Tax Gap
Actions That Could Improve Rental Real Estate Reporting Compliance Gao ID: GAO-08-956 August 28, 2008As part of its most recent estimate of the tax gap, for tax year 2001, the Internal Revenue Service (IRS) estimated that individuals underreported taxes related to their rental real estate activities by as much as $13 billion. Given the magnitude of underreporting, even small improvements in taxpayer compliance could result in substantial revenue. GAO was asked to provide information on rental real estate reporting compliance. This report (1) provides information on the extent and primary types of taxpayer misreporting of rental real estate activities and (2) identifies challenges IRS faces in ensuring compliance and assesses options for increasing compliance. For estimates of taxpayer misreporting, GAO analyzed a probability sample of examination cases for tax year 2001 from IRS's most recent National Research Program (NRP) study of individual taxpayer compliance.
At least an estimated 53 percent of individual taxpayers with rental real estate misreported their rental real estate activities for tax year 2001, resulting in an estimated $12.4 billion of net misreported income. This amount of misreporting is understated because IRS knows it does not detect all misreporting during its NRP examinations and adjusts the amount of misreporting it detects to estimate the tax gap. Also, the rate of misreporting of rental real estate activity was substantially higher than for some other sources of income, such as wages, a disparity that undermines the fairness of the tax system. Misreporting of rental real estate expenses was the most common type of rental real estate misreporting. Limited third-party information reporting for rental real estate activity is among the challenges IRS faces in ensuring compliance for rental real estate reporting. While information reporting, such as financial institutions sending information to IRS about taxpayers' mortgage interest payments, improves compliance, it is not practical to implement and enforce broad, new information reporting requirements for rental real estate activities. However, improving existing information reporting requirements is one of various options that could improve compliance. For example, based on current law, whether rental real estate property owners must file information returns for certain expenses they incur depends on whether the owners' rental activities are considered a trade or business, but the law does not define how to make this determination. Another approach to improving compliance is to require taxpayers to report additional detail about their rental real estate activities on tax returns. For example, requiring taxpayers to report complete property address information, which GAO found that some taxpayers did not report, could help IRS address misreporting. Requiring additional detail on tax returns could also compel paid tax return preparers, used by about 80 percent of individual taxpayers who report rental real estate activity, to obtain more accurate information from taxpayers. Enhanced IRS guidance, such as on required recordkeeping, and additional IRS outreach to paid preparers and others about rental real estate misreporting could also improve compliance.
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Report to the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
August 2008:
Tax Gap:
Actions That Could Improve Rental Real Estate Reporting Compliance:
GAO-08-956:
GAO Highlights:
Highlights of GAO-08-956, a report to the Committee on Finance, U.S.
Senate.
Why GAO Did This Study:
As part of its most recent estimate of the tax gap, for tax year 2001,
the Internal Revenue Service (IRS) estimated that individuals
underreported taxes related to their rental real estate activities by
as much as $13 billion. Given the magnitude of underreporting, even
small improvements in taxpayer compliance could result in substantial
revenue.
GAO was asked to provide information on rental real estate reporting
compliance. This report (1) provides information on the extent and
primary types of taxpayer misreporting of rental real estate activities
and (2) identifies challenges IRS faces in ensuring compliance and
assesses options for increasing compliance. For estimates of taxpayer
misreporting, GAO analyzed a probability sample of examination cases
for tax year 2001 from IRS‘s most recent National Research Program
(NRP) study of individual taxpayer compliance.
What GAO Found:
At least an estimated 53 percent of individual taxpayers with rental
real estate misreported their rental real estate activities for tax
year 2001, resulting in an estimated $12.4 billion of net misreported
income. This amount of misreporting is understated because IRS knows it
does not detect all misreporting during its NRP examinations and
adjusts the amount of misreporting it detects to estimate the tax gap.
Also, the rate of misreporting of rental real estate activity was
substantially higher than for some other sources of income, such as
wages, a disparity that undermines the fairness of the tax system.
Misreporting of rental real estate expenses was the most common type of
rental real estate misreporting.
Table: Estimated Frequency of Types of Individual Taxpayer Misreporting
of Rental Real Estate Activities That IRS Detected through NRP
Examinations, Tax Year 2001:
Type of misreporting: Misreported rental real estate expenses;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 43.
Type of misreporting: Misreported rent received; Estimated percentage
of taxpayers with rental real estate activity who misreported: 15.
Type of misreporting: Reported activity on an incorrect part of the
individual tax return; Estimated percentage of taxpayers with rental
real estate activity who misreported: 6.
Type of misreporting: Misreported loss from rental real estate;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 2.
Type of misreporting: Other types of misreporting; Estimated percentage
of taxpayers with rental real estate activity who misreported: 5.
Type of misreporting: All types of misreporting; Estimated percentage
of taxpayers with rental real estate activity who misreported: 53.
Source: GAO analysis of IRS data and examination case files.
Notes: Some taxpayers misreported rental activity for more than one
type of misreporting. As such, estimates for types of misreporting do
not sum to the total percentage of taxpayers who misreported.
[End of table]
Limited third-party information reporting for rental real estate
activity is among the challenges IRS faces in ensuring compliance for
rental real estate reporting. While information reporting, such as
financial institutions sending information to IRS about taxpayers‘
mortgage interest payments, improves compliance, it is not practical to
implement and enforce broad, new information reporting requirements for
rental real estate activities. However, improving existing information
reporting requirements is one of various options that could improve
compliance. For example, based on current law, whether rental real
estate property owners must file information returns for certain
expenses they incur depends on whether the owners‘ rental activities
are considered a trade or business, but the law does not define how to
make this determination. Another approach to improving compliance is to
require taxpayers to report additional detail about their rental real
estate activities on tax returns. For example, requiring taxpayers to
report complete property address information, which GAO found that some
taxpayers did not report, could help IRS address misreporting.
Requiring additional detail on tax returns could also compel paid tax
return preparers, used by about 80 percent of individual taxpayers who
report rental real estate activity, to obtain more accurate information
from taxpayers. Enhanced IRS guidance, such as on required
recordkeeping, and additional IRS outreach to paid preparers and others
about rental real estate misreporting could also improve compliance.
What GAO Recommends:
Congress should consider making all taxpayers reporting rental real
estate activity subject to the same information reporting requirements
as other taxpayers with a trade or business. GAO also recommends that
IRS require the reporting of additional details on tax and information
returns, provide taxpayers with additional guidance, and enhance its
outreach efforts.
In commenting on a draft of this report, IRS agreed with most of our
recommendations.
To view the full product, including the scope and methodology, click on
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-956]. For more
information, contact James White at (202) 512-9110 or whitej@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
About Half of Individual Taxpayers with Rental Real Estate Activities
Misreported, Often Because of Overstated or Unsubstantiated Expenses:
Limited Information Reporting and Complexity Hinder Compliance, and
Various Options Exist for Improving Compliance:
Conclusions:
Matter for Congressional Consideration:
Recommendations for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Scope and Methodology:
Appendix II: Comments from the Internal Revenue Service:
Appendix III: GAO Contact and Staff Acknowledgments:
Related GAO Products:
Tables:
Table 1: Distribution of the Estimated Amount of Net Misreported Income
from Rental Real Estate by Individual Taxpayers, Tax Year 2001:
Table 2: Estimated Distribution of All Individual Taxpayers and
Individual Taxpayers Who Reported and Misreported Rental Real Estate
Activity and Associated Net Misreported Amounts by Adjusted Gross
Income, Tax Year 2001:
Table 3: Estimated Frequency of Types of Individual Taxpayer
Misreporting of Rental Real Estate Activities That IRS Detected through
NRP Examinations, Tax Year 2001:
Table 4: Estimated Frequency of Types of Misreporting of Rental Real
Estate Expenses by Individual Taxpayers, Tax Year 2001:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
August 28, 2008:
The Honorable Max Baucus:
Chairman:
The Honorable Charles Grassley:
Ranking Member:
Committee on Finance:
United States Senate:
The Internal Revenue Service (IRS) estimated that individual owners of
rental real estate underreported their taxes by as much as $13 billion
for tax year 2001.[Footnote 1] By misreporting their rental real estate
activities, these taxpayers contribute to the gross tax gap, most
recently estimated at around $345 billion for tax year 2001. The tax
gap is the difference between the taxes that taxpayers pay voluntarily
and on time and the amounts they should pay under the law.
We have noted in past reports and testimonies that the tax gap has
multiple causes, spans five types of taxes, and is spread over
individuals and different business types. For these reasons, addressing
the tax gap requires understanding the characteristics of specific
types of misreporting, such as for rental real estate, in order to
develop potential solutions for closing the gap. Given the magnitude of
the estimated tax gap from rental real estate misreporting, even small
improvements in taxpayer compliance could result in substantial
revenue. Increasing compliance could also improve the fairness of the
tax system, as misreporting taxpayers increase the burden of funding
the nation's commitments for those taxpayers who voluntarily pay their
taxes.
Given your long-standing concern about the tax gap, you asked us to
provide information on individual taxpayer compliance in reporting
rental real estate activity. In response, this report (1) provides
information on the extent and primary types of individual taxpayer
misreporting of rental real estate activities and (2) identifies
challenges IRS faces in ensuring compliance with rental real estate
reporting and assesses options for increasing compliance.
To provide information on the extent and primary types of individual
taxpayer misreporting of rental real estate activities, we selected a
probability sample of case files from a larger sample of individual tax
returns IRS examined through its National Research Program (NRP). We
reviewed case files for 1,000 returns that included rental real estate
or royalty activity[Footnote 2] and used the results of our case file
review along with data from IRS's examinations of the tax returns from
NRP to make estimates for the entire population of individual taxpayers
with rental real estate activity. Since our estimates are based on a
sample, we express our confidence in the estimates as a 95 percent
confidence interval, plus or minus a margin of error. These intervals
would contain the actual population value for 95 percent of the samples
we could have selected. Unless otherwise noted, all percentage
estimates have a margin of error of less than 5 percentage points;
value estimates have a margin of error of less than 8 percent. To
identify challenges IRS faces in ensuring rental real estate reporting
compliance and assess options for increasing compliance, we reviewed
IRS forms, publications, and other taxpayer guidance related to
reporting rental real estate activity and reviewed documents and data
from IRS's enforcement programs. In addition, we interviewed officials
from IRS's Small Business/Self-Employed; Wage and Investment; and
Research, Analysis, and Statistics divisions who have knowledge of
rental real estate compliance issues. We also interviewed
representatives of the tax return preparation, property management, and
mortgage banking industries. We conducted this performance audit from
May 2007 through August 2008 in accordance with generally accepted
government auditing standards. Those standards require that we plan and
perform the audit to obtain sufficient, appropriate evidence to provide
a reasonable basis for our findings and conclusions based on our audit
objectives. We believe that the evidence obtained provides a reasonable
basis for our findings and conclusions based on our audit objectives.
Results in Brief:
We estimate that at least 53 percent of individual taxpayers with
rental real estate activity for tax year 2001 misreported their rental
real estate activity, resulting in an estimated $12.4 billion of net
misreported income. This amount of misreporting understates the total
amount of misreported income from rental real estate because IRS knows
it does not detect all misreporting during its NRP examinations and
uses various methodologies and other sources of data to adjust the
amount of misreporting it detects to estimate the tax gap. Also,
individual taxpayers misreported net income from rental real estate
more frequently than some other types of income. For example, 10
percent of taxpayers misreported the amount of wages they earned. This
disparity in compliance undermines the fairness of our tax system.
