoned. IRS follow-up could be exmintions, possibly trgeted t geogrphic res or txpyers with the lrgest potentil overdeductions; correspondence to txpyers s described in n erlier section; or outrech to the tx return preprtion community. Outrech to preprers could inform them tht the home equity re is being scrutinized by IRS nd, if txpyers returns hd not properly considered the $100,000 or fir mrket vlue limittions, mended returns might be wrrnted. Nonexmintion efforts might be preferble to resource-intensive exmintions becuse the mounts of possible extr tx per noncomplint txpyer might be reltively smll. For exmple, if txpyer with n 8- percent interest rte on $200,000 home equity lon deducted interest on the entire lon, the overdeduction would be bout $8,000, or bout $2,000 in txes for txpyer in the 25-percent brcket. Pge 53

60 Appendix VIII: from the Internl Revenue Service Appendix VIII: Comments from the Internl Revenue Service Pge 54

61 Appendix VIII: Comments from the Internl Revenue Service Pge 55

62 Appendix VIII: Comments from the Internl Revenue Service Pge 56

63 Appendix VIII: Comments from the Internl Revenue Service Pge 57

64 Appendix IX: GAO nd Stff A Appendix IX: GAO Contct nd Stff cknowledgments Acknowledgments GAO Contct Acknowledgments Jmes R. White, (202) , [email protected] In ddition to the contct nmed bove, Chrlie Dniel, Assistnt Director; Amy Bowser; Sr Dleski; Eric Gormn; Lwrence Korb; Kren O Conor; Anne Stevens; nd John Zombro mde key contributions to this report. (450675) Pge 58

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