Real Estate Tax Deduction
Taxpayers Face Challenges in Determining What Qualifies; Better Information Could Improve Compliance Gao ID: GAO-09-521 May 13, 2009The Joint Committee on Taxation identified improved taxpayer compliance with the real-estate tax deduction as a way to reduce the federal tax gap--the difference between taxes owed and taxes voluntarily and timely paid. Regarding the deduction, GAO was asked to examine (1) factors that contribute to taxpayers including nondeductible charges, (2) the extent that taxpayers may be claiming such charges, (3) the extent that Internal Revenue Service (IRS) examinations focus on the inclusion of such charges, and (4) possible options for improving taxpayer compliance. GAO surveyed a generalizable sample of local governments, studied taxpayer compliance in two jurisdictions that met selection criteria, reviewed IRS documents, and interviewed government officials and others. Addressing the complexity of current tax law on real-estate tax deductions was outside the scope of this review.
Taxpayers who itemize federal income-tax deductions and whose local real-estate tax bills include nondeductible charges face challenges determining what real-estate taxes they can deduct on their federal income tax returns. Neither local-government tax bills nor mortgage-servicer documents identify what taxpayers can properly deduct. Without such information, determining deductibility can be complex and involve significant effort. While IRS guidance for taxpayers discusses what qualifies as deductible, it does not indicate that taxpayers may need to check both tax bills and other information sources to make the determination. In addition, tax software and paid preparers may not ensure that taxpayers only deduct qualified amounts. There are no reliable estimates for the extent of noncompliance caused by taxpayers claiming nondeductible charges, or the associated federal tax loss. However, GAO estimates that almost half of local governments nationwide included generally nondeductible charges on their bills. While the full extent of overstatement is unknown due to data limitations, GAO estimates that taxpayers in two counties collectively overstated their deductions by at least $23 (or $46 million using broader matching criteria). IRS examinations of real-estate tax deductions focus more on whether the taxpayer owned the property and paid the taxes than whether the taxpayer claimed only deductible amounts, primarily because nondeductible charges are generally small. IRS guidance does not require examiners to request proof of deductibility or direct them to look for nondeductible charges on tax bills. Various options could improve compliance with the real-estate tax deduction, such as providing taxpayers with better guidance and more information, and increasing IRS enforcement. However, the lack of information regarding the extent of noncompliance and the associated tax loss makes it difficult to evaluate these options. If IRS obtained information on real-estate tax bill charges, it could find areas with potentially significant noncompliance and use targeted methods to reduce noncompliance in those areas.
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Report to the Joint Committee on Taxation:
United States Government Accountability Office:
GAO:
May 2009:
Real Estate Tax Deduction:
Taxpayers Face Challenges in Determining What Qualifies; Better
Information Could Improve Compliance:
GAO-09-521:
GAO Highlights:
Highlights of GAO-09-521, a report to the Joint Committee on Taxation.
Why GAO Did This Study:
The Joint Committee on Taxation identified improved taxpayer compliance
with the real-estate tax deduction as a way to reduce the federal tax
gap”the difference between taxes owed and taxes voluntarily and timely
paid.
Regarding the deduction, GAO was asked to examine (1) factors that
contribute to taxpayers including nondeductible charges, (2) the extent
that taxpayers may be claiming such charges, (3) the extent that
Internal Revenue Service (IRS) examinations focus on the inclusion of
such charges, and (4) possible options for improving taxpayer
compliance. GAO surveyed a generalizable sample of local governments,
studied taxpayer compliance in two jurisdictions that met selection
criteria, reviewed IRS documents, and interviewed government officials
and others. Addressing the complexity of current tax law on real-estate
tax deductions was outside the scope of this review.
What GAO Found:
Taxpayers who itemize federal income-tax deductions and whose local
real-estate tax bills include nondeductible charges face challenges
determining what real-estate taxes they can deduct on their federal
income tax returns. Neither local-government tax bills nor mortgage-
servicer documents identify what taxpayers can properly deduct. Without
such information, determining deductibility can be complex and involve
significant effort. While IRS guidance for taxpayers discusses what
qualifies as deductible, it does not indicate that taxpayers may need
to check both tax bills and other information sources to make the
determination. In addition, tax software and paid preparers may not
ensure that taxpayers only deduct qualified amounts.
There are no reliable estimates for the extent of noncompliance caused
by taxpayers claiming nondeductible charges, or the associated federal
tax loss. However, GAO estimates that almost half of local governments
nationwide included generally nondeductible charges on their bills.
While the full extent of overstatement is unknown due to data
limitations, GAO estimates that taxpayers in two counties collectively
overstated their deductions by at least $23 (or $46 million using
broader matching criteria).
IRS examinations of real-estate tax deductions focus more on whether
the taxpayer owned the property and paid the taxes than whether the
taxpayer claimed only deductible amounts, primarily because
nondeductible charges are generally small. IRS guidance does not
require examiners to request proof of deductibility or direct them to
look for nondeductible charges on tax bills.
Various options could improve compliance with the real-estate tax
deduction, such as providing taxpayers with better guidance and more
information, and increasing IRS enforcement. However, the lack of
information regarding the extent of noncompliance and the associated
tax loss makes it difficult to evaluate these options. If IRS obtained
information on real-estate tax bill charges, it could find areas with
potentially significant noncompliance and use targeted methods to
reduce noncompliance in those areas.
Figure: Determining What Qualifies As Deductible Is Complex:
[Refer to PDF for image: illustration]
1) Is the tax levied by a state, local, or foreign government?
Yes: continue;
No: Nondeductible.
2) Is the tax imposed on an interest in real property?
Yes: continue;
No: Nondeductible.
3) For what purpose is the tax levied?
General public welfare: deductible;
Local benefits that tend to increase the value of the property[A]:
Nondeductible.
Increasing level of effort and knowledge may be required to determine
deductibility of charges as determination process progresses.
[A] Charges for the repair or maintenance of local benefits and
associated interest are deductible.
Source: GAO analysis of Internal Revenue Code provisions.
[End of figure]
What GAO Recommends:
GAO recommends that the Commissioner of Internal Revenue change IRS
guidance to taxpayers, revise IRS guidance for auditing the deduction,
identify a cost-effective means of obtaining information on tax bill
charges, and conduct outreach to local governments and others on
options for helping taxpayers comply. IRS agreed with most of the
recommendations, but disagreed with changing guidance for auditing the
deduction. GAO continues to believe it should be improved.
View [hyperlink, http://www.gao.gov/products/GAO-09-521] or key
components. For more information, contact Michael Brostek at (202) 512-
9110 or brostekm@gao.gov.
[End of section]
Contents:
Letter:
Background:
Scope and Methodology:
Taxpayers Face Challenges Determining What Real-Estate Taxes They Can
Deduct for Their Federal Income Tax Returns:
Many Bills Contain Generally Nondeductible Charges, and Taxpayers in
Two Jurisdictions Likely Overstated Their Deductions, but the Full
Extent of Overstatement Is Unknown:
Examinations of Real-Estate Tax Deduction Focus on Other Noncompliance
Rather Than on the Inclusion of Nondeductible Charges:
Some Options Could Improve Compliance with the Real-Estate Tax
Deduction; Better Information Is Needed to Assess Other Options:
Conclusions:
Recommendations for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Methodology for Survey of Local Governments:
Appendix II: Methodology for Review of Real-Estate Tax Bills:
Appendix III: Methodology for Case Studies of Taxpayer Noncompliance:
Appendix IV: Comments from the Internal Revenue Service:
Appendix V: GAO Contact and Staff Acknowledgments:
Tables:
Table 1: Taxpayer Records from Alameda County Data and Hennepin County
Data Matched to Tax Returns with Claimed Real-Estate Tax Deductions:
Table 2: Matched Taxpayer Records with Non-Ad-Valorem Charges:
Table 3: Number and Dollar Amounts of Likely Overstated Real-Estate Tax
Deductions by Individual Taxpayers in Alameda County and Hennepin
County for Tax Year 2006:
Table 4: Options That Could Address Problems in Tax Compliance with and
the IRS Enforcement of the Real-Estate Tax Deduction:
Table 5: Summary of IRS's Deductibility Determinations for Five
Selected Jurisdictions:
Table 6: Summary of Taxpayer Records Matched from IRS Data to Alameda
County Data and Hennepin County Data for 2006:
Table 7: Number and Dollar Amounts of Likely Overstated Real-Estate Tax
Deductions by Individual Taxpayers in Alameda County and Hennepin
County for Tax Year 2006:
Figures:
Figure 1: Determining What Qualifies As Deductible Is Complex:
Figure 2: Information Requested by IRS's Office of Chief Counsel to
Make Deductibility Determinations:
Figure 3: Relative Burden of Options to Provide Information on Local
Charges:
Abbreviations:
IRS: Internal Revenue Service:
NRP: National Research Program:
QPTS: Quarterly Property Tax Survey:
SSN: Social Security number:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
May 13, 2009:
The Honorable Charles B. Rangel:
Chairman:
Joint Committee on Taxation:
House of Representatives:
The Honorable Max Baucus:
Vice Chairman:
Joint Committee on Taxation:
United States Senate:
Voluntary compliance with federal tax laws is a critical component of
the federal tax system. Each year, however, a gap arises between tax
amounts that were voluntarily reported and paid on time and those that
should have been paid. The Internal Revenue Service's (IRS) most recent
estimate is that the gross federal tax gap for tax year 2001 was $345
billion.[Footnote 1]
In 2006, the Joint Committee on Taxation identified overstated real-
estate tax deductions as a potential area of taxpayer noncompliance
that could be improved to reduce the tax gap, referencing our 1993
report in which we had determined that taxpayers may have overstated
the federal income tax deductions they claimed for real-estate taxes.