Misreporting of rental real estate expenses was the most common type of
misreporting of rental real estate activities we found that IRS
identified through the NRP examinations. One problem was substantiating
expenses--about one-quarter of taxpayers with rental real estate
activity could not substantiate some expenses they reported on their
tax returns. Other types of misreporting included misreporting of rents
received, reporting activity on the wrong part of the individual tax
return, and misreporting the amount of loss from rental real estate.
Limited information reporting for rental real estate activity, the
complexity involved in reporting the activity, and the number of
taxpayers misreporting their rental real estate activity are challenges
IRS faces in ensuring compliance with rental real estate reporting. For
example, IRS receives information returns from third parties--such as
those that rental real estate management companies file reporting the
rent taxpayers receive or that financial institutions file reporting
the mortgage interest taxpayers pay--for only a small number of
taxpayers who report rental real estate activity on their tax returns.
As a result, it can be difficult for IRS to systematically identify
taxpayers who may have misreported or failed to report their
activities. While information reporting improves compliance,
implementing broad, new third-party information reporting for rental
real estate activities is not practical. For example, requiring all
renters to report to IRS the amount of rent they pay would place a
substantial burden on renters and would present enforcement challenges
for IRS. However, other options exist to improve rental real estate
reporting compliance. Existing third-party information reporting
requirements could be improved. Currently, financial institutions do
not have to provide mortgaged property addresses when reporting to IRS
on taxpayers' mortgage interest payments. Also, under existing law,
only taxpayers whose rental real estate activity is considered a trade
or business are required to report expense payments on information
returns, but the law for filing the returns does not clearly spell out
how to determine whether taxpayers' rental real estate activity should
be considered a trade or business. Another approach to improving
taxpayer compliance is to require taxpayers to report additional detail
about their rental real estate activities on tax returns. For example,
requiring taxpayers to report complete property address information,
which we found that some taxpayers did not report, could help IRS
address misreporting during examinations. Requiring additional detail
on tax returns could have the added benefit of compelling paid tax
return preparers, used by about 80 percent of individual taxpayers who
report rental real estate activity, to obtain more accurate income and
expense information from taxpayers. Also, IRS guidance in the
instructions to the individual tax return could be improved for some
aspects of rental real estate activity, such as required recordkeeping.
Finally, IRS officials suggested additional IRS outreach to paid tax
return preparers and others about common types of rental real estate
misreporting.
This report suggests that Congress consider amending the Internal
Revenue Code to make all taxpayers with rental real estate activity
subject to the same information reporting requirements as other
taxpayers operating a trade or business. We are also making several
recommendations to IRS to help it identify and address misreporting and
assist taxpayers, and their paid preparers, in accurately reporting
rental real estate activities, such as requiring third parties to
report mortgaged property addresses on mortgage interest statements,
requiring taxpayers to report additional information on their tax
returns for their rental real estate activities, providing taxpayers
with additional guidance, and enhancing IRS's outreach efforts with
regard to rental real estate activity. In commenting on a draft of the
report, IRS agreed with seven of our nine recommendations. However, IRS
agreed only to consider implementing our recommendation to require
third parties to report mortgaged property addresses on the mortgage
interest statement information return because the requirement would
increase burden on third parties. Also, IRS disagreed with our
recommendation to require taxpayers to report on the individual tax
return the basis amount attributed to land versus structure when
depreciating rental properties. However, IRS agreed to add information
in its instructions about allocating basis to land. We believe that
these two recommendations could improve compliance if implemented.
Representatives of the mortgage banking industry told us that it would
be feasible to report property address information on mortgage interest
statements. Also, we believe that requiring taxpayers to report the
land values on tax returns could prevent some taxpayers from including
the value of their land when calculating depreciation for their rental
properties. Although the instructions to the individual tax return
state that land is not depreciable, we found that about 166,000
taxpayers included the value of land when depreciating their rental
properties for tax year 2001.
Background:
Individuals report their rental real estate activities on their tax
returns, including for the rental of residential, vacation, and
commercial properties. Individuals own and manage a large amount of
residential properties in the United States. According to a study by
the Department of Housing and Urban Development and the U.S. Census
Bureau (Census), individuals owned an estimated 83 percent of the 15.7
million rental housing properties with fewer than 50 units in 2001
(with the remainder owned by partnerships or other entities).
Individuals owned 13 percent of the estimated 71,000 rental properties
with 50 units or more.[Footnote 3]
Likewise, according to a Census study of rental property management
characteristics for 1995, an estimated 67 percent of rental housing
properties with fewer than 50 units were managed by their owners as
opposed to management companies or another type of manager. Owners
managed an estimated 5 percent of rental properties with 50 units or
more.[Footnote 4] According to IRS data, the estimated number of
individual taxpayers who reported rental real estate activity for
properties they owned directly was 8.7 million in 2001 and 9.1 million
in 2005.[Footnote 5]
Individual taxpayers generally must report as income any rent they
receive from the use or occupation of real estate on Part I of Schedule
E, which they attach to the individual tax return--Form 1040.[Footnote
6] The amount of income taxpayers must report includes rent payments
and other amounts, such as kept security deposits or the fair market
value of services taxpayers receive from tenants in lieu of rent.
Taxpayers ordinarily are allowed to deduct the expenses of renting
property from their rental income on Part I of Schedule E.[Footnote 7]
However, the costs of property improvements that add to the value of a
property or extend its useful life, such as a bathroom addition or new
built-in appliances, must be depreciated, meaning that taxpayers must
deduct such costs on their tax returns over multiple years. Likewise,
taxpayers must depreciate the cost of acquiring a rental property. The
amount of depreciation that a taxpayer can deduct for both property
improvements and the cost of rental property depends on the taxpayer's
basis in the property, among other factors. A taxpayer's basis in a
rental property is generally the cost of the property when it was
acquired, excluding the cost of land, which is not depreciable (in
practice, taxpayers must determine what portion of the cost of their
properties is attributed to land versus actual structures in order to
determine their depreciable basis).
If individual taxpayers use their properties for both rental and
personal purposes in a given tax year the expenses they can deduct may
be limited.[Footnote 8] Personal use of a property includes the use by
the taxpayer or any other person who has an interest in the property or
use of the property by a family member of either, even if the property
is rented at a fair rental price.[Footnote 9] Personal use also
includes use by nonowners and non-family members if the rental is at
less than a fair rental price. However, in general, renting property to
a family member or another person is not considered to be personal use
if the property is rented at a fair rental price and is used by the
renter as his or her principal residence. Taxpayers who use their
properties for both rental and personal purposes, but whose personal
use is not enough for the property to be considered a residence, must
allocate their expenses between rental and personal use based on the
number of days used for each purpose.
To assist in filing their tax returns, individual taxpayers are
expected, and in some cases required, to keep records, including those
for rent received and expenses. Additionally, taxpayers must keep
records to substantiate items on their tax returns in case IRS has
questions about the items. Taxpayers who, upon IRS examination, cannot
produce evidence to support items they reported on their tax returns
may be subject to additional taxes and penalties. For example,
taxpayers who cannot substantiate their rental real estate expenses
with appropriate records may have their expenses disallowed, resulting
in additional taxes owed.
Information reporting provides taxpayers, as well as IRS, with some
records of rent received and expenses from rental real estate. For
example, when an individual taxpayer receives rent of $600 or more
through a rental agent, such as a rental management company, the agent
is required to report the amount of rent received to the taxpayer and
IRS on a Form 1099-MISC. Payees of rent payments of $600 or more made
in the course of a trade or business, such as renting office space, are
also required to report those payments on Form 1099-MISC.[Footnote 10]
Likewise, financial institutions are required to report to taxpayers
and IRS on Form 1098 the amount of interest taxpayers paid on mortgages
they held on their rental properties. A taxpayer whose rental real
estate activity is a trade or business is required to report service
payments of $600 or more on Form 1099-MISC. However, according to IRS,
whether a taxpayer's rental real estate activity is considered a trade
or business is determined on a facts and circumstances basis.
Generally, taxpayers currently do not have to file Form 1099-MISC for
payments made to corporations.
IRS relies on both enforcement and taxpayer service programs to ensure
compliance by taxpayers with rental real estate activity. Two
enforcement programs IRS uses to ensure compliance are the Automated
Underreporter program (AUR) and examinations. Through AUR, IRS matches
information that taxpayers report on Schedule E for rent received and
mortgage interest to amounts that third parties report for these items
on Forms 1099-MISC and 1098, respectively. When mismatches arise
between amounts on tax returns and Forms 1099-MISC and 1098, IRS may
send notices asking taxpayers to explain the discrepancies or pay
additional taxes. Examinations may address any type of misreporting and
come in three forms. Correspondence examinations are conducted through
the mail and usually cover a narrow issue or two. Office examinations
are also limited in scope but involve taxpayers going to an IRS office.
For field examinations, IRS sends a revenue agent to a taxpayer's home
or business to examine the misreporting that IRS suspects it has
identified. During examinations, IRS uses information from third
parties, taxpayers, and external sources, such as public records.
Through its taxpayer service programs, IRS provides publications,
forms, and instructions to help taxpayers understand and comply with
their rental real estate reporting requirements.[Footnote 11] IRS also
disseminates relevant information to tax professionals, such as tax
return preparer associations, and business organizations. For example,
in July 2007, IRS released a fact sheet on the requirements for
reporting rental real estate activity. In addition to publishing the
fact sheet on its Web site, IRS disseminated the information to the
media and a wide network of tax professional and small business
organizations. IRS also provides assistance to taxpayers through its
toll-free telephone service where taxpayers can call and speak directly
with IRS staff about their tax issues.
IRS periodically measures taxpayer compliance and the tax gap that
results from misreporting, including those for individual taxpayers
with rental real estate activity. The portion of IRS's 2001 tax gap
estimate caused by individual underreporting is based on NRP. Through
NRP, IRS conducted a review and examination of a representative sample
of about 46,000 individual tax returns from tax year 2001. IRS
generalized from the NRP sample results to compute estimates of
underreporting of income and taxes for all individual tax returns.
Because even the detailed NRP reviews could not detect all
misreporting, IRS adjusted the NRP results to account for undetected
misreporting when estimating the tax gap, as will be discussed in the
next section of this report.
About Half of Individual Taxpayers with Rental Real Estate Activities
Misreported, Often Because of Overstated or Unsubstantiated Expenses:
Based on the unadjusted NRP results, at least an estimated 53 percent
of taxpayers with rental real estate activity (about 4.8 million out of
8.9 million taxpayers) misreported their rental real estate activities
for tax year 2001. Individual taxpayers misreported their rental real
estate activities more frequently than some other types of income for
tax year 2001. For example, we previously reported that an estimated 10
percent, 17 percent, and 22 percent of individual taxpayers with wage
and salary, dividend, and interest income, respectively, misreported
their income from these sources.[Footnote 12] This disparity in
compliance undermines the fairness of the tax system, because when some
taxpayers fail to pay the amount of taxes they should pay under the
law, the burden of funding the nation's commitments falls more heavily
on compliant taxpayers.
Individual taxpayers misreported an estimated $12.4 billion of net
income from rental real estate, before adjusting for tax gap purposes.
[Footnote 13] The unadjusted NRP results understate the amount of net
misreported income from rental real estate, as they represent only what
IRS detected through NRP examinations. IRS knows that it does not
detect all misreporting during its examinations. As such, it uses
various methodologies and other sources of data to adjust the aggregate
NRP results for tax gap purposes to estimate net misreporting for
categories of income or activities, such as rental real estate and
royalties (total rental real estate income or loss is reported on the
same line of Schedule E). After these adjustments, IRS estimated that
the tax gap for rental real estate and royalty activities was $13
billion for tax year 2001. Misreported rental real estate likely
accounted for most of the $13 billion because taxpayers misreported an
estimated $23.7 million of net income from royalties[Footnote 14]
compared to the $12.4 billion of net income from rental real estate
that taxpayers misreported.
Of the 4.8 million taxpayers who misreported their rental real estate
activities, an estimated 75 percent underreported their net income from
rental real estate (by either understating rent received or overstating
expenses or loss). For these taxpayers, a relatively small number
underreported $10,000 or more in net income from rental real estate,
but these taxpayers accounted for a large amount of misreported net
income, as shown in table 1. Conversely, nearly one-third of
underreporting taxpayers (about 1.2 million out of about 3.6 million
underreporting taxpayers) underreported less than $1,000. By
comparison, an estimated 25 percent of taxpayers who misreported rental
real estate activities overreported their net income from rental real
estate (by overstating rent received or understating expenses or loss),
although the amounts they misreported were relatively small. For
example, the estimated median amount of net income that misreporting
taxpayers overreported was $518,[Footnote 15] about one-quarter of the
median amount of net income of $1,981[Footnote 16] that misreporting
taxpayers underreported. Some taxpayers who misreported did so in a way
that may not have affected the amount of income tax they owed but may
have affected the amount of employment tax they owed, as discussed
later in this report.
Table 1: Distribution of the Estimated Amount of Net Misreported Income
from Rental Real Estate by Individual Taxpayers, Tax Year 2001:
Net misreported amount: Overreporting taxpayers; Less than $1,000;
Number of misreporting taxpayers (millions): 0.7;
Percentage of misreporting taxpayers: 16;
Net misreported income (billions of dollars): -$0.2.
Net misreported amount: Overreporting taxpayers; $1,000 and greater;
Number of misreporting taxpayers (millions): 0.4;
Percentage of misreporting taxpayers: 9;
Net misreported income (billions of dollars): -$1.9.
Net misreported amount: Underreporting taxpayers; Less than $1,000;
Number of misreporting taxpayers (millions): 1.2;
Percentage of misreporting taxpayers: 24;
Net misreported income (billions of dollars): $0.4.
Net misreported amount: Underreporting taxpayers; $1,000 to $9,999;
Number of misreporting taxpayers (millions): 2.1;
Percentage of misreporting taxpayers: 45;
Net misreported income (billions of dollars): $7.8.
Net misreported amount: Underreporting taxpayers; $10,000 and greater;
Number of misreporting taxpayers (millions): 0.3;
Percentage of misreporting taxpayers: 6;
Net misreported income (billions of dollars): $6.3.
Net misreported amount: Total;
Number of misreporting taxpayers (millions): 4.8;
Percentage of misreporting taxpayers: 100;
Net misreported income (billions of dollars): $12.4.
Source: GAO analysis of IRS data and examination case files.
Notes: Figures for the number of misreporting taxpayers do not sum to
the total because of rounding. Percentage estimates have margins of
error of less than 5 percentage points. Value estimates have margins of
error of less than 40 percent.
[End of table]
In terms of income levels, the distribution of taxpayers who
misreported rental real estate activity did not vary greatly from the
income levels for all taxpayers who reported rental real estate
activity for tax year 2001, as shown in table 2. However, taxpayers who
reported--and misreported--rental real estate activity were generally
of higher income levels than all individual taxpayers. Most of the
misreporting, in dollar terms, was attributed to taxpayers with more
than $50,000 of adjusted gross income.
Table 2: Estimated Distribution of All Individual Taxpayers and
Individual Taxpayers Who Reported and Misreported Rental Real Estate
Activity and Associated Net Misreported Amounts by Adjusted Gross
Income, Tax Year 2001:
Adjusted gross income: Less than $25,000;
Percentage of all individual taxpayers: 46;
Percentage of individual taxpayers reporting rental real estate
activity: 24;
Percentage of individual taxpayers misreporting rental real estate
activity: 20;
Net misreported income (billions of dollars): $2.5.
Adjusted gross income: $25,000 to $49,999;
Percentage of all individual taxpayers: 25;
Percentage of individual taxpayers reporting rental real estate
activity: 22;
Percentage of individual taxpayers misreporting rental real estate
activity: 23;
Net misreported income (billions of dollars): $1.7.
Adjusted gross income: $50,000 to $99,999;
Percentage of all individual taxpayers: 20;
Percentage of individual taxpayers reporting rental real estate
activity: 31;
Percentage of individual taxpayers misreporting rental real estate
activity: 34;
Net misreported income (billions of dollars): $3.9.
Adjusted gross income: $100,000 or greater;
Percentage of all individual taxpayers: 9;
Percentage of individual taxpayers reporting rental real estate
activity: 24;
Percentage of individual taxpayers misreporting rental real estate
activity: 23;
Net misreported income (billions of dollars): $4.3.
Adjusted gross income: Total;
Percentage of all individual taxpayers: 100;
Percentage of individual taxpayers reporting rental real estate
activity: 100;
Percentage of individual taxpayers misreporting rental real estate
activity: 100;
Net misreported income (billions of dollars): $12.4.
Source: GAO analysis of IRS data and examination case files.
Notes: Estimates for individual taxpayers reporting rental real estate
activity do not sum to 100 percent because of rounding. For
misreporting taxpayers, estimates have margins of error of less than 5
percentage points. For taxpayers reporting rental real estate activity
and all individual taxpayers, estimates have margins of error of less
than 2 percentage points. For net misreported amounts, estimates have
margins of error of less than 49 percent.
[End of table]
Misreporting of Rental Real Estate Expenses Was the Most Common Type of
Misreporting We Found That IRS Detected during NRP Examinations:
As shown in table 3, misreporting of rental real estate expenses was
the most common type of misreporting that we found through our file
review that IRS detected through the NRP examinations of taxpayers with
rental real estate activity. The figures in table 3 do not include
additional misreporting that IRS assumes to have taken place, which it
takes into account when estimating the tax gap. Following table 3 we
discuss the specific types of misreporting that we found IRS to have
detected through NRP.
Table 3: Estimated Frequency of Types of Individual Taxpayer
Misreporting of Rental Real Estate Activities That IRS Detected through
NRP Examinations, Tax Year 2001:
Type of misreporting: Misreported rental real estate expenses;
Number of misreporting taxpayers (millions): 3.9;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 43;
Net misreported income (billions of dollars): $9.0.
Type of misreporting: Misreported rent received;
Number of misreporting taxpayers (millions): 1.3;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 15;
Net misreported income (billions of dollars): [A].
Type of misreporting: Reported activity on an incorrect part of the
individual tax return;
Number of misreporting taxpayers (millions): 0.5;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 6;
Net misreported income (billions of dollars): [A].
Type of misreporting: Misreported loss from rental real estate;
Number of misreporting taxpayers (millions): [A];
Estimated percentage of taxpayers with rental real estate activity who
misreported: 2;
Net misreported income (billions of dollars): [A].
Type of misreporting: Other types of misreporting;
Number of misreporting taxpayers (millions): 0.4;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 5;
Net misreported income (billions of dollars): [A].
Type of misreporting: All types of misreporting;
Number of misreporting taxpayers (millions): 4.8;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 53;
Net misreported income (billions of dollars): $12.4.
Source: GAO analysis of IRS data and examination case files.
Notes: Some taxpayers misreported rental real estate activity for more
than one type of misreporting. As such, estimates for types of
misreporting do not sum to totals. Estimates in this table do not
include some instances of misreporting from 10 cases where we could not
determine the type of misreporting. Other types of misreporting
included taxpayers who made errors elsewhere on their tax returns that
led to errors in reporting rental real estate activities or errors that
were made by taxpayers' paid tax return preparers. Estimates for
numbers of taxpayers have margins of error of less than 34 percent.
Estimates for percentages of taxpayers have margins of error of less
than 4 percentage points. The estimate for net misreported income due
to misreported rental real estate expenses has a margin of error of
less than 24 percent.
[A] We could not provide a reliable estimate for this type of
misreporting.
[End of table]
Misreported Rental Real Estate Expenses:
The most common reason why taxpayers misreported their rental real
estate expenses was because they lacked documentation to substantiate
some of the expenses they deducted, as shown in table 4.[Footnote 17]
Table 4: Estimated Frequency of Types of Misreporting of Rental Real
Estate Expenses by Individual Taxpayers, Tax Year 2001:
Type of expense misreporting: Did not substantiate a reported expense;
Number of misreporting taxpayers (millions): 2.1;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 24;
Net misreported income (billions of dollars): $5.2.
Type of expense misreporting: Did not report or fully report an allowed
expense;
Number of misreporting taxpayers (millions): 1.7;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 19;
Net misreported income (billions of dollars): -$2.6.
Type of expense misreporting: Miscalculated depreciation;
Number of misreporting taxpayers (millions): 1.0;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 11;
Net misreported income (billions of dollars): [A].
Type of expense misreporting: Improperly deducted personal expenses;
Number of misreporting taxpayers (millions): 1.0;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 11;
Net misreported income (billions of dollars): $3.2.
Type of expense misreporting: Deducted an expense in full that should
have been depreciated;
Number of misreporting taxpayers (millions): 0.5;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 5;
Net misreported income (billions of dollars): $1.7.
Type of expense misreporting: Misreported rental expenses for other
reasons;
Number of misreporting taxpayers (millions): 1.0;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 12;
Net misreported income (billions of dollars): $1.9.
Type of expense misreporting: All types of misreporting of expenses;
Number of misreporting taxpayers (millions): 3.9;
Estimated percentage of taxpayers with rental real estate activity who
misreported: 43;
Net misreported income (billions of dollars): $9.0.
Source: GAO analysis of IRS data and examination case files.
Notes: Some taxpayers misreported rental real estate activity for more
than one type of misreporting. As such, estimates for types of expense
misreporting do not sum to totals. Estimates for numbers of taxpayers
have margins of error of less than 32 percent. Estimates for
percentages of taxpayers have margins of error of less than 3
percentage points. Dollar estimates have margins of error of less than
41 percent.
[A] We could not provide a reliable estimate for net misreported income
from miscalculated depreciation.
[End of table]
For taxpayers who did not substantiate expenses, some may have incurred
the expenses they could not document while other taxpayers may simply
have made up expenses. Generally, we could not discern from our case
file review why taxpayers did not substantiate reported expenses.
We found two scenarios for taxpayers who did not report or fully report
all allowable expenses. During the course of IRS's examinations, some
taxpayers discovered additional expenses for properties that they
reported on their tax returns. For other taxpayers, unreported expenses
were related to properties for which they received rent that they did
not report on their tax returns--and that IRS subsequently identified.
For these properties, IRS required the taxpayers to report the rent
that they received and allowed them to deduct related expenses that
they could document. We could not estimate the frequency of these
scenarios because we could not always determine whether the unreported
expenses were related to unreported rent.
Taxpayers misreported depreciation expenses in a variety of ways. We
estimate that about 166,000 taxpayers included the value of their land
within the depreciable basis of their properties.[Footnote 18] Other
types of misreported depreciation included taxpayers deducting
depreciation for properties that they had already fully depreciated or
miscalculating depreciation by using an incorrect length of time
(useful life) over which to depreciate property.