[Footnote 2] In our 1993 report, we stated that two reasons for
noncompliance were: (1) real-estate tax bills that did not distinguish
between deductible taxes and nondeductible user fees; and (2)
inadequate IRS education and enforcement activities with respect to the
deduction for real-estate taxes.
In 2006, individuals' federal deductions of real-estate taxes amounted
to about $156 billion. Because of your interest in the extent, if any,
to which individual taxpayers may have overstated their federal income
tax deduction for real-estate tax payments by including nondeductible
real-estate-related charges and the reasons for any overstated
deductions,[Footnote 3] you asked that we do the following:
* Describe factors that contribute to the inclusion of nondeductible
charges in real-estate tax deductions.
* Describe the extent that taxpayers may be overstating real-estate tax
deductions by including nondeductible charges.
* Describe the extent that IRS examinations of real-estate tax
deductions focus on the inclusion of nondeductible charges.
* Assess possible options for improving voluntary taxpayer compliance
with the real-estate tax deduction.
Background:
Real-estate taxes in the United States are levied by a number of
different taxing authorities, including state and local governments,
but mostly by local governments. Local governments, such as counties,
can levy and collect taxes on behalf of smaller jurisdictions within
their boundaries. For example, a county could collect real-estate taxes
on behalf of a city within the county. In 2006, local-government
property tax revenue[Footnote 4] was about $347 billion, compared to
about $12 billion for state-government property tax revenue.[Footnote
5] Local governments can use property tax revenues to fund local
services, such as road maintenance and law enforcement. In 2006,
property taxes made up an average of 45 percent of general own-source
revenue for local governments nationwide.[Footnote 6]
According to the Congressional Research Service, the real-estate tax
deduction was the most frequently itemized federal income tax deduction
claimed by individual taxpayers from 1998 through 2006; the deduction
was claimed on approximately 31 percent of all individual tax returns,
and on about 87 percent of all returns with itemized deductions.
[Footnote 7] The real-estate tax deduction provides a benefit to
homeowners and also provides an indirect federal subsidy to local
governments that levy this and other deductible taxes, since it
decreases the net cost of the tax to taxpayers. Deductible real-estate
taxes also may encourage local governments to impose higher taxes,
which may allow them to provide more services than they otherwise would
without the deduction. In 2006, individual taxpayers claimed about $156
billion in real-estate taxes as an itemized deduction. By allowing
taxpayers to deduct qualified real-estate taxes, the federal government
forfeits tax revenues that it could otherwise collect.[Footnote 8]
Taxpayers can claim paid real-estate taxes as an itemized deduction on
Schedule A of the federal income tax return for individuals.[Footnote
9] In addition, the Housing and Recovery Act signed July 30, 2008,
included a provision that allowed non-itemizers to deduct up to $500
($1,000 for joint filers) in real-estate taxes paid for tax year 2008.
[Footnote 10] Taxpayers can also deduct paid real-estate taxes on other
parts of the tax return, including as part of a deduction for a home
office or in calculating net income from rental properties.[Footnote
11] For purposes of this report, references to the real-estate tax
deduction mean the itemized deduction on Schedule A.
Taxpayers may deduct state, local, and foreign real-property taxes from
their federal tax returns if certain conditions are met.[Footnote 12]
Taxpayers may only deduct real-estate property taxes paid or accrued in
the taxable year.[Footnote 13] To be deductible, real-estate taxes must
be imposed on an interest in real property.[Footnote 14] Taxes based on
the value of property are known as ad valorem.[Footnote 15] Further,
real-estate taxes are only deductible when they are levied for the
general public welfare by the proper taxing authority at a like rate
against all property in the jurisdiction.[Footnote 16] Real-estate-
related charges for services are not deductible. Examples of such
charges for services include unit fees for water usage or trash
collection. In addition, taxpayers may not deduct taxes assessed
against local benefits of a kind tending to increase the value of their
property.[Footnote 17] Such local benefit taxes include assessments for
streets, sidewalks, and similar improvements. However, local benefit
taxes can be deductible if they are for the purpose of maintenance and
repair of such benefits or related interest charges.[Footnote 18]
IRS estimates that on income tax returns for 2001, all overstated
deductions taken together resulted in $14 billion in tax loss. IRS
estimated the amount of misreporting of deductions, but did not
estimate the resulting tax loss for each deduction. However, according
to data from IRS's National Research Program, which is designed to
measure individual taxpayer reporting compliance, in 2001 about 5.5
million taxpayers overstated their real-estate tax deductions, which
resulted in a total overstatement of about $5.0 billion. The median
overstatement was $436, or about 23 percent of the median claimed
deduction amount of $1,915. We estimate that 38.8 million taxpayers
claimed this deduction in 2001. While about 5.5 million taxpayers
overstated their deductions, about 3.3 million understated their
deductions. Taken as a whole, about 8.8 million taxpayers on average
overstated their deductions by about $85 each, which resulted in a net
total overstatement of about $2.5 billion.
Taxpayers can overstate or understate their real-estate tax deductions
in a number of ways. For example, they can overstate their deduction by
not meeting such eligibility requirements as property ownership and
payment during the tax year, or by inappropriately deducting the same
taxes on multiple parts of the income tax return. Taxpayers can also
overstate by claiming such real-estate tax-related amounts as local
benefit taxes and itemized charges for services, which, as noted
earlier, are not deductible. Taxpayers can also understate their real-
estate deduction. For example, first-time homeowners may understate
this deduction because they are not aware that they are entitled to
claim it. Similarly, taxpayers who buy and sell a home in the same year
could understate this deduction out of confusion over how much in taxes
they can deduct for the old and new homes.[Footnote 19]
Our 1993 report found that a majority of the local real-estate tax
bills that we reviewed included nondeductible items, such as service
charges, in addition to deductible real-estate taxes.[Footnote 20] Our
report also indicated that local governments had increased their use of
service charges in reaction to events that had reduced their revenues,
such as local laws that restricted growth in real-estate taxes. By
increasing user fees to finance services, local governments could keep
their tax rates lower. We also reported that some local jurisdictions
did not clearly indicate nondeductible items on real-estate tax bills
and combined all types of payments (e.g., deductible and nondeductible
real-estate taxes) into a total amount, which may lead taxpayers to
claim this total amount on the bill as deductible and thereby overstate
their deduction.
Most taxpayers rely upon either paid preparers or tax software to file
their tax returns. Recent estimates indicate that about 75 percent of
taxpayers used either a paid preparer (59 percent) or tax software (16
percent) to file their 2007 taxes.[Footnote 21] Any evaluation of the
factors that contribute to taxpayers overstating the real-estate tax
deduction would need to take paid preparers and tax software into
consideration.
Scope and Methodology:
To describe factors that contribute to the inclusion of nondeductible
charges in real-estate tax deductions, we conducted a number of
analyses and spoke with various external stakeholders, as follows.
* To determine what information local governments report on real-estate
tax bills relating to federal deductibility, we surveyed a
generalizable sample of over 1,700 local governments.[Footnote 22] We
also reviewed about 500 local-government real-estate tax bills provided
to us by survey respondents.[Footnote 23] We also interviewed officials
with organizations representing local governments, including the
National Association of Counties; the National Association of County
Collectors, Treasurers, and Financial Officers; and the Government
Finance Officers Association. To determine what mortgage servicers
report on mortgage documents,[Footnote 24] we interviewed
representatives from the mortgage industry from the Consumer Mortgage
Coalition, the Mortgage Bankers Association, and the three largest
mortgage servicing companies in 2007.