Additional ways in which taxpayers misreported rental real estate
expenses included the following:
* Deducting expenses in full that should have been depreciated. For
example, taxpayers deducted expenses related to improving a property or
deducted the full expense of buying an item, such as a washing machine,
instead of depreciating these costs.
* Improperly deducting personal expenses. Some taxpayers deducted
expenses that were completely personal in nature while others made
errors in how they divided expenses that were for both personal and
rental real estate purposes.
* Other types of misreporting of expenses. These included taxpayers
deducting unallowable expenses, such as penalties or interest related
to real estate taxes, or making mathematical errors on their tax
returns.
Misreported Rent Received:
We identified three scenarios for taxpayers who misreported rent
received.
* Taxpayers who did not report any rental activity.
* Taxpayers who reported receiving rent for some properties but not for
others.
* Taxpayers who reported receiving rent for all of their properties but
reported incorrect rent amounts. Some examples of misreporting rent in
this manner included taxpayers failing to count certain items as rent,
such as expenses paid by tenants or kept security deposits, or having
inadequate records.
We could not estimate the frequency of these scenarios because we could
not always determine the exact nature of the misreported rent.
Reported Activity on an Incorrect Part of the Individual Tax Return:
This type of misreporting includes taxpayers who reported income or
expenses as rental real estate activity on Part I of Schedule E that
they should have reported elsewhere on their tax returns and taxpayers
who reported an activity elsewhere on their tax returns that they
should have reported on Part I of Schedule E. For example, some
taxpayers reported business activities as rental real estate activities
on Part I of Schedule E that IRS determined should have been reported
on the schedule to the individual tax return for profit and loss from
business (Schedule C). We also found taxpayers who reported income or
expenses on Schedule C that should have been reported as rental real
estate activity on Part I of Schedule E. This type of misreporting may
not have affected the calculation of the amount of income tax owed.
However, reporting activities on the wrong schedule could have affected
the amount of self-employment tax these taxpayers owed, as net income
from a trade or business is subject to self-employment tax whereas net
income from rental real estate reported on Schedule E generally is not.
IRS estimated that underreported self-employment tax accounted for $39
billion of the 2001 tax gap.
Misreported Loss from Rental Real Estate:
The most common reason why taxpayers misreported loss from their rental
real estate activities was because they also used their rental property
as a residence--including taxpayers who rented their properties at less
than a fair rental price--and claimed a loss to which they were not
entitled. Other reasons why taxpayers misreported loss were because
they were not actively participating in their rental real estate
activities or exceeded applicable income limitations for deducting a
loss from rental real estate.[Footnote 19]
Limited Information Reporting and Complexity Hinder Compliance, and
Various Options Exist for Improving Compliance:
Limited information reporting, complexity, and the number of taxpayers
misreporting are challenges IRS faces in ensuring compliance with
rental real estate reporting. IRS receives information returns for a
relatively small number of taxpayers with rental real estate activity.
For tax year 2001, for example, IRS received Forms 1099-MISC reporting
rent received for about 327,000 taxpayers who reported rent on their
tax returns.[Footnote 20] By comparison, there were about 8.2 million
taxpayers who reported rent on their tax returns for whom IRS did not
receive a corresponding Form 1099-MISC from a third party reporting the
rent. For taxpayers who deduct rental real estate expenses, IRS
generally receives information returns from third parties only for
mortgage interest that taxpayers pay. For tax year 2001, about 55
percent of taxpayers who reported rental real estate activity deducted
mortgage interest, accounting for about 36 percent of the total amount
of all rental expenses, including depreciation, that taxpayers deducted
for that year. As a result, about 64 percent of the total amount of all
rental real estate expenses taxpayers reported may not have been
subject to information reporting.
IRS enforcement officials cited limited information reporting as a
major challenge in ensuring compliance for the reporting of rental real
estate activities because without third-party information reporting it
is difficult for IRS to systematically detect taxpayers who fail to
report any rent or determine whether the rent and expense amounts
taxpayers report are accurate. The officials also told us that because
third parties are not required to include on Form 1098 the address of
the property for which they are reporting mortgage interest, IRS is
less able to determine if the interest is for a property used for
rental or personal purposes.
In addition, limited information reporting on rental real estate
activities results in lower levels of taxpayer voluntary compliance in
reporting rental real estate activities when compared to other types of
income or activities covered by more extensive information reporting.
Taxpayers tend to more accurately report income that third parties
report on information returns--such as Forms 1099-MISC and 1098--
because the income is transparent to taxpayers as well as to IRS. As
shown in figure 1, individual taxpayers misreport receiving rent to a
greater extent than they misreport income subject to more extensive
information reporting.
Figure 1: Individual Net Income Misreporting Categorized by the Extent
of Income Subject to Information Reporting, Tax Year 2001:
[See PDF for image]
This figure is a vertical bar graph depicting the following data:
Substantial information reporting and withholding:
* Wages and salaries;
Net misreporting percentage: 1.2.
Substantial information reporting:
* Pensions and annuities;
* Dividend income;
* Interest income;
* Unemployment compensation;
* Social Security benefits;
Net misreporting percentage: 4.5.
Some information reporting:
* Deductions;
* Partnership/S-Corp income;
* Exemptions;
* Capital gains;
* Alimony income;
Net misreporting percentage: 8.6.
Little or no reporting:
* Rents and royalties;
* Nonfarm proprietor income;
* Informal supplier income;
* Other income;
* Farm income;
* Form 4947 income;
* Adjustments;
Net misreporting percentage: 53.9.
Source: IRS.
[End of figure]
Although information reporting tends to lead to high rates of
compliance, requiring all individuals who pay rent to report to IRS the
annual amount of rent they pay to property owners or their
intermediaries is not practical. Officials at IRS and representatives
from the tax return preparation industry told us that although such a
requirement would likely improve compliance, it would place a
substantial burden on taxpayers, who may not have any incentive to
comply. Likewise, the requirement would be very difficult for IRS to
enforce given the large number of potential information return filers.
IRS compliance officials and representatives of the paid tax return
preparer industry told us that the complexity involved in reporting
rental real estate activities also hampers compliance. For example, the
rules surrounding whether to file Forms 1099-MISC or how to accurately
depreciate property may be challenging for some taxpayers to
understand.
Due to limited information reporting and the complexity of reporting
for rental real estate activity, IRS primarily addresses rental real
estate misreporting through field and office examinations. IRS
supplements examination coverage for rental real estate misreporting
through AUR, to a limited extent, based on rental income amounts
reported on Form 1099-MISC or mortgage interest reported on Form 1098.
[Footnote 21]
Given the limited extent of information reporting, it can be difficult
for IRS to identify misreporting taxpayers. Also, field examinations
are resource intensive and on average address relatively large amounts
of misreporting compared to the misreported amounts for most taxpayers
who misreported rental real estate activity. For example, for fiscal
year 2006, the average tax assessment IRS recommended for field
examinations of individual taxpayers was about $18,000 per taxpayer. We
found that taxpayers who underreported their net income from rental
real estate misreported an average of $4,055[Footnote 22]. As a
consequence, field examinations may not be a cost-effective tool for
targeting most rental real estate misreporting. Further, the number of
individual taxpayers misreporting rental real estate activity (4.8
million) is large relative to the approximately 300,000 field
examinations of individual taxpayers IRS conducted in fiscal year 2006.
According to IRS's examination program, relatively small amounts of
misreporting are more likely to be addressed through correspondence
examinations.
Various Options Exist for Improving Rental Real Estate Reporting
Compliance:
Although as previously discussed, implementing broad, new third-party
information reporting requirements for rental real estate activities is
not practical, changing existing requirements is one of various options
that could improve rental real estate reporting compliance. One change
to current information reporting requirements that could improve rental
real estate income reporting compliance is to require third parties to
include mortgaged property addresses when reporting taxpayers' mortgage
interest payments on Form 1098. As previously noted, not having
property addresses on Form 1098 hinders IRS's efforts to enforce rental
real estate reporting compliance. IRS officials told us that having
third parties consistently report property addresses on Form 1098 would
help them in their enforcement efforts, for example, by allowing them
to better distinguish between owner-occupied and rental properties.
Also, taxpayers who receive Forms 1098 that include the addresses of
their rental properties could be deterred from failing to report
activity for their properties. Representatives of the mortgage banking
industry told us that it would be feasible to report property address
information on Form 1098 because mortgage lenders maintain this
information. The representatives also told us that reporting this
information would involve costs because lenders would have to change
their reporting systems. They said that such costs would be lessened if
lenders were only required to send property address information to IRS,
which they would send electronically, and not to taxpayers, for whom
the lenders may send Forms 1098 on paper, as changing systems for
electronic submissions is less costly than changing systems for printed
forms. However, excluding property address information from Forms 1098
sent to taxpayers might eliminate any deterrent effect.
Another potential change to existing information reporting requirements
is to expand the requirement for taxpayers to file Forms 1099-MISC for
certain payments they deduct as expenses, for example, when taxpayers
pay contractors to perform repair work on their rental properties.
Existing law on whether taxpayers must file information returns on
selected rental real estate expenses they incur requires a case-by-case
analysis that depends on the facts and circumstances for each taxpayer.
Currently, only taxpayers whose rental real estate activity is
considered a trade or business are required to report payments on Form
1099-MISC. However, the law for filing information returns[Footnote 23]
does not clearly spell out how to determine whether taxpayers' rental
real estate activity should be considered a trade or business, and IRS
must make this determination on a case-by-case basis. Without concrete
statutory language, it may be difficult for taxpayers who report rental
real estate activity to determine if they are required to file Forms
1099-MISC for certain expense payments they make. As a result, it is
possible that some taxpayers who should file Forms 1099-MISC for
payments they make in the course of renting out real estate may not
file the forms. IRS does not have data on the number of taxpayers who
file Form 1099-MISC reporting expense payments from rental real estate
activities. Taxpayers are not required to indicate on Form 1099-MISC
the type of activity for which they are filing the form (e.g., business
activity on Schedule C versus rental real estate activity on Schedule
E). Therefore, under current statutory and regulatory guidance, it is
not possible for IRS to determine the activities for which Forms 1099-
MISC are filed.
Although it would be a departure from the trade or business
requirement, making all taxpayers with rental real estate activity
subject to the Form 1099-MISC filing requirement would provide clear
guidance for who must file Forms 1099-MISC.[Footnote 24] Such clarity
could benefit both IRS and taxpayers. Taxpayers would have clear
direction on whether they had to file the form. As previously
discussed, we found through our file review that a large amount of
misreported net income from rental real estate was from taxpayers for
whom IRS disallowed expenses that the taxpayers could not substantiate.
It is likely that some of these taxpayers reported on their tax returns
expenses that they did not incur. Requiring taxpayers to file
information returns for certain rental real estate expense payments
could deter these taxpayers from reporting expenses they did not incur
because IRS would have a record of expenses it could use as part of an
enforcement action. Given the magnitude of misreporting for taxpayers
who could not substantiate some rental real estate expenses they
deducted, even small improvements in compliance could yield substantial
revenue.
Also, a change to the Form 1099-MISC filing requirement would put
taxpayers reporting rental real estate on par with other individual
taxpayers, such as sole proprietors of other types of trades or
businesses, who are generally required to file Forms 1099-MISC.
Currently taxpayers reporting rental real estate expenses whose
activities are not considered a trade or business and sole proprietors
of other types of business who generate similar amounts of gross income
from their activities are treated differently based on the information
return statutes. For example, a taxpayer with rental real estate
activities not considered a trade or business would not have to file an
information return reporting a payment made to an individual contractor
for repair services whereas a sole proprietor engaged in a trade or
business would have to file for a similar service, assuming the
payments exceeded the minimum reportable amount threshold. It is
questionable whether, without additional statutory authority, IRS can
require all taxpayers with rental real estate activities to report
expense payments on Forms 1099-MISC regardless of whether their
activities are trades or businesses.
An expansion of the Form 1099-MISC filing requirement could have the
added benefit of improving compliance among payment recipients, such as
contractors who are sole proprietors, because additional payments would
be transparent to IRS and the payment recipients. IRS estimated that
sole proprietors misreport at a relatively high rate and accounted for
a significant portion--$68 billion--of the tax gap for tax year 2001.
Extending the Form 1099-MISC filing requirement to additional taxpayers
who report rental real estate involves costs and burdens for taxpayers.
Many taxpayers who were not required to file in the past or were
unaware of the filing requirement would have to learn the reporting
rules and file Form 1099-MISC. However, not all individual taxpayers
with rental activity would have to file Form 1099-MISC because not all
will have paid $600 or more to a single individual during the tax year,
which is the threshold for the reporting requirement.[Footnote 25] One
way to further limit the number of taxpayers with rental real estate
activity that would be required to file Form 1099-MISC would be to
increase the exemption amount for payments to a single person. The $600
or more threshold for reporting payments made in the course of a trade
or business has not been updated since the 1950s, and as such a greater
percentage of payments are likely subject to reporting than when the
requirement was first put in place because of inflation.
One obstacle for taxpayers in determining if they are required to file
Form 1099-MISC is that generally taxpayers do not have to file the
forms for payments made to corporations. As such, taxpayers must figure
out whether the persons or businesses to which they make payments are
incorporated to determine whether they need to file Form 1099-MISC. A
way to remove this obstacle is to expand information reporting to
include payments made to corporations. In the past, we have identified
requiring information reporting on payments made to corporations as a
way to improve compliance.[Footnote 26] Also, the administration in its
fiscal year 2009 budget proposed requiring information reporting on
payments to corporations.[Footnote 27]
Additionally, IRS would need to inform taxpayers and others of the
expanded Form 1099-MISC filing requirement. Communicating the
requirement could be complicated by the different deadlines for filing
Form 1099-MISC and the individual tax return. Taxpayers must send Form
1099-MISC to payment recipients by January 31, whereas the deadline to
file tax returns is April 15.[Footnote 28] Filing Form 1099-MISC past
the deadline may result in a penalty. Taxpayers who are newly required
to file Form 1099-MISC may not learn of the requirement until they
begin to prepare their tax returns, which some may not begin to do
until after the January 31 Form 1099-MISC filing deadline. IRS
compliance officials told us that taxpayers who realize that they are
late in filing required Forms 1099-MISC may choose not to file them
rather than run the risk of incurring penalties from filing late. One
way to lessen the impact of potential penalties on taxpayers who are
newly required to file Form 1099-MISC would be to waive penalties for
late filers the first year they are required to file.
We are examining issues involved with filing Form 1099-MISC in a
forthcoming report. As such, we did not examine in depth some of the
issues involved with filing Form 1099-MISC that we highlighted in this
report, such as increasing the reporting threshold, requiring reporting
for payments made to corporations, and penalties.
Requiring Taxpayers to Report Additional Information on Tax Returns for
Rental Real Estate Activity Could Improve Rental Real Estate Reporting
Compliance:
Requiring taxpayers to report additional information on their tax
returns for their rental real estate activity could improve rental real
estate reporting compliance by eliciting more accurate information from
taxpayers and providing IRS with additional information to detect
misreporting. As previously discussed, the requirements for reporting
rental real estate activities are complex. Such complexity may be why
individual taxpayers reporting this activity use paid preparers more
frequently than other individual taxpayers. For example, for tax year
2001, an estimated 77 percent of individual taxpayers reporting rental
real estate activity used a paid tax return preparer.[Footnote 29] By
comparison, an estimated 56 percent of all individual taxpayers used a
paid preparer for that tax year.[Footnote 30]As we have said in past
reports, paid preparers are a critical quality-control checkpoint for
the tax system and the quality of service they provide is important.
[Footnote 31] However, taxpayers with rental real estate activity who
used a paid preparer were statistically as likely to have misreported
as taxpayers with rental real estate activity who prepared their
returns themselves.[Footnote 32]
One of the challenges that paid preparers encounter when preparing
returns for taxpayers with rental real estate activity is that the
preparers do not always receive complete or accurate information from
taxpayers. Requiring preparers to verify taxpayers' documentation of
rental real estate expenses or perform increased due diligence of
taxpayers' rental real estate activities could improve the accuracy of
what taxpayers report. However, both of these requirements would
involve substantial costs and burdens for paid preparers, taxpayers,
and IRS that could outweigh any related compliance benefits.
Requiring taxpayers to report additional information for their rental
real estate activities on their tax returns is an alternative way to
elicit more accurate and complete information from taxpayers who use
paid preparers--as well as taxpayers who self-prepare. These additions
would add a level of due diligence because paid preparers would have to
obtain additional information on taxpayers' income and expenses in
order to complete the taxpayers' returns. For example, requiring
taxpayers to report on Part I of Schedule E if they filed a Form 1099-
MISC for one or more deducted expenses, such as through a check-the-box
question, could increase taxpayer awareness of the requirement and
prompt paid preparers to ask taxpayers questions about the nature of
their clients' expenses, which could improve the accuracy of the
expenses taxpayers report. IRS compliance officials were uncertain if
having this information for use in its enforcement efforts would
provide additional compliance benefits. As we are examining issues
involved with filing Form 1099-MISC in a forthcoming report, we did not
examine whether requiring taxpayers to indicate on their tax returns if
they filed a Form 1099-MISC would be a cost-effective way to improve
compliance.
As previously mentioned, about 166,000 taxpayers improperly included
the value of land when depreciating their rental properties. Requiring
taxpayers to report on their tax returns the basis amount attributed to
land versus structure when depreciating rental property could further
improve compliance. With such a requirement, IRS could identify
taxpayers who depreciated land or may have undervalued their land when
calculating depreciation.[Footnote 33] This requirement would not be
unprecedented, as IRS currently requires taxpayers to report the value
of their land when determining the amount of depreciation to deduct for
the business use of their homes.[Footnote 34]
Also, through our file review, we found that taxpayers do not always
report on their tax returns the type of property they rented out. The
instructions to Schedule E currently provide the example of "townhouse"
as the type of information taxpayers should report on property type on
Part I of Schedule E. The instructions do not ask the taxpayer to
report if the house was rented for residential, vacation, commercial,
or other purposes, for example. If IRS is to use information on
property type in its enforcement efforts, it needs to receive
consistent information, such as that which taxpayers could provide by
answering a check-the-box question that included the various types of
properties taxpayers might rent out.
Although such a check-the-box question would provide IRS with more
consistent information on property type, including such a question on
Part I of Schedule E would involve challenges. For example, IRS would
need to clearly define the different types of properties taxpayers
might report, and some rental properties could be used for multiple
purposes. Also, IRS compliance officials were uncertain to what extent
IRS could use this information in its enforcement efforts.
Finally, we found that about 36 percent of taxpayers reporting rental
real estate activity did not include the complete address of their
rental properties on their tax returns for tax year 2001. Although the
instructions to Schedule E direct taxpayers to report the street
address, city or town, and state for their properties (the instructions
state that taxpayers do not have to report zip codes), the language on
the actual form directs taxpayers to list the "location" of their
rental real estate properties. Specifically directing taxpayers to
report complete property addresses could increase the number of
taxpayers reporting addresses, rather than general location
information. According to IRS examination officials, having complete
address information would allow IRS examiners to use commercially
available data sources on property values to help determine fair rental
prices for taxpayers whose returns are selected for examination.
Whether having complete address information could also cost effectively
enhance IRS's examination selection process is less clear, according to
the officials.
Providing Taxpayers with Additional Guidance on Rental Real Estate
Reporting Requirements Could Improve Compliance, Although to What
Extent Is Difficult to Measure:
Another way to help taxpayers to more accurately report their rental
real estate activities is by providing them with additional guidance to
help them complete their tax returns. The impact on the tax gap from
providing additional guidance may be difficult to measure, as IRS
researchers have found it difficult to determine the extent to which
taxpayer services, such as tax form instructions, improve compliance
among taxpayers who want to comply. Likewise, providing taxpayers with
additional guidance does not guarantee that the taxpayers will actually
read the guidance, especially those who use paid preparers, and would
not affect taxpayers who willfully misreported. Regardless, providing
taxpayers with additional guidance could produce compliance benefits
among taxpayers who want to comply that exceed the related
implementation costs, which may be low relative to other actions IRS
could take to improve compliance, such as increased enforcement
efforts. Providing additional guidance could be particularly helpful
for taxpayers who use tax return preparation software to prepare their
returns if the software included or is based on the guidance.
For example, regardless of whether the requirement for who must file a
Form 1099-MISC changes in the future, at least some taxpayers who
reported rental real estate activity are currently required to file.
However, the instructions to Schedule E do not discuss this
requirement. Including guidance on the Form 1099-MISC filing
requirement in the instructions to Schedule E could inform taxpayers of
the requirement and could result in more taxpayers filing the form.
Likewise, IRS's publication on residential rental property[Footnote 35]
discusses that land cannot be depreciated and provides guidance on how
taxpayers can determine the value of their land. Although the
instructions to Schedule E also state that land cannot be depreciated,
they do not provide guidance on how to determine the value of land.
Representatives from the tax return preparation industry told us that
taxpayers are more likely to review tax form instructions than IRS
publications. As such, providing guidance on resources available to
taxpayers for determining how to distinguish between the cost of land
versus the cost of structures in the instructions to Schedule E could
help taxpayers more accurately determine the value of their land, which
could help them more accurately report depreciation.
With regard to recordkeeping, IRS produces a publication with general
guidance for individual taxpayers.[Footnote 36] However, recordkeeping
requirements for expense deductions are only discussed in the
instructions to Part I of Schedule E with regard to deducting mortgage
or other interest. Providing general guidance on recordkeeping
requirements in the instructions to Part I of Schedule E could
encourage taxpayers to keep better records, which could lead to more
accurate reporting. The instructions could also include language
similar to that in IRS's publication on recordkeeping, explaining that
taxpayers who, upon IRS examination, cannot produce records to
substantiate items they report on their tax returns may be subject to
additional taxes and penalties. Including this language could increase
voluntary compliance by deterring taxpayers from reporting expenses
they did not incur.
Outreach to Taxpayers and Other Stakeholders Could Improve
Understanding of Reporting Requirements and Common Types of
Misreporting:
Given that some taxpayers may not read IRS's guidance, an additional
way to inform taxpayers of the reporting requirements is to send them
notices covering key requirements and common mistakes taxpayers make
with regard to reporting rental real estate activity. In addition to
making taxpayers aware of the reporting requirements, such notices
could serve as a reminder to taxpayers that IRS is aware that they have
rental real estate activity, which in turn could serve as a deterrent
to intentional misreporting. These notices could be sent to some
taxpayers, such as taxpayers reporting rental real estate for the first
time, or all taxpayers who report rental real estate activity. Sending
these notices to taxpayers could also help inform paid preparers of the
requirements and common types of misreporting given that taxpayers who
received such notices would likely share them with their paid
preparers, according to representatives of the tax return preparation
industry.