* We reviewed three IRS publications for tax year 2007 that provide
guidance to individual taxpayers claiming the real-estate tax deduction
as an itemized deduction on their federal income tax returns: the
instructions for IRS Form 1040, Schedule A, the form and schedule where
taxpayers can deduct real-estate taxes and other items from their
taxable income; IRS Publication 17, which provides information for
individuals on general rules for filing a federal income tax return;
and IRS Publication 530, a guide for homeowners. We checked whether
each of these publications explained the factors that taxpayers need to
consider in determining deductibility and guided taxpayers on where
they could obtain additional information necessary for determining
deductibility.
* To determine the extent that tax-preparation software and paid
professional tax preparers assisted taxpayers in only claiming
deductible real-estate taxes, we reviewed online software versions of
the three largest tax-preparation software programs in 2008--TaxAct,
TaxCut, and TurboTax--and interviewed representatives from those three
companies and representatives from the National Association of Enrolled
Agents.
We used the results of our survey of over 1,700 governments to
determine the extent to which local governments send real-estate tax
bills with certain generally nondeductible charges. To get an
indication of the extent to which taxpayers may be overstating their
real-estate tax deductions by including such nondeductible charges, we
conducted case studies on five large local governments, collecting and
analyzing tax data from them and IRS. Specifically, we worked with IRS
to determine which charges on the five local governments' tax bills
were likely deductible. While conducting these five case studies of
taxpayer noncompliance in claiming the real-estate tax deduction, we
identified challenges in determining what charges qualify as deductible
real-estate taxes. Then, to the extent possible, for two jurisdictions
we compared the amounts that were likely deductible to the amounts the
taxpayers claimed as deductions on Schedule A of their 2006 federal tax
returns. Appendix III provides details on the methodology for this case
study, including jurisdiction selection.[Footnote 25]
To describe the extent that IRS examinations of the real-estate tax
deduction focus on potential overstatements due to taxpayer inclusion
of nondeductible charges, we reviewed IRS guidance for examiners
related to the real-estate tax deduction, and interviewed IRS examiners
about the standard procedures and methods they use for auditing this
deduction. We reviewed guidance in the Internal Revenue Manual, which
serves as the handbook for IRS examiners, to determine how clearly it
instructs examiners to verify the deductibility of charges on real-
estate bills when auditing this deduction. Our interviews with IRS
examiners focused on the extent to which examiners determine the
deductibility of charges on real-estate bills when auditing this
deduction, challenges faced by examiners auditing this deduction, and
whether examiners have information about local jurisdictions with large
nondeductible charges on their real-estate tax bills. The examiners we
interviewed included examiners and managers based in IRS offices across
the United States.
To assess possible options for improving voluntary taxpayer compliance
with the real-estate tax deduction, we interviewed members of
organizations representing local governments and IRS officials about
potential options. We also identified potential options along with
their benefits and trade-offs based on our other work for this report.
We conducted this performance audit from October 2007 through May 2009,
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.
Taxpayers Face Challenges Determining What Real-Estate Taxes They Can
Deduct for Their Federal Income Tax Returns:
Local governments generally do not inform taxpayers what charges on
real-estate tax bills qualify as deductible real-estate taxes, which
creates a challenge for taxpayers attempting to determine what they can
deduct. Groups representing local governments told us that local
governments do not identify on real-estate tax bills which charges are
deductible, and our review of almost 500 real-estate tax bills supplied
by local governments[Footnote 26] supports this. In our review, we
found no instances where the local government indicated on the bill
what amounts were deductible for federal real-estate tax purposes.
Furthermore, while IRS requires various entities to provide information
about relevant federal tax items to both taxpayers and IRS on
statements known as information returns, local governments are not
required to provide information returns on real-estate taxes paid.
Local government groups told us that local governments do not identify
what taxes are deductible because they cannot easily determine whether
their charges meet federal deductibility requirements. They said that
local government tax collectors do not have the background or expertise
to determine what items are deductible according to federal income-tax
law and may lack information necessary for making such determinations
for charges billed on behalf of another taxing jurisdiction.[Footnote
27] As a result, local governments did not want to make such
determinations.
Taxpayers with mortgages may also receive information about real-estate
tax bill charges paid on their behalf by mortgage servicers, but this
information generally does not identify what taxes can be deducted. To
protect a mortgage holder's interest in a mortgaged property, mortgage
servicers often collect funds from property owners whose mortgages they
service (borrowers) and hold them in escrow accounts. They then draw
from the funds to pay real-estate taxes and related charges on the
properties as they are due. Mortgage servicers provide borrowers with
annual statements summarizing these and other deposits and withdrawals
of escrow account funds. In addition, mortgage servicers have the
option of reporting such escrow payments on information returns
relating to paid mortgage interest, but can choose to report other
information instead.[Footnote 28]
Mortgage industry representatives we spoke with stated that when
reporting escrow payments, mortgage servicers usually report the total
amount paid at any given time to local governments from escrow accounts
and do not itemize the specific types of charges paid for, regardless
of the statement used. As a result, any nondeductible charges paid for
would be embedded in this payment total and reported as "property
taxes" or "real-estate taxes" on mortgage servicer documents, including
IRS forms.
According to mortgage industry representatives, mortgage servicers only
report a total because most only track and receive information on the
total payment amount due. Mortgage servicers are interested in total
amounts because local governments can place a lien on a mortgaged
property if all billed charges are not paid. In addition, not all
mortgage servicers receive detailed information about charges. Our
survey of local governments on real-estate tax billing practices showed
that an estimated 43 percent[Footnote 29] of local governments provide
mortgage companies with only total amounts owed for requested
properties.[Footnote 30]
That annual mortgage statements report only totals is significant
because not all property owners receive tax bills. Based on responses
to our local government survey, an estimated 25 percent[Footnote 31] of
local governments do not send property owners a copy of their tax bill
if the taxpayer escrows their taxes through a mortgage company. Even
though real-estate tax bills do not indicate what charges are
deductible, tax bills can contain information on the types of charges
assessed on a property, which is a starting point for taxpayers in
determining what they can deduct.
Determining What Items Qualify as Deductible Real-Estate Taxes Can Be
Complicated and Require Significant Effort:
In the absence of information identifying deductible real-estate taxes,
determining whether certain amounts on the tax bills are deductible can
be complex and require significant effort. Taxpayers generally cannot
be assured that their real-estate tax bill has enough information to
determine which of the charges listed are deductible for federal
purposes. Deductible real-estate taxes are any state, local, or foreign
taxes on real property levied for the general public welfare by the
proper taxing authority at a like rate against all property in the
jurisdiction. Charges for services and charges for improvements tending
to increase the value of one's property are generally not deductible.
However, even if a real-estate tax bill labels a charge as a "tax" or
"for services," the designation given by a local government does not
determine whether a charge on a real-estate tax bill is deductible. For
example, a charge that is labeled a tax on a local real-estate tax
bill, but is not used for public or governmental purposes such as
police or fire protection, likely would not be deductible; whereas a
charge that is labeled a fee could be considered a deductible tax if
the charge is imposed at a uniform rate based on the value of the real
estate and is used for the general public welfare. Complicating the
matter is that local benefit taxes, which are generally not deductible,
can be deductible if the revenue raised is used to maintain or repair
existing improvements. Figure 1 depicts some of the questions that
taxpayers need to be able to answer for each real-estate-tax-related
charge they wish to deduct. Taxpayers who are unsure how to answer
these questions (as well as others) with respect to a given charge
cannot be assured of the charge's deductibility.
Figure 1: Determining What Qualifies As Deductible Is Complex:
[Refer to PDF for image: illustration]
1) Is the tax levied by a state, local, or foreign government?
Yes: continue;
No: Nondeductible.
2) Is the tax imposed on an interest in real property?
Yes: continue;
No: Nondeductible.
3) For what purpose is the tax levied?
General public welfare: deductible;
Local benefits that tend to increase the value of the property[A]:
Nondeductible.
Increasing level of effort and knowledge may be required to determine
deductibility of charges as determination process progresses.
[A] Charges for the repair or maintenance of local benefits and
associated interest are deductible.
Source: GAO analysis of Internal Revenue Code provisions.
[End of figure]
Because determining what qualifies as deductible can be complex, we
asked IRS's Office of Chief Counsel to help us determine the
deductibility of amounts on tax bills in five large local governments
as part of case studies on taxpayer compliance with the real-estate tax
deduction. We asked attorneys in IRS's Office of Chief Counsel what
information they would need to determine whether charges that appear on
real-estate tax bills in the jurisdictions were deductible. IRS's
Office of Chief Counsel indicated that it would need information on the
questions indicated in figure 2.