However, the cost-effectiveness of sending notices like these is not
clear. IRS would have to dedicate resources to take calls from
taxpayers who receive the notices and have questions, which would be a
likely scenario according to IRS communications officials and
representatives of the tax return preparation industry. Producing and
sending the notices would also involve costs. Also, IRS would not
necessarily be able to target taxpayers who potentially misreported
their rental real estate activities when sending the notices. Given
these limitations, it would be important for IRS to test the
effectiveness of sending notices to taxpayers to determine if they can
increase compliance in a cost-effective manner.
A way to indirectly inform taxpayers of the reporting requirements and
common types of misreporting for rental real estate is for IRS to
enhance its focus on rental real estate in its outreach efforts to paid
preparers and other external stakeholders. Outreach to paid preparers
could be particularly important given that about 80 percent of
individual taxpayers who report rental real estate use a paid preparer,
[Footnote 37] but these taxpayers were as likely to have misreported as
taxpayers who self-prepared their tax returns. As previously discussed,
IRS produced and disseminated a fact sheet on the requirements for
reporting rental real estate activity, although the fact sheet did not
include information on common types of misreporting. Providing
additional information on the common types of misreporting, such as
those we found that IRS identified through NRP examinations, in
outreach efforts could help paid preparers assist individual taxpayers
to comply with the reporting requirements.
An IRS examination official told us that outreach, such as contacting
national paid preparer groups or providing information at IRS
Nationwide Tax Forums and other conferences that paid preparers attend
to fulfill their continuing professional education requirements, could
be a good approach to improving paid preparer due diligence. An IRS
official involved with outreach to external stakeholders told us that
although in the past IRS had targeted its outreach efforts primarily to
individual paid preparers, IRS is starting to reach out to tax return
preparation companies and tax preparation software vendors as well.
These outreach efforts could include providing information on common
types of rental real estate misreporting. Likewise, IRS compliance and
stakeholder liaison officials suggested including property managers
within IRS outreach efforts for this area of compliance.
Conclusions:
The disparity in individual taxpayer reporting compliance between net
income from sources subject to minimal information reporting, such as
rental real estate, and income that is subject to extensive information
reporting, such as wages, results in substantial revenue loss and
undermines the fairness of our tax system. However, significant
obstacles stand in the way of improving tax compliance by owners of
rental real estate. There are few practical opportunities for
additional third-party information reporting. Some taxpayers may not
fully understand the complex rules governing the reporting of rental
real estate activity, in part because their heavy reliance on paid
preparers means that many taxpayers may not read IRS guidance.
Detecting misreporting often requires face-to-face examinations, which
are costly to IRS and reach relatively few individual taxpayers.
Nevertheless, opportunities exist to improve compliance by individual
taxpayers who own rental real estate. First, existing information
reporting requirements could be improved. For example, under current
law, only taxpayers whose rental real estate activity is considered a
trade or business are required to report expense payments on Form 1099-
MISC, but the law for filing the form does not clearly spell out how to
determine whether taxpayers' rental real estate activity should be
considered a trade or business. To hold taxpayers with rental real
estate to the same requirements for filing Form 1099-MISC as taxpayers
whose activities are considered a trade or business would provide
clarity about who is required to file. Likewise, requiring property
addresses on Forms 1098 that report mortgage interest could provide IRS
with additional information to identify taxpayers who may not have
reported rental real estate activity and could deter taxpayers from
failing to report. Second, requiring taxpayers to report additional
information on their tax returns for their rental real estate
activities could force taxpayers to pay more attention to IRS guidance
or seek advice from paid preparers, act as a deterrent to intentional
misreporting, and compel paid preparers to obtain more accurate income
and expense information from taxpayers. Third, although it is unclear
the extent to which individual taxpayers read guidance on reporting
requirements, especially taxpayers who use paid preparers, enhancements
to IRS's guidance on rental real estate reporting requirements could
reduce unintentional misreporting. Such enhancements might also be
useful to paid preparers and could be reflected in tax preparation
software. Fourth, improving outreach efforts could also improve
compliance. Given the uncertainty about whether individual taxpayers
read IRS guidance, researching the effectiveness of outreach to
taxpayers could be beneficial. Also, given the heavy reliance on paid
preparers by owners of rental real estate, additional outreach to paid
preparers, among others, could be an effective way to indirectly reach
large numbers of taxpayers.
Matter for Congressional Consideration:
To provide clarity for which taxpayers with rental real estate activity
must report expense payments on information returns and to provide
greater information reporting, Congress should consider amending the
Internal Revenue Code to make all taxpayers with rental real estate
activity subject to the same information reporting requirements as
other taxpayers operating a trade or business.
Recommendations for Executive Action:
We are making nine recommendations to the Commissioner of Internal
Revenue.
To help IRS identify taxpayers who may have misreported their rental
real estate activity, we recommend that the Commissioner of Internal
Revenue require third parties to report mortgaged property addresses on
Form 1098 mortgage interest statements.
To elicit more accurate information from taxpayers on their rental real
estate activities, we recommend that the Commissioner of Internal
Revenue:
* require taxpayers to report on the individual tax return the basis
amount attributed to land versus structure when depreciating rental
real estate;
* determine if IRS uses property type information that taxpayers
currently report on Schedule E in its efforts to enforce rental real
estate reporting compliance, and:
- if it is determined that IRS uses the information, the Commissioner
should require taxpayers to provide specific information on Part I of
Schedule E about the type of properties for which they are reporting
activity, for example by answering a check-the-box question, and:
- if it is determined that IRS does not use the information, the
Commissioner should not require taxpayers to report any property type
information; and:
* require taxpayers to report the exact "address" of their rental real
estate properties on Part I Schedule E instead of property "location,"
as currently worded, and require taxpayers to report property zip
codes.
To help taxpayers understand the requirements related to certain
aspects of reporting rental real estate activities, we recommend that
the Commissioner of Internal Revenue include guidance within the
instructions to Part I of Schedule E on:
* the requirement for some taxpayers with rental real estate activity
to report on Form 1099-MISC certain payments made in the course of
renting out real estate;
* resources available to taxpayers for determining how to distinguish
between the cost of land versus the cost of structures; and:
* recordkeeping requirements and the potential for disallowed expenses
and penalties if taxpayers cannot produce documentation for reported
expenses upon examination by IRS.
To enhance IRS's outreach efforts, we recommend that the Commissioner
of Internal Revenue:
* evaluate whether sending notices to some or all taxpayers who report
rental real estate activity would be a cost-effective way to reduce
misreporting of some types of rental real estate activity and:
* expand outreach efforts to external stakeholders, such as paid tax
return preparers, tax return preparation software providers, and
industry groups related to rental real estate, to include common types
of misreporting for rental real estate activity, such as those
identified in this report.
Agency Comments and Our Evaluation:
In written comments on a draft of this report, which are reprinted in
appendix II, IRS agreed with seven of our nine recommendations.
However, IRS agreed only to consider implementing our recommendation to
require third parties to report mortgaged property addresses on Form
1098 mortgage interest statements citing the burden the requirement
could place on third parties. Although it is important to take third-
party burden into account when considering whether to require
information reporting, representatives of the mortgage banking industry
told us that it would be feasible to report property address
information on Form 1098 because mortgage lenders already maintain this
information. Also, IRS disagreed with our recommendation to require
taxpayers to report on the individual tax return the basis amount
attributed to land versus structure when depreciating rental real
estate properties. Specifically, IRS stated that taxpayers report
depreciation on Form 4562 and not on Schedule E to the individual tax
return, and that the basis of land is not used in calculating
depreciation. However, taxpayers are not required to report the basis
amount attributable to land on Form 4562. Further, we did not
specifically recommend on which form or schedule taxpayers should be
required to report the value of their land for properties they
depreciate. Also, we believe that, in effect, the basis of land is used
in calculating depreciation because taxpayers must subtract the value
of land from the overall basis of their properties. We found that for
tax year 2001, about 166,000 individual taxpayers included the value of
land when calculating depreciation for their rental properties. We
believe that requiring taxpayers to report the value of land in
conjunction with reporting depreciation calculations--whether on Form
4562, Schedule E, or elsewhere--would serve to reduce the number of
taxpayers who improperly include the value of land when calculating
depreciation for their rental properties. We agree with IRS that more
guidance to taxpayers is needed about allocating basis to land.
As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
from its issue date. At that time, we will send copies to the Chairman
and Ranking Member, House Committee on Ways and Means; the Secretary of
the Treasury; the Commissioner of Internal Revenue; and other
interested parties. Copies will be made available to others upon
request. This report will also be available at no charge on GAO's Web
site at [hyperlink, http://www.gao.gov].
If you or your staff have any questions, please contact me at (202) 512-
9110 or whitej@gao.gov. Contact points for our Offices of Congressional
Relations and Public Affairs may be found on the last page of this
report. Key contributors to this report are listed in appendix III.
Signed by:
James White:
Director, Tax Issues:
Strategic Issues Team:
[End of section]
Appendix I: Scope and Methodology:
To provide information on the extent and primary types of individual
taxpayer misreporting of rental real estate activities, we relied on
data and examination case files from the Internal Revenue Service's
(IRS) most recent National Research Program (NRP) study of individual
taxpayers. Through NRP, IRS selected and reviewed a stratified random
sample of 45,925 individual income tax returns from tax year 2001. We
selected a sample of cases that included taxpayers with rental real
estate activity from this NRP sample. The NRP sample is divided across
30 strata by the type of individual tax return filed and income levels.
IRS accepted as filed some of the NRP returns, accepted others with
minor adjustments, and examined the remainder of returns either through
correspondence or face-to-face meetings with taxpayers. If IRS
examiners determined that taxpayers misreported any aspect of the
selected tax returns, they adjusted the taxpayers' income accordingly
and assessed additional taxes.
IRS captured data from tax returns and examination results in the NRP
database, including data for rental real estate activities. However,
because taxpayers report expenses from both rental real estate and
royalty activities on the same lines of Part I of Schedule E, it is not
possible to determine with certainty whether adjustments examiners made
in the NRP database to these expense lines were for rental real estate
or royalty activities. Likewise, the data do not include detailed
information on why examiners made adjustments to rental real estate
activities. Therefore, to distinguish between misreporting for rental
real estate versus royalty expenses and to identify the primary types
of misreporting of rental real estate activities, we selected a
statistical sample of NRP examination case files to review.
We selected a sample of 1,202 cases from the tax returns IRS examined
from its NRP sample. We selected tax returns for taxpayers who reported
rental real estate or royalty activity on Part I of Schedule E.
[Footnote 38] Our sample was made up of four groups: (1) taxpayers for
whom IRS made adjustments to rental real estate activity, (2) taxpayers
who reported rental real estate activity for whom IRS did not make
adjustments to rental real estate activity, (3) taxpayers for whom IRS
made adjustments to royalty activity, and (4) taxpayers who reported
royalty activity for whom IRS did not make adjustments to royalty
activity. We included cases for taxpayers who accurately reported
rental real estate activity in order to make comparisons between
taxpayers for whom IRS did and did not make adjustments to rental real
estate activity. We selected cases with royalty activity to estimate
misreporting from royalties, which IRS combines with misreporting from
rental real estate to estimate the tax gap for these two activities.