Figure 2: Information Requested by IRS's Office of Chief Counsel to
Make Deductibility Determinations:
[Refer to PDF for image: information list]
(1) Is the tax imposed by a State, possession, or political subdivision
thereof, against interests in real property located in the jurisdiction
for the general public welfare?
(2) Is the assessment an enforced contribution, exacted pursuant to
legislative authority in the exercise of the taxing power? Is payment
optional or avoidable?
(3) The purpose of the charge. Is it collected for the purpose of
raising revenue to be used for public or governmental purposes?
(4) Is the tax assessed against all property within the jurisdiction?
(5) Is the tax assessed at a uniform rate?
(6) Whether the payer of the assessment is entitled to any privilege or
service as a result of the payment. Is the assessment imposed as a
payment for some special privilege granted or service rendered? Is
there any relationship between the assessment and any services provided
or special privilege granted?
(7) Is use of the funds by the tax authority restricted in any way? Are
the funds earmarked for any specific purpose?
(8) Is the assessment for local benefits of a kind tending to increase
the value of the property assessed? Does the assessment fund
improvements to or benefiting certain properties or certain types of
property? If so, is a portion of the assessment allocable to separately
stated interest or maintenance charges?.
Source: IRS Office of Chief Counsel.
[End of figure]
To provide IRS with this information, we searched local government Web
sites for information on each charge that appeared on tax bills. We
also interviewed local government officials, collected and analyzed
additional documentation related to the charges, and identified
sections of local statutes that provided the authority to impose the
charges on the local tax bills. We summarized this information in
summary documents that totaled over 120 pages across the five selected
local governments.
Despite this level of effort, the information was not sufficient to
allow IRS to make a judgment as to the deductibility of all of the
charges in the five selected jurisdictions. While local government
officials we spoke with provided us with significant support in our
research, some of the information we asked for was either unavailable
or impractical to obtain due to format or volume. The main challenge we
faced was that each of the five local governments had over 100 taxing
districts--cities, townships, school districts, special districts,
etc.--and gathering detailed information for each district, such as how
each district calculates the rate it charges, was difficult and time-
consuming. As a result, IRS attorneys were not able to make
determinations on some charges in three of the five jurisdictions.
[Footnote 32]
Because individual real-estate tax bills in these jurisdictions would
likely include only a subset of the amounts we researched, taxpayers in
these jurisdictions would not necessarily need to apply the same total
level of effort that we did. However, they would still face similar
challenges in determining whether the amounts on their tax bills
qualified as deductible. For example, one county official told us that
not all charges are itemized on their tax bills and as a result, it is
nearly impossible for a taxpayer in her county to find out the nature
and purpose of those charges for which they are assessed.
Taxpayer Guidance for Deducting Real-Estate Taxes Explains What
Taxpayers Can Deduct, but Does Not Direct Taxpayers to Consult
Appropriate Resources to Determine Deductibility:
IRS instructions and guidance for taxpayers on claiming the real-estate
tax deduction explain generally what taxpayers can deduct, but lack
more specific information on how to comply. IRS instructions for
claiming the real-estate tax deduction on the federal income-tax return
for individuals explain that real-estate taxes are deductible if they
are based on the value of property, they are assessed uniformly on
property throughout the jurisdiction, and proceeds are used for general
governmental purposes.[Footnote 33] The instructions also indicate that
per-unit charges for services and charges for improvements that tend to
increase the value of one's property are generally not deductible. The
IRS general guide for individuals filing an income tax return and the
IRS guide for first-time homeowners similarly explain what taxpayers
can deduct,[Footnote 34] and also provide examples of nondeductible
charges for services and local benefit taxes.
However, these three IRS publications do not inform taxpayers that they
should check both real-estate tax bills and available local government
resources with information about the nature and purpose of specific
charges. While the two IRS guides alert taxpayers that they should
check real-estate taxes bills, IRS's instructions for deducting real-
estate taxes are silent on what taxpayers need to check. None of the
publications inform taxpayers that they may also need to consult local
government Web sites, pamphlets, or other available documents with
information about the nature and purpose of specific charges to
determine what amounts qualify as deductible real-estate taxes. Without
specific instruction to do otherwise, taxpayers could believe that they
are getting deductible amounts from their mortgage servicer.
Searching for more information may not be conclusive for all charges,
but may be sufficient for determining the deductibility of many
charges, as we found while examining charges in five local governments
with IRS. Similarly, even though some taxpayers may be unable to
determine the deductibility of a few charges on their tax bills after
consulting available local government resources, they likely need such
information on other charges to comply with requirements of the real-
estate tax deduction. Taxpayers need to know that they may need to
consult available local government resources because more information
may be required before they can determine which charges they can deduct
from their tax bill.
Tax-Preparation Software and Paid Tax Preparer Assistance May Not Be
Sufficient to Help Ensure That Taxpayers Only Deduct Qualified Real-
Estate Taxes:
Tax-preparation software and assistance provided by paid tax preparers
may not be sufficient to help ensure that taxpayers only deduct
qualified real-estate taxes. At the time of our review, two of the
three most frequently used tax-preparation software programs for 2008-
-TaxAct, TaxCut, and TurboTax--did not alert taxpayers to the fact that
not all charges on real-estate tax bills may qualify as deductible real-
estate taxes.[Footnote 35] The sections of these two programs where
users entered real-estate taxes paid lacked an alert informing users
that not all charges that appear on a real-estate tax bill may qualify
as deductible real-estate taxes. While all three of the programs
contained information about what qualified as deductible real-estate
taxes in various screens, users had to proactively click on buttons to
access these sections to learn that some charges on their tax bill may
not have been deductible.[Footnote 36]
One software-program representative indicated that alerts need to be
carefully tailored to have the intended effect. He cautioned that too
much information can actually have undesirable effects that do not lead
to improved compliance. Specifically, to the extent that they are not
relevant to taxpayers whose bills do not contain nondeductible items,
overly broad or irrelevant alerts can result in taxpayers reading less,
thereby creating confusion, causing errors to be made, and
unnecessarily increasing taxpayer burden by increasing the time and
complexity involved in taxpayers preparing their returns.
Nevertheless, software-program representatives we spoke with were
receptive to potential improvements that could be made to their
software programs. Prior to our review, none of the three largest
software programs contained an alert informing users that not all items
on real-estate tax bills may be deductible. In addition, one of the
three programs did not discuss the fact that deductible real-estate
taxes are based on the assessed value of property and that charges for
services and local benefit taxes are generally not deductible. In
response to our discussions with them on these issues, all three tax
software programs made changes to their programs. One program added an
alert to users indicating that not all charges on real-estate tax bills
may be deductible and the other two programs added information about
what qualifies as real-estate taxes or made such information more
prominent in the guidance accessible from their sections on real-estate
taxes.
Paid preparers we spoke with indicated that they invested only limited
time and energy making sure that taxpayers included only qualified real-
estate taxes in their deductions.[Footnote 37] Most taxpayers do not
understand that some charges assessed against a property may not be
deductible, and often only provide preparers with mortgage interest
statements or canceled checks to local governments that contain only
total payment amounts, making it difficult for the preparers to
identify potentially nondeductible charges. Some preparers indicated
that from their experience such charges are relatively small, and may
have negligible impacts on a taxpayer's tax liability, especially after
other parts of the tax return are considered. As a result, even if they
thought that clients may be claiming nondeductible charges, they often
did not consider identifying such charges to be worth the effort. The
paid preparers that we spoke with also indicated that more information
from local governments or IRS on what taxes are deductible would be
helpful in improving taxpayer compliance with the deduction.
Many Bills Contain Generally Nondeductible Charges, and Taxpayers in
Two Jurisdictions Likely Overstated Their Deductions, but the Full
Extent of Overstatement Is Unknown:
As mentioned earlier, deductible real-estate taxes are generally ad
valorem or based on the assessed value of property. We used the ad-
valorem/non-ad-valorem distinction as a rough proxy to indicate
potential deductibility in our survey of local governments' real-estate
billing practices. The ad-valorem/non-ad-valorem distinction is not a
perfect indicator of deductibility, since, under certain circumstances,
some ad-valorem charges could be nondeductible and some non-ad-valorem
charges could be deductible. However, based on the information we
provided, IRS's Office of Chief Counsel determined that all non-ad-
valorem charges in our case study jurisdictions were not deductible.