The first group of cases consisted of 752 cases of taxpayers for whom
IRS made an adjustment to rents received, expenses, or loss reported on
Part I of Schedule E. Within this group we included, where possible,
the 10 cases in each stratum for which the adjustments examiners made
had the largest impact on the total amount of these adjustments for all
taxpayers when weighted for the entire population of individual
taxpayers (a total of 204 cases). We focused on cases with the largest
adjustments, in weighted terms, because including these cases would
improve the level of confidence of any estimates of the total amount of
adjustments to taxpayers' rental real estate activities. We selected
the remaining 548 cases in this first group of cases at random and in
proportion to the number of NRP returns for which IRS made adjustments
to taxpayers' rent, expenses, or loss reported on Part I of Schedule E.
Because our sample is a subsample of the NRP sample and is subject to
sampling error, we added cases, where applicable, to ensure that each
stratum contained a minimum of 5 randomly selected cases.
For the second group of cases we selected 248 cases for taxpayers who
reported rents received, expenses, or loss on Part I of Schedule E that
IRS did not adjust. We selected these cases at random and in proportion
to the NRP sample through an iterative process ensuring, where
possible, that a minimum of 5 cases was included in each stratum.
The third group of cases included 102 cases where IRS made an
adjustment to taxpayers' royalties received. The aggregate of these 102
cases and 30 cases with adjustments to royalties received selected as
part of the first group of cases account for all 132 cases in the NRP
database where examiners made adjustments to taxpayers' royalties
received. The fourth group consisted of 100 cases, selected at random
and in proportion to the NRP sample, for taxpayers who did not report
rents received and reported royalties received that IRS did not adjust.
We ensured, where possible, that a minimum of 5 cases were included in
each stratum.
Of the 1,202 cases we selected for our sample, we reviewed 1,000 cases.
We did not review the remaining 202 cases because either IRS did not
provide the files in time to include in our review (185 cases) or the
files did not contain examination workpapers essential to determine if
or why examiners made adjustments to taxpayers' rental real estate
activities (17 cases).[Footnote 39] We requested the cases at two
points, in late-May 2007 and late-June 2007, and periodically checked
on the status of our requests with IRS. We were only able to review
cases that arrived by January 11, 2008, in order to meet our agreed-
upon issue date for the report.
We recorded information from the case files using a data collection
instrument (DCI) that we developed. To ensure that our data collection
efforts conformed to GAO's data quality standards, each DCI entry that
a GAO analyst completed was reviewed by another GAO analyst. The
reviewers compared the data recorded within the DCI entry to the data
in the corresponding case file to determine whether they agreed on how
the data were recorded. When the analysts' views on how the data were
recorded differed, they met to reconcile any differences.
The estimates we included in this report were based on the NRP database
and the data we collected through our file review and were generated
using statistical software. All computer programming for the resulting
statistical analyses were checked by a second, independent analyst. Our
final sample size was large enough to generalize the results of our
review for the entire population of individual taxpayers with rental
real estate activity or had margins of error small enough to produce
meaningful estimates, unless otherwise noted in the report.[Footnote
40]
Because we followed a probability procedure based on random selection,
our sample is only one of a large number of samples that we might have
selected. Since each sample could have resulted in different estimates,
we express our confidence in the precision of our particular sample's
results as a 95 percent confidence interval, plus or minus the margin
of error. These intervals would contain the actual population value for
95 percent of the samples we could have selected. Unless otherwise
noted, all percentage estimates have a margin of error of less than 5
percentage points; value estimates have a margin of error of less than
8 percent.
We assessed whether the examination results and data contained in the
NRP database were sufficiently reliable for the purposes of our review.
For this assessment, we interviewed IRS officials about the data,
collected and reviewed documentation about the data and the system used
to capture the data, and compared the information we collected through
our case file review to corresponding information in the NRP database
to identify inconsistencies. Based on our assessment, we determined
that the NRP database was sufficiently reliable for the purposes of our
review.
We also used IRS's Statistics of Income (SOI) file for individual
taxpayers from tax years 2001 through 2005, which relies on a
stratified probability sample of individual income tax returns, to
develop estimates on characteristics for taxpayers who reported rental
real estate activity. Where possible, we compared our analyses against
published IRS data to determine that the SOI database was sufficiently
reliable for the purposes of our review.
To identify challenges IRS faces in ensuring rental real estate
reporting compliance and to assess options for increasing compliance,
we reviewed IRS forms, publications, and other taxpayer guidance
related to reporting rental real estate activity and documents from
IRS's enforcement programs. We also reviewed data from the Automated
Underreporter program and published data on examinations to determine
the extent of IRS's enforcement efforts. We also examined data on
individual taxpayers from SOI to determine the extent to which (1)
individual taxpayers use paid tax return preparers and (2) third
parties report information on rental real estate activity on Form 1099-
MISC. In addition, we interviewed officials from IRS's Small Business/
Self-Employed; Wage and Investment; and Research, Analysis, and
Statistics divisions who have knowledge of rental real estate
compliance issues. We also spoke with representatives of the American
Institute of Certified Public Accountants, National Association of
Enrolled Agents, National Association of Residential Property Managers,
and Mortgage Bankers Association to get their perspectives on issues
related to rental real estate reporting compliance.
We conducted this performance audit from May 2007 through August 2008
in accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe that
the evidence obtained provides a reasonable basis for our findings and
conclusions based on our audit objectives.
[End of section]
Appendix II: Comments from the Internal Revenue Service:
Department Of The Treasury:
Internal Revenue Service:
Deputy Commissioner:
Washington, D.C. 20224:
August 26, 2008:
James R. White:
Director, Tax Issues:
United States Government Accountability Office:
Washington, DC 20548:
Dear Mr. White:
Thank you for the opportunity to review the Government Accountability
Office (GAO) draft report entitled "Tax Gap - Actions That Could
Improve Rental Real Estate Reporting Compliance (GAO-08-956)."
We appreciate your comprehensive report and the suggestions to address
noncompliance in this area. They will assist us as we strive to address
the tax gap through a balanced approach.
We agree there are opportunities to expand our outreach efforts
regarding proper reporting for rental real estate activity. We will
issue an updated fact sheet on rental real estate, which will include
common types of misreporting. We will post this fact sheet on
[hyperlink, http://www/irs.gov] and include the information on the real
estate industry web page. This message will also be used in educational
outreach to tax professionals and software providers, and appropriate
industry organizations, such as rental owner associations.
We also appreciate your suggestions to revise several forms and
instructions related to real estate reporting. Unfortunately, due to
the complexity of rental real estate issues and limitations of the
forms, we are unable to implement all of them.
The enclosed response addresses each of your recommendations
separately.
If you have any questions, please contact Christopher Wagner, Acting
Commissioner, Small Business/Self-Employed Division at (202) 622-0600.
Sincerely,
Signed by:
Linda E. Stiff:
Enclosure:
GAO Recommendations and IRS Responses to GAO Draft Report: Tax Gap -
Actions That Could Improve Rental Real Estate Reporting Compliance
GAO-08-956:
Recommendation: Require third parties to report mortgaged property
addresses on Form 1098 mortgage interest statements.
Comments: We will consider requiring third parties to report mortgaged
property addresses on Form 1098 mortgage interest statements.
Currently, the Form 1098 provides optional reporting of the mortgaged
property address. However, it will be an increase in burden to the
third parties.
Recommendation: Require taxpayers to report on the individual tax
return the basis amount attributed to land versus structure when
depreciating rental real estate.
Comments: We do not agree with this recommendation. The depreciation
calculation is reported on Form 4562, Depreciation and Amortization,
and not on Schedule E (Form 1040) and the basis of land is not used to
compute depreciation. However, we will add information to the
instructions for Schedule E (Form 1040) about allocating basis to land.
Recommendation: Determine if IRS uses property type information that
taxpayers currently report on Schedule E in its efforts to enforce
rental real estate reporting compliance. If it is determined that IRS
uses the information, the Commissioner should require taxpayers to
provide specific information on Part I of Schedule E about the types of
properties for which they are reporting activity, for example by
answering a check-the-box question. If it is determined that IRS does
not use the information, the Commissioner should not require taxpayers
to report any property type information.
Comments: We agree to evaluate the use of property type information,
currently reported by the taxpayer on Schedule E, in our compliance
efforts. As recommended, if it is determined IRS uses property type
information in its efforts to enforce rental real estate reporting
compliance, we will revise Part I of Schedule E (Form 1040). If it is
determined the IRS does not use the information, we will not require
taxpayers to report any property type information.
Recommendation: Require taxpayers to report the exact "address" of
their rental real estate properties on Part I Schedule E instead of
property "location," as currently worded, and require taxpayers to
report property zip codes.
Comments: We agree that reporting the exact "address" versus "location"
of rental real estate will elicit more accurate information from
taxpayers on their rental real estate activities, while not imposing a
burden. We will change the wording on Part I Schedule E to read,
"address, city, state, and zip code."
Recommendation: Include guidance within the instructions to Part I of
Schedule E on the requirement for some taxpayers with rental real
estate activity to report on Form 1099-MISC certain payments made in
the course of renting out real estate.
Comments: We agree to adopt this recommendation.
Recommendation: Include guidance within the instructions to Part I of
Schedule E on resources available to taxpayers for determining how to
distinguish between the cost of land versus the cost of a structure.
Comments: We agree to add guidance in the instructions to Part I of
Schedule E (Form 1040) on how to allocate the basis between land versus
the cost of a structure.
Recommendation: Include guidance within the instructions to Part I of
Schedule E on recordkeeping requirements and the potential for
disallowed expenses and penalties if taxpayers cannot produce
documentation for expenses upon examination by the IRS.
Comments: We agree to add guidance within the general instructions of
the Schedule E (Form 1040) on recordkeeping requirements and penalties.
Recommendation: Evaluate whether sending notices to some or all
taxpayers who report rental real estate activity would be a cost-
effective way to reduce misreporting of some types of rental real
estate activity.
Comments: We agree with this recommendation and will conduct a test of
approximately 31,000 soft notices for tax year 2007. The sample will
include some rent and royalty information documents. IRS will evaluate
the results of the soft notice test in FY 2009 and make decisions on
its effectiveness and whether it should be expanded in subsequent
years.
Recommendation: Expand outreach efforts to external stakeholders, such
as paid tax return preparers, tax return preparation software
providers, and industry groups related to rental real estate, to
include common types of misreporting for rental real estate activity,
such as those identified in this report.
Comments: We agree that we can further expand our outreach efforts
regarding proper reporting for rental real estate activity. We will
issue an updated fact sheet on rental real estate, which will include
common types of misreporting. We will post this fact sheet on irs.gov
and will include the information on the real estate industry web page.
We will also utilize this message in educational outreach to tax
professionals, software providers, and to appropriate industry
organizations, such as rental owner associations.
[End of section]
Appendix III: GAO Contact and Staff Acknowledgments:
GAO Contact:
James White, (202) 512-9110 or whitej@gao.gov:
Acknowledgments:
In addition to the contact named above, Charlie Daniel, Assistant
Director; Jeff Arkin; Ellen Grady; Laura Henry; Shirley Jones; Winchee
Lin; John Mingus; Karen O'Conor; Ellen Rominger; Jeff Schmerling;
Andrew Stephens; and Elwood White made key contributions to this
report.
[End of section]
Related GAO Products:
Highlights of the Joint Forum on Tax Compliance: Options for
Improvement and Their Budgetary Potential. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-08-703SP]. Washington, D.C.: June
2008.
Tax Administration: The Internal Revenue Service Can Improve Its
Management of Paper Case Files. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-07-1160]. Washington, D.C.: September 28, 2007.
Tax Gap: A Strategy for Reducing the Gap Should Include Options for
Addressing Sole Proprietor Noncompliance. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-07-1014]. Washington, D.C.: July
13, 2007.