[Footnote 38]
We estimate that almost half of local governments nationwide included
charges on their real-estate tax bills that were generally not
deductible, based on responses to our survey. We surveyed a sample of
over 1,700 local governments identified as collecting real-estate taxes
and asked them whether their real-estate tax bills included non-ad-
valorem charges, that is, charges that are not based on the value of
property and therefore generally not deductible. Examples of such
charges include fees for trash and garbage pickup. Based on responses,
we estimate that 45 percent of local governments nationwide included
such charges on their tax bills.[Footnote 39] The property taxes
[Footnote 40] collected by local governments with non-ad-valorem
charges on their bills represented an estimated 72 percent of the
property taxes collected by local governments nationwide.[Footnote 41]
Of the local governments surveyed that included non-ad-valorem charges
on their bills, only 22 percent reported that they label such charges
as non-ad valorem.[Footnote 42] As a result, even if taxpayers owning
real estate in the other 78 percent of these locations review their tax
bills, they may not be able to identify which charges, if any, are non-
ad valorem and likely nondeductible.
Full Extent of Overstated Real-Estate Taxes from Claiming Nondeductible
Items Is Unknown Due to Data Limitations:
In identifying how much taxpayers may have overstated real-estate tax
deductions from individual taxpayers claiming nondeductible charges, we
encountered data limitations that constrained our analysis and made it
impossible to develop nationwide estimates of these overstatements.
[Footnote 43] Some of the main limitations follow:
* The jurisdictions we selected did not maintain their tax data in a
way that allowed us to itemize all of the charges on individuals' tax
bills. They also did not always maintain information on those charges
necessary for IRS and us to determine deductibility. As a result, we
were not able to account for all potentially nondeductible ad-valorem
charges. Similarly to the approach we took in our survey of local
governments, we categorized all ad-valorem charges as deductible and
all non-ad-valorem charges as nondeductible in identifying how much
taxpayers overstated their real-estate tax deductions.
* The selected jurisdictions also did not track the real-estate tax
liabilities and payments by individuals' Social Security number (SSN),
which is the unique identifier used in the IRS tax return data for each
taxpayer. Consequently, we used available information--name, address,
and zip code--to calculate for each taxpayer the total amount billed by
the local government and compare the amount billed to the amount
claimed as a real-estate tax deduction on Schedule A of the taxpayer's
return. This process was very time-and resource-intensive.[Footnote 44]
* We could not explicitly account for other income tax deductions or
adjustments to income that could influence the amount taxpayers are
eligible to claim on the Schedule A, such as the home-office deduction
and rental real-estate income.[Footnote 45] IRS did not have
information readily available on how much real-estate taxes taxpayers
in our case-study jurisdictions claimed as a home-office deduction, nor
did it have information on the locations of other rental real-estate
properties owned by a taxpayer, which could have been in multiple
jurisdictions. We aimed to mitigate these issues by only analyzing
records where (1) the amount claimed in the IRS data was roughly
equivalent to the total amount billed to the taxpayer in the local
government data, or (2) the amount claimed was less than 15 percent
greater than the total billed amount.[Footnote 46]
Because of these limitations, we were able to match only 42 percent of
the individuals (195,432 of 463,066) who itemized their real-estate tax
deductions on their tax returns to the data we received from two
counties, as table 1 shows (see appendix III for a more detailed
discussion of our methodology). The counties--Alameda County,
California and Hennepin County, Minnesota--were among the largest
taxing jurisdictions in the United States that had non-ad-valorem
charges, such as fees for services, special assessments, and special
district charges, on their real-estate tax bills in 2006.[Footnote 47]
Table 1: Taxpayer Records from Alameda County Data and Hennepin County
Data Matched to Tax Returns with Claimed Real-Estate Tax Deductions:
IRS records[A] with claimed real-estate tax deduction;
Alameda County: Number: 221,543;
Alameda County: Percent: 100.0;
Hennepin County: Number: 241,523;
Hennepin County: Percent: 100.0;
Total: Number: 463,066;
Total: Percent: 100.0.
County records matched to IRS records;
Alameda County: Number: 99,630;
Alameda County: Percent: 45.0;
Hennepin County: Number: 95,793;
Hennepin County: Percent: 39.7;
Total: Number: 195,423;
Total: Percent: 42.2.
Source: GAO analysis of IRS, Alameda County, and Hennepin County data.
[A] Each IRS record is based on an individual tax return for tax year
2006 with a real-estate tax deduction on Schedule A.
[End of table]
Table 2 shows that of the 195,423 matched taxpayer records in the two
counties, 56 percent, or 109,040 individuals had non-ad-valorem charges
on their local bills. However, over 99 percent of the Alameda County
bills had non-ad-valorem charges compared to only about 10 percent of
the Hennepin County bills.
Table 2: Matched Taxpayer Records with Non-Ad-Valorem Charges:
County records matched to IRS records;
Alameda County: Number: 99,630;
Alameda County: Percent: 100.0;
Hennepin County: Number: 95,793;
Hennepin County: Percent: 100.0;
Total: Number: 195,423; Total:
Percent: 100.0.
Matched records with non-ad-valorem charges;
Alameda County: Number: 99,521;
Alameda County: Percent: 99.9;
Hennepin County: Number: 9,519;
Hennepin County: Percent: 9.9;
Total: Number: 109,040;
Total: Percent: 55.8.
Source: GAO analysis of IRS, Alameda County, and Hennepin County data.
[End of table]
Taxpayers in Two Jurisdictions Collectively May Have Overstated
Millions of Dollars in Real-Estate Tax Deductions by Including
Nondeductible Charges:
Our analysis of the 109,040 individuals in the two counties who had non-
ad-valorem charges on their bills that could be matched to IRS data
indicates that almost 42,000 (38.3 percent) collectively overstated
their real-estate tax deductions by at least $22.5 million (i.e., "very
likely overstated") for tax year 2006. When one includes over 37,000
taxpayers who had non-ad-valorem charges and overstated their
deductions up to 15 percent greater than their total amounts billed in
2006 (i.e., "likely overstated") the amount of potential overstatement
increases to $46.2 million. Table 3 summarizes the results on
overstated deductions from claiming nondeductible charges for the two
counties.
Table 3: Number and Dollar Amounts of Likely Overstated Real-Estate Tax
Deductions by Individual Taxpayers in Alameda County and Hennepin
County for Tax Year 2006:
Alameda County:
Very likely overstated[A]: Number: 37,168;
Very likely overstated[A]: Dollars in millions: $20.9;
Likely overstated[B]: Number: 35,651;
Likely overstated[B]: Dollars in millions: $23.2;
Total: Number: 72,819;
Total: Dollars in millions: $44.1.
Hennepin County:
Very likely overstated[A]: Number: 4,603;
Very likely overstated[A]: Dollars in millions: $1.6;
Likely overstated[B]: Number: 1,494;
Likely overstated[B]: Dollars in millions: $0.5;
Total: Number: 6,097;
Total: Dollars in millions: $2.1.
Total:
Very likely overstated[A]: Number: 41,771;
Very likely overstated[A]: Dollars in millions: $22.5;
Likely overstated[B]: Number: 37,145;
Likely overstated[B]: Dollars in millions: $23.7;
Total: Number: 78,916;
Total: Dollars in millions: $46.2.
Source: GAO analysis of IRS, Alameda County, and Hennepin County data.
[A] We defined "very likely overstated" as those taxpayers who claimed
a deduction that is within $2 of total billed amount in 2006.
[B] We defined "likely overstated" as those taxpayers who claimed a
deduction that was greater than $1 less than the ad-valorem amount
billed in 2006 but less than 1.15 times the total billed amount.
[End of table]
While 72.4 percent of taxpayers (78,916 of 109,040) with non-ad-valorem
charges that we could match to tax returns overstated their real-estate
tax deduction, these overstated amounts on average only involved
amounts in the hundreds of dollars. According to our analysis, the
median "very likely" overstatement was $414 in Alameda County and $241
in Hennepin County. The median "likely" overstatement was $493 for
Alameda County and $179 for Hennepin County.
It is important to recognize that these overstated deduction amounts
are not the tax revenue loss. The tax revenue loss would be much less
and depend, in part, on the marginal tax rates of the individuals who
overstated their deductions as well as other factors that we did not
have the data or resources to model appropriately. Those factors would
include the amount of real-estate taxes and local-benefit taxes that
should be allocated to other schedules on the tax return and other
attributes such as the amount of refundable and nonrefundable credits.
As a result, while many taxpayers are erring in claiming nondeductible
charges, the small tax consequences of such overstatements may not
justify the cost of IRS enforcement efforts to pursue just these
claims.