Using Data from the Internal Revenue Service's National Research
Program to Identify Potential Opportunities to Reduce the Tax Gap.
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-423R]. Washington,
D.C.: March 15, 2007.
Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax Gap.
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-488T]. Washington,
D.C.: February 16, 2007.
Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax Gap.
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-391T]. Washington,
D.C.: January 23, 2007.
Tax Compliance: Opportunities Exist to Reduce the Tax Gap Using a
Variety of Approaches. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-06-1000T]. Washington, D.C.: July 26, 2006.
Tax Compliance: Challenges to Corporate Tax Enforcement and Options to
Improve Securities Basis Reporting. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-06-851T]. Washington, D.C.: June 13, 2006.
Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost
Basis Would Improve Compliance if Related Challenges Are Addressed.
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-603]. Washington,
D.C.: June 13, 2006.
Tax Gap: Making Significant Progress in Improving Tax Compliance Rests
on Enhancing Current IRS Techniques and Adopting New Legislative
Actions. [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-453T].
Washington, D.C.: February 15, 2006.
Tax Gap: Multiple Strategies, Better Compliance Data, and Long-Term
Goals Are Needed to Improve Taxpayer Compliance. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-06-208T]. Washington, D.C.:
October 26, 2005.
Tax Compliance: Better Compliance Data and Long-term Goals Would
Support a More Strategic IRS Approach to Reducing the Tax Gap.
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-753]. Washington,
D.C.: July 18, 2005.
Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal
Sustainability but Will Require a Variety of Strategies. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-05-527T]. Washington, D.C.: April
14, 2005.
Tax Administration: IRS Is Implementing the National Research Program
as Planned. [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-03-614].
Washington, D.C.: June 16, 2003.
Tax Administration: New Compliance Research Effort Is on Track, but
Important Work Remains. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-02-769]. Washington, D.C.: June 27, 2002.
Tax Administration: Status of IRS' Efforts to Develop Measures of
Voluntary Compliance. [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-
01-535]. Washington, D.C.: June 18, 2001.
[End of section]
Footnotes:
[1] This $13 billion portion of the tax gap includes misreported net
income from royalties--such as from oil, gas, or mineral properties;
copyrights; and patents--because individual taxpayers are required to
report net income from rental real estate and royalties on the same
part of the individual tax return (Part I of Schedule E). The estimate
does not distinguish what part of the $13 billion is attributed to
rental real estate misreporting. We do not evaluate royalties in this
report. Likewise, net income or loss from rental real estate held
through a partnership, S corporation, estate, or trust or for farm
rentals is to be reported elsewhere on Schedule E, and IRS includes
misreporting from these activities in a separate portion of the tax gap
estimate. Accordingly, our analyses in this report only cover rental
real estate activities that were, or should have been, reported on Part
I of Schedule E.
[2] We selected cases with royalty activity to estimate misreporting
from royalties, which IRS combines with misreporting from rental real
estate to estimate the tax gap for these two activities.
[3] Department of Housing and Urban Development and Department of
Commerce, U.S. Census Bureau, Residential Finance Survey: 2001
(Washington, D.C.: 2005). These estimates include rented and vacant
single-family and multifamily houses, condominiums, mobile homes and
complexes, and rental or cooperative apartment buildings. Certain
properties, such as some publicly owned properties or properties with
more than 50 percent of the floor space used for business, industrial,
or nonresidential purposes, were not included in the estimate.
[4] U.S. Census Bureau, 1995 Property Owners and Managers Survey,
[hyperlink, http://www.census.gov/hhes/www/housing/poms/poms.html]
(accessed Apr. 17, 2007). Certain properties, such as those owned by a
public housing authority or properties used primarily as second or
vacation homes, were not included in the estimate.
[5] Figures do not include taxpayers who reported activity from rental
real estate held by a partnership or other entity. According to an IRS
technical advisor, a large percentage of partnerships are engaged in
rental real estate activity.
[6] Income from other types of rental activities, such as rentals where
significant services (such as maid services) are provided, the rental
of personal property or farm rentals, and rental properties held by a
partnership or other entity, are reported elsewhere on the individual
tax return.
[7] Deductible expenses include advertising, auto and travel, cleaning
and maintenance, commissions, insurance, legal and professional fees,
management fees, mortgage and other interest, repairs, supplies, taxes,
utilities, and other miscellaneous expenses.
[8] The tax treatment of rental property that taxpayers also use for
personal purposes depends on whether taxpayers use the property as a
residence. For the purposes of this requirement, a property is
considered to be used as a residence if the taxpayer uses it for
personal purposes more than the greater of (1) 14 days or (2) 10
percent of the number of days the unit is rented at a fair rental
price. 26 U.S.C. § 280A(d).
[9] Fair rental price for a given property is generally the amount of
rent that a person not related to the property owner(s) would be
willing to pay to rent the property.
[10] Direct payments of rent to rental agents and rent payments made to
corporations are excluded from the Form 1099-MISC reporting
requirement.
[11] In addition to Schedule E and its associated instructions, IRS
produces publications that cover rental real estate issues, such as
Publication 527, Residential Rental Property, and Publication 925,
Passive Activity and At-Risk Rules.
[12] GAO, Capital Gains Tax Gap: Requiring Brokers to Report Securities
Cost Basis Would Improve Compliance if Related Challenges Are
Addressed, [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-603]
(Washington, D.C.: June 13, 2006).
[13] Estimate has a margin of error of less than 21 percent.
[14] We are 95 percent confident that taxpayers who misreported their
net income from royalties misreported from -$15.5 million to $63.0
million, meaning that these taxpayers may have reported more net income
from royalties than they should have.
[15] Estimate has a margin of error of less than 44 percent.
[16] Estimate has a margin of error of less than 26 percent.
[17] For the purposes of this report, we characterize taxpayers who
could not substantiate expenses that IRS ultimately disallowed as
having misreported.
[18] Estimate has a margin of error of less than 17 percent. We could
not reliably estimate net misreported income for taxpayers who included
the value of land within depreciable basis because of the small number
of cases in our sample for which we identified this type of
misreporting.
[19] Rental real estate activities are generally considered passive
activities, and the amount of loss that taxpayers can deduct for these
activities is limited. Generally, taxpayers cannot deduct losses from
rental real estate activities unless they have income from other
passive activities. Taxpayers may be able to deduct some rental real
estate losses without regard to whether they have income from other
passive activities if they actively participate in their rental
activities (such as by selecting tenants or deciding on rental terms)
and own at least 10 percent, by value, of their rental properties.
Taxpayers who actively participate in a rental real estate activity can
deduct up to $25,000 of loss from their nonpassive income ($12,500 for
taxpayers who are married but file separate tax returns) if they do not
exceed certain income limits. Losses for taxpayers who are real estate
professionals and materially participated in their rental activities
are not limited by these passive activity rules. To qualify as a real
estate professional for the purposes of this exception, taxpayers must
perform more than 750 hours of services in real property trades or
businesses in which they materially participate during the tax year and
more than half of all the personal services they perform during the tax
year must have been for real property trades or businesses in which
they materially participated. They also must materially participate in
each of their rental activities for the activities to be considered
nonpassive. 26 U.S.C. § 469.
[20] Estimate has a margin of error of less than 11 percent.
[21] Rent and royalty information is combined in AUR. Through AUR, IRS
assessed an average of about $12 million in additional taxes for about
5,100 taxpayers who misreported rent and royalties from 2001 through
2005. We could not determine how often IRS assessed additional taxes
for taxpayers who misreported mortgage interest for their rental
properties because Form 1098 does not indicate if reported mortgage
interest is from rental properties versus other types of properties,
such as personal residences.
[22] Estimate has a margin of error of less than 15 percent.
[23] 26 U.S.C. § 6041.
[24] An expansion of this requirement could also apply to other
entities that report rental real estate activity, such as partnerships.
[25] For example, for tax year 2001, an estimated 5.3 million taxpayers
reported expenses of $600 or more for any line item on Part I of
Schedule E, not including mortgage interest, which is already reported
by third parties, and taxes, because tax payments to municipal
governments generally do not have to be reported on information
returns. By comparison, 8.9 million individual taxpayers reported
rental real estate activity on Part I of Schedule E. The 5.3 million
figure likely overstates the number of taxpayers who paid $600 or more
to a single individual because (1) some expenses reported on Part I of
Schedule E could have related to royalty rather than rental real estate
activity and (2) some expenses of $600 or more in the aggregate for a
given line item may have been for payments to multiple individuals. For
example, if a taxpayer reported a repair expense of $1,000 dollars, we
concluded that the taxpayer could have been required to file a Form
1099-MISC because he or she could have contracted the repair service
from one individual. However, this taxpayer may have paid two separate
individuals $500 each, in which case the taxpayer would not have had to
file Forms 1099-MISC reporting the payments for either individual. It
is also possible, however, that a taxpayer could have made payments to
a single individual that the taxpayer reported on more than one line
item.
[26] GAO, Tax Compliance: Opportunities Exist to Reduce the Tax Gap
Using a Variety of Approaches, [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-06-1000T] (Washington, D.C.: July 26, 2006).
[27] Executive Office of the President, Office of Management and
Budget, Analytical Perspectives, Budget of the United States
Government, Fiscal Year 2009.
[28] Taxpayers must file Forms 1099-MISC with IRS by February 28 or by
March 31 if filing electronically.
[29] For 2005, use of paid preparers by taxpayers with rental real
estate activity was about 81 percent. In addition, an unknown number of
taxpayers who self-prepared their tax returns may use tax return
preparation software.
[30] For 2005, use of paid preparers by all individual taxpayers was
about 60 percent.
[31] GAO, Tax Administration: 2007 Filing Season Continues Trend of
Improvement, but Opportunities to Reduce Costs and Increase Tax
Compliance Should be Evaluated, [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-08-38] (Washington, D.C.: Nov. 15, 2007).
[32] Fifty-three percent of taxpayers who had rental real estate
activity and used a paid preparer misreported their rental real estate
activity (estimate has a margin of error of less than 5 percentage
points), and 55 percent of taxpayers who had rental real estate
activity and prepared their own returns misreported (estimate has a
margin of error of less than 8 percentage points). The difference
between these two estimates is not statistically significant. We
previously reported that some tax return preparers made serious errors
when completing returns. See GAO, Paid Tax Return Preparers: In a
Limited Study, Chain Preparers Made Serious Errors, GAO-06-563T
(Washington, D.C.: Apr. 4, 2006).
[33] An IRS technical advisor told us that allocating the value of a
property attributed to land can vary greatly depending on the type and
location of the property.
[34] Taxpayers use Form 8829 to deduct business expenses from the use
of their homes.
[35] IRS Publication 527, Residential Rental Property, and IRS
Publication 946, How to Depreciate Property.
[36] IRS Publication 552, Recordkeeping for Individuals.
[37] As previously discussed, 77 percent and 81 percent of individual
taxpayers who reported rental real estate activity used paid preparers
in 2001 and 2005, respectively.
[38] We used IRS's database of NRP results to identify these taxpayers.
[39] We previously reported on difficulties IRS has had in managing
paper case files. See GAO, Tax Administration: The Internal Revenue
Service Can Improve Its Management of Paper Case Files, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-07-1160] (Washington, D.C.: Sept.
28, 2007).
[40] We considered margins of error of less than 10 percentage points
for percentage estimates and less than 50 percent for value estimates
small enough to produce meaningful estimates.
[End of section]
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