Examinations of Real-Estate Tax Deduction Focus on Other Noncompliance
Rather Than on the Inclusion of Nondeductible Charges:
IRS's guidance to examiners does not require them to check
documentation to verify that the entire real-estate tax deduction
amount claimed on Schedule A of Form 1040 is deductible. Such
documentation would indicate whether taxpayers claim nondeductible
charges. Rather, IRS's guidance gives examiners discretion on which
documentation to request from taxpayers to verify the real-estate tax
deduction. Examiners are authorized to request copies of real-estate
tax bills, verification of legal property ownership, copies of canceled
checks or receipts, copies of settlement statements, and verification
and an explanation for any special assessments deducted. Because of the
discretion in the guidance, examiners are not required to request or
examine each form of documentation.
The guidance also does not direct examiners to look for all potentially
nondeductible charges in real-estate tax bills. Some IRS examiners we
interviewed considered Form 1098 for mortgage interest paid to be
appropriate documentation if the taxpayer failed to provide a real-
estate tax bill because this form could demonstrate that the taxpayer
paid the taxes through an escrow account set up with the mortgage
company. However, as noted earlier, Form 1098 shows payments to local
governments for all real-estate tax-related charges billed, including
any nondeductible charges. In other words, Form 1098 does not
conclusively demonstrate deductibility.
Rather than focusing on the nature of charges claimed, IRS examinations
of real-estate tax deductions focus on other issues, such as evidence
that the taxpayer actually owned the property and paid the real-estate
taxes claimed during the year in question. IRS examiners told us that
they focus on proof of ownership and payment because, in their
experience, taxpayer noncompliance with these requirements could result
in larger overstatements. For example, a taxpayer residing in the home
owned by his or her parent(s) could incorrectly claim the real-estate
tax deduction for the property. It is also common for first-time
homebuyers to improperly claim the full amount of real-estate taxes
paid for the tax year, even though the seller had paid a portion of
these taxes.
Examinations of the real-estate tax deduction usually take place as
part of a broader examination of inconsistent claims across the
individual tax return. In examining deductions on the Schedule A, IRS
examiners have found cases in which some taxpayers incorrectly include
real-estate taxes as personal-property taxes on Schedule A, sometimes
deducting the same tax charges as both personal-property taxes and real-
estate taxes. Furthermore, IRS examiners might find claims on other
parts of the return that prompt them to check the real-estate tax
claimed on Schedule A, or find overstated real-estate tax deductions on
Schedule A that indicate noncompliance elsewhere on the return. For
instance, a taxpayer might claim the real-estate tax deduction for
multiple properties on Schedule A, but fail to report any rental income
earned from these properties on the Schedule E form, which is used to
report income or loss from rental income.[Footnote 48] Also, a taxpayer
might claim the total amount of real-estate taxes paid on Schedule A,
but improperly claim these taxes again as part of the business expense
deductions on the Schedule E or Schedule C forms, or both.[Footnote 49]
IRS guidance instructs taxpayers to deduct only real-estate taxes paid
for their private residences on Schedule A, and to deduct any real-
estate taxes paid on rental properties on Schedule E. If taxpayers use
a part of their private residence as the principal place for conducting
business, they should divide the total real-estate taxes paid on the
property accordingly, with the portion of real-estate taxes paid for
the business deducted on Schedule C.
As noted earlier, the format and the level of detail about charges on
local real-estate bills vary greatly across local governments. IRS
examiners told us that they do not focus on the deductibility of most
real-estate charges when auditing real-estate tax deductions because
determining deductibility from looking at such bills can take
significant time and effort. They also said that when they detect
apparent nondeductible charges claimed in the real-estate tax
deduction, the amounts are usually small. As a result, the examiners we
interviewed generally contended that determining the deductibility of
every charge on a bill could be an inefficient use of IRS resources.
Examiners reasoned that the amount of nondeductible charges on a real-
estate tax bill would have to be quite high to justify an examination
and adjustment of tax liability.
IRS does not have information about which local governments are likely
to have large nondeductible charges on their real-estate tax bills. IRS
examiners also told us that if they had this information, they could
use it to target any examination of the real-estate tax deduction
toward large deductions claimed by taxpayers in these specific
jurisdictions. Several examiners told us that they look for large
nondeductible charges that are commonly claimed as real-estate taxes,
but they only know about these nondeductible items from personal
experience. For example, IRS examiners located in Florida and
California indicated that some taxpayers attempt to improperly deduct
large homeowners' association fees as part of the real-estate tax
deduction. Absent information about potentially nondeductible charges,
some examiners told us that when they are examining a real-estate tax
deduction, they might research taxpayer information accessible from the
respective county assessor's Web site, such as information about real-
estate bill charges, or from other databases, such as how many
properties a taxpayer owns and the amount of taxes paid for each
property.
Some Options Could Improve Compliance with the Real-Estate Tax
Deduction; Better Information Is Needed to Assess Other Options:
Various options could help address one or more of the identified
problems that make it hard for individual taxpayers to comply by only
claiming deductible charges when computing their real-estate tax
deduction, and improve IRS's ability to check compliance.[Footnote 50]
Given the general difficulty in determining deductibility, one option
would be to change the tax code. Changing the tax code could affect
both taxpayers who overstate and those who understate their deductions.
Depending on the public policy goals envisioned for the real-estate tax
deduction, policymakers may wish to consider changes to balance
achieving those goals and make it simpler for individuals to determine
how much of their total amount for local charges can be deducted.
Changing the law to help taxpayers correctly claim the deduction could
be done in different ways. However, assessing such changes to the law
and their effects was beyond the scope of this review. Thus, we have
not included nor will we further discuss in this report an option for
changing the tax code.
Assuming no statutory changes are made to clarify how much of local
charges on real-estate tax bills can be deducted, table 4 lists some
broad options under three areas involving improved information,
guidance, and enforcement to address the problems. The options we
discuss are concepts rather than proposals with details on
implementation and likely effects. These options would likely affect
both those taxpayers who overstate and those who understate their real-
estate tax deductions. A combination of these options would be needed
to address the four main problems.
Table 4: Options That Could Address Problems in Tax Compliance with and
the IRS Enforcement of the Real-Estate Tax Deduction:
Tax compliance and IRS enforcement problems addressed:
Options: More information: Local governments report deductible amounts
on: Information returns to taxpayers/IRS;
Deductibility of amounts not indicated: [Check];
Incomplete information on charges: [Check];
Incomplete guidance on deductibility: [Check];
Incomplete examination guidance: [Empty].
Options: More information: Local governments report deductible amounts
on: Local real-estate tax bills provided to taxpayers;
Deductibility of amounts not indicated: [Check];
Incomplete information on charges: [Check];
Incomplete guidance on deductibility: [Check];
Incomplete examination guidance: [Empty].
Options: More information: Local governments provide IRS with lists of
their charges on bills to use in determining deductibility;
Deductibility of amounts not indicated: [Check];
Incomplete information on charges: [Check];
Incomplete guidance on deductibility: [Check];
Incomplete examination guidance: [Empty].
Options: More information: Local governments change tax bills to show:
Ad-valorem charges;
Deductibility of amounts not indicated: [Empty];
Incomplete information on charges: [Check];
Incomplete guidance on deductibility: [Empty];
Incomplete examination guidance: [Empty].
Options: More information: Local governments change tax bills to show:
A disclaimer that some charges may not be deductible;
Deductibility of amounts not indicated: [Empty];
Incomplete information on charges: [Check];
Incomplete guidance on deductibility: [Empty];
Incomplete examination guidance: [Empty].
Options: Better guidance: IRS enhances its taxpayer guidance;
Deductibility of amounts not indicated: [Empty];
Incomplete information on charges: [Check];
Incomplete guidance on deductibility: [Check];
Incomplete examination guidance: [Empty].
Options: Better guidance: IRS reaches out to third parties on
disclaimers (i.e., nondeductible charges) and on IRS guidance;
Deductibility of amounts not indicated: [Empty];
Incomplete information on charges: [Check];
Incomplete guidance on deductibility: [Check];
Incomplete examination guidance: [Empty].
Options: Enhanced enforcement: IRS clarifies its examination guidance
on seeking evidence of deductibility;
Deductibility of amounts not indicated: [Empty];
Incomplete information on charges: [Empty];
Incomplete guidance on deductibility: [Empty];
Incomplete examination guidance: [Check].
Source: GAO analysis.
Note: Not all of the options in the table would have the same degree of
impact on the respective problem. For example, although the option of
having local governments include a total for the deductible amount on
real-estate tax bills after receiving assistance from IRS on
determining deductibility and the option of having local governments
include disclaimers on real-estate tax bills both address the problem
of incomplete information on charges, the first option would more
completely address the problem.
[End of table]
In considering the options, it is important to know how many individual
taxpayers claim nondeductible charges from real-estate tax bills and
how much federal revenue is lost. Such knowledge could signal how
urgently solutions are needed. However, the extent of taxpayer
noncompliance and related federal revenue loss is not known, and we
could not estimate this with the resources available for our review. If
many taxpayers overstate the deduction and the aggregate revenue loss
is high enough, pursuing options to reduce noncompliance would be more
important. Conversely, fewer taxpayers making errors and lower revenue
losses might lead to a decision to not pursue any options or only
options that have minimal costs and burdens. Ultimately, policymakers
in concert with tax administrators will have to judge whether concerns
about noncompliance justify the extent to which options, including
those on which we make recommendations, should be pursued to help
taxpayers comply.[Footnote 51]
Compliance could be measured in different ways, which could yield
better information at increasing cost. For example, IRS has research
programs that are designed to measure compliance. One option is to
modify IRS's National Research Program (NRP) studies that IRS planned
to launch in October 2007, which were designed to annually examine
compliance on about 13,000 individual tax returns. NRP staff could
begin to collect information through this annual study to compute how
much of the overall amount of noncompliance with claiming the real-
estate tax deduction is caused by taxpayers claiming nondeductible
charges.[Footnote 52] If pursued, IRS would need to consider how much
additional time and money to invest in its annual research to measure
taxpayer compliance in claiming only deductible charges in the real-
estate tax deduction. IRS also could consider focusing its compliance
efforts on local governments that put large nondeductible charges on
real-estate tax bills.
Lacking information on the potential compliance gains compared to
potential costs and burdens makes it difficult to assess whether most
options are justified. Even so, some of these options could improve
compliance with the real-estate tax deduction while generating lower
costs and burdens for IRS and third parties. Although we did not
measure the benefits and costs, the following discussion describes key
trade-offs to be considered for each option, such as burdens on IRS,
local governments, and other third parties, as well as implementation
barriers.
Providing More Information about Local Charges:
Taxpayers are responsible for determining which charges are deductible.
The burden to be fully compliant can be significant, depending on how
many charges are on the real-estate tax bill, how quickly information
can be accessed on how the charge is computed and used, and how long it
takes taxpayers to use that information to determine deductibility. In
the absence of data, a simple illustration can provide context,
recognizing that taxpayer experiences would vary widely. To illustrate,
if we use an IRS estimate that roughly 43 million taxpayers claimed the
real-estate tax deduction in 2006,[Footnote 53] and assume that each
taxpayer spent only 1 hour to access and use information about charges
on the bill to make determinations about deductibility,[Footnote 54]
then a total of 43 million taxpayer hours would be used to calculate
this deduction. If we further assume that the value of a taxpayer's
time averaged $30 per hour, which is the figure used by the Office of
Management and Budget,[Footnote 55] the value of this compliance burden
on taxpayers for the real-estate tax deduction would total $1.29
billion.
The options for providing information about the local charges generally
would lessen the burden on individual taxpayers while likely increasing
compliance levels. However, depending on the option, the burden would
shift to local governments. Although the local-government
representatives we interviewed did not have data on the costs for any
option and said that the costs and burdens could vary widely across
local governments, they had views on the relative burdens for each
option. Figure 3 provides a rough depiction of this burden shifting.
Figure 3: Relative Burden of Options to Provide Information on Local
Charges:
[Refer to PDF for image: illustration]
This illustration is an arrow depicting a continuum of burden in two
directions:
At the left end:
* Higher burdens for local governments, lower burdens for taxpayers;
* Highest likely compliance improvement.
At the right end:
* Higher burdens for taxpayers, lower burdens for local governments;
* Lowest likely compliance improvement.
Indicated from left to right on the continuum are the following
options:
Information reporting;
Changes to bills to identify what is deductable;
Provide IRS list of charges on bill;
Differentiate Ad Valorem items in bill from Non-Ad Valorem;
Disclaimer on deductibility.
Source: GAO.
[End of figure]
Local Governments Report Information on Deductible Charges:
Given the complexity of determining the federal deductibility of local
charges, a problem we found was that taxpayers are not told how much of
the total amount of charges on the local bill can be deducted. Two
options for reporting information on deductible charges are (1)
information reporting, or (2) changing the local real-estate tax bills.
[Footnote 56]
Information reporting on deductible amounts:
Requiring information reporting in which local governments determine in
their opinion which charges are federally deductible and report the
deductible amount to their taxpayers and to IRS would provide very
helpful information related to deductibility. A barrier to any
information reporting is that 19 of the 20 local-government tax
collectors that we interviewed did not maintain records by a unique
taxpayer identifier, such as the SSN. For IRS to check compliance in
claiming only deductible charges, IRS would need an unambiguous way of
matching the local data to the federal data, which traditionally relies
on the SSN. Local-government representatives said significant
challenges could arise in collecting and providing SSNs to IRS, given
concerns about privacy, and possible needed changes to state laws.
Local-government representatives that we interviewed viewed information
reporting as having the highest costs and burdens of the options that
we discussed for providing additional information to taxpayers. One
example of a potentially high cost that local governments would incur
is the cost associated with computer reprogramming to enable them to
report the information. One way to reduce the costs for many local
governments would be to require information reporting for larger local
governments only or for those that have nondeductible charges on their
real estate bills. Requiring information reporting only selectively
would eliminate the cost for some local governments, but would not
reduce the costs for those that still have to report to IRS and would
not eliminate concerns about providing the SSN.
Reporting deductible amounts on local real-estate tax bills:
Another option for providing taxpayers with information about
deductibility would be to report the deductible amounts on the local
government bills provided to taxpayers only. This would eliminate the
concerns about collecting and providing SSNs as well as the costs of
reporting to IRS. Local-government representatives we interviewed said
that their costs still could be high if major changes are required to
local computer systems and bills. For example, they might have to
regroup and to subtotal charges based on deductibility. Furthermore,
not all local governments provide a copy of their bills to taxpayers
who pay their real-estate taxes through mortgage escrow accounts. These
taxpayers would need to receive an informational copy of their bills or
be alerted to the nondeductible charges in some other manner.
Whether providing information on deductibility through information
reporting or changing local bills, a major concern for local
governments was determining deductibility. Local-government
representatives expressed concerns about local governments protecting
themselves from legal challenges over what is deductible, given the
judgment necessary to determine deductibility. Local-government
representatives and officials told us that local governments do not
want to become experts in the federal tax code and would oppose making
any determination of deductibility without assistance.
Providing a List to IRS on the Types of Charges on Local Real-Estate
Tax Bills:
Given local governments' concern about determining deductibility, local
governments could provide information to IRS about the types of charges
on their bills and IRS could use that information to help local
governments determine deductibility, reducing their burden and concern
somewhat while increasing costs to IRS. Even if IRS took on the
responsibility of determining the federal deductibility of local
government real-estate charges, local governments probably would still
need to be involved. The IRS officials that we spoke with for the
purpose of this job did not have extensive knowledge about charges on
local tax bills. Local-government representatives indicated that local
governments' willingness to work with IRS would greatly depend on IRS's
approach. After determining deductibility, IRS and local governments
could pursue cost-effective strategies for making information on
deductibility available to taxpayers, such as posting this information
on their respective Web sites.
IRS's processing costs could be large if tens of thousands of local
governments reported on many types of specific charges. Even if IRS had
some uniform format for local governments to use in reporting, the
amount of information to be processed likely would be voluminous and
diverse given variation in local charges. IRS also would incur costs to
analyze the information and work with local governments that appear to
have nondeductible charges. These IRS costs would vary with the breadth
and depth of involvement with the selected local governments. IRS could
mitigate costs if it could identify jurisdictions with significant
dollar amounts of nondeductible charges, and work only with those
jurisdictions.
Changing Real-Estate Tax Bills to Provide Information about Local
Charges:
In addition to not being given information on which local charges were
deductible, another problem we found was that taxpayers do not receive
enough information about the charges on real-estate tax bills to help
them determine how much to deduct. Knowing about the basis for the
charges, how the charges were used, and whether they applied across the
locality are key pieces of information that could help taxpayers
determine deductibility. We found that some local governments provided
some of this information on their real-estate tax bills but many did
not.
An alternative for informing taxpayers about local charges would be for
local governments to identify which charges on its tax bills are ad
valorem and non-ad valorem. Our work with IRS attorneys on the charges
on tax bills in five large counties indicated to us that non-ad-valorem
charges usually would be nondeductible because they generally are not
applied at a uniform rate across a locality. Similarly, many ad-valorem
charges would be deductible but with exceptions, such as when charges
were not applied at a uniform rate across the locality or when they
generated "local benefits" for the taxpayer. Because not all ad-valorem
charges are deductible and not all non-ad-valorem charges are
nondeductible, taxpayers still would be required to make the
determinations.
If taxpayers claimed only the ad-valorem charges listed on their bills,
compliance would likely improve for those who otherwise would deduct
the full bill amount that includes nondeductible charges. Local
governments that do not currently differentiate ad valorem from non-ad
valorem would incur costs that would vary with how much the bill needs
to change and the space available to report the information. However,
representatives of local governments with whom we spoke saw this option
as less burdensome than determining and reporting the deductible
amounts.
Changing Local Bills to Provide Disclaimers That Some Charges May Not
Be Deductible:
A final option involving information on local tax bills could generate
the lowest costs but would provide less information for taxpayers than
other options related to changing local tax bills. That option is for
local governments to place disclaimers on real-estate tax bills to
alert taxpayers that some charges may not be deductible for federal
income tax purposes.[Footnote 57] Local-government representatives said
that the direct costs would be minimal to the extent that the
disclaimer was brief and that space was available on the bill. Adding
pages or inserts to the bill would increase printing, handling, and
mailing costs. Because the disclaimers would not provide any
information to taxpayers to help them determine deductibility, some
taxpayers would likely seek that information by calling the local
governments. Handling a large volume of calls could be costly for local
governments.
Improving Guidance to Taxpayers:
Even if taxpayers were to receive more information about the local
charges on their real estate bills, we found that taxpayers may not
receive enough guidance from IRS and third parties to help them
determine how much to deduct and to alert them to the presence of
nondeductible charges. For example, although IRS's guidance to
taxpayers discusses what qualifies as deductible real-estate taxes, we
found a few areas in which it was incomplete given that determining
deductibility can be complex. Furthermore, third parties in the
mortgage and tax-preparation industries did not regularly alert
taxpayers through disclaimers and other information that not all
charges may be deductible.
Options for helping taxpayers to apply information in order to
determine which local charges are deductible include (a) enhancing
IRS's existing guidance to individual taxpayers, and (b) having IRS
engage in outreach to mortgage-servicer and tax-preparation industries
about nondeductible charges and about any enhanced IRS guidance.
Enhancing IRS's Guidance to Taxpayers:
Although IRS's guidance publications provided basic information to
taxpayers about what could be deducted as a real-estate tax and the
types of charges that could not be deducted, we found areas that, if
improved, might help some taxpayers to comply. Those include:
* placing a stronger disclaimer early in the guidance to alert
taxpayers about the need to check whether all charges on their real-
estate tax bill are deductible; across the IRS publications we
reviewed, such an explicit disclaimer either was made near the end of
the guidance or not at all;
* clarifying that a real-estate tax bill may not be sufficient evidence
of deductibility if the bill includes nondeductible charges that are
not clearly stated; our work showed that some bills could not be relied
upon to prove deductibility but we found nothing that explicitly told
taxpayers that they could not always rely on the bills as such
evidence; and:
* providing information or a worksheet on possible steps to take to
obtain information about whether bills include nondeductible charges
and what those charges are; to the extent that taxpayers may not know
where to find the information necessary to determine whether any
charges on their local bills are nondeductible, the guidance could
suggest steps to help taxpayers start to get the necessary information.
The cost of IRS enhancing its guidance would vary based on the extent
that IRS made changes in its written publications and electronic media,
but these changes would not necessarily be costly to make. Taxpayer
compliance could improve for those who have nondeductible charges on
their local bills but who are not aware about the nondeductible charges
and how to find them. Taxpayers also could spend some time and effort
to discover whether any of the local charges are nondeductible but that
time and effort would largely be a onetime investment unless the local
government changes the charges on the real estate bills from year to
year.
Having IRS Outreach to Third Parties on Disclaimers and IRS's Guidance:
IRS could conduct outreach to two types of third parties that provide
information or offer assistance to individual taxpayers about the real-
estate tax deduction. First, IRS could engage mortgage servicers in how
they might alert taxpayers that real-estate payments made through
escrow accounts could include nondeductible charges, including those
reported on IRS forms. The trade-offs discussed for putting disclaimers
on local real-estate tax bills would apply here as well. Mortgage
servicers would likely use a generic disclaimer on all escrow
statements because currently the servicers do not receive information
about nondeductible local charges that appear on the bills and usually
only receive total amounts to be paid. However, if mortgage servicers
happen to receive itemized information about local charges from local
governments, they could report these details on escrow statements to
inform taxpayers who may not receive a copy of their local real estate
bill because their local charges are paid through the escrow. Doing so
would generate some computing costs for the servicers.
Also, IRS could reach out to the tax-preparation industry--those who
develop tax-preparation software as well to those who help individuals
prepare their tax returns. The goals would be to ensure that those who
provide guidance to taxpayers are alerted to the potential presence of
nondeductible charges on real-estate tax bills and to ensure that they
understand IRS's guidance, particularly if it is enhanced. IRS also
could solicit ideas on ways to improve guidance to help individual
taxpayers. The tax-preparation software companies could incur some
costs if conversations with IRS result in revisions to their software.
Other types of tax preparers, such as enrolled agents, would likely not
incur many monetary costs but may experience resistance from individual
taxpayers who do not wish to comply.
Enhancing IRS Enforcement of Compliance:
If the implementation barriers to information reporting on this
deduction were resolved and local governments were required to report
information on real-estate taxes to IRS, IRS could expand its existing
computer-matching system to include the real-estate tax deduction. If
this option were chosen, IRS would incur the costs of processing and
checking the adequacy of the local data, developing matching criteria,
generating notices to taxpayers when significant matching discrepancies
arise, and providing resources to interact with taxpayers who respond
to the notices. However, such matching programs have proven to be
effective tools for addressing compliance.
IRS already conducts tens of thousands of examinations annually that
check compliance in claiming the real-estate tax deduction. IRS could
do more examinations of this deduction. However, the costs involved may
not be justified given the current lack of information about the extent
of noncompliance caused by claiming nondeductible charges and the
associated tax loss.
Given that IRS is already doing so many examinations that audit the
real-estate tax deduction, an option that could be less burdensome for
IRS would be to ensure that its examiners know about this issue of
nondeductible local charges whenever they are assigned to audit the
deduction. Specifically, IRS could require its examiners to verify the
deductibility of real-estate charges claimed whenever the examiners are
examining a real-estate tax deduction with potentially large, unusual,
or questionable nondeductible items.[Footnote 58] Currently, examiners
have the discretion to request evidence on the deductibility of real-
estate charges, but are not required to request it. Furthermore, the
guidance to examiners lists canceled checks, mortgage escrow
statements, Forms 1098 on mortgage interest amounts, and local
government real-estate tax bills as acceptable types of evidence of
deductibility. However, none of these documents necessarily confirm
whether all local charges can be deducted. Since IRS is already
examining the deduction, the marginal cost to IRS would stem from the
fact that some examinations might take slightly longer if examiners
take the time to ask taxpayers to provide the correct type of evidence
to substantiate their real-estate tax deduction. However, this cost
could be justified to ensure compliance with the existing law. IRS also
may incur some costs to expand its existing training if examiners are
not adequately informed about the deduction.
A Targeted Option to Improve Information, Guidance, and Enforcement:
We identified one option that cuts across the problems facing both
taxpayers and IRS and targets actions in the three areas of improving
information, guidance, and enforcement. As discussed earlier, local
governments could provide IRS a list of the types of charges on local
real-estate tax bills that IRS could then use to help local governments
determine deductibility if some charges appear to be nondeductible.
However, that would impose reporting costs on all local governments and
could inundate IRS with a lot of information to process, analyze, and
use.
In this crosscutting option, IRS would limit its data collection to
larger local governments that have apparent larger nondeductible
charges on their real-estate tax bills. Our work initially focused on
41 of the largest local governments because they were most likely to
have large property tax revenue and because smaller local governments
would have a harder time compiling the information.
IRS could choose from a number of ways to identify larger local
governments that appear to have larger nondeductible charges on their
bills. A starting point could be the Census data we used to identify
those local governments that collect the most property tax (see
appendix III of this report). Using these data, IRS could identify the
larger local governments on which IRS could focus its data-collection
efforts. For example, as an alternative to, or in addition to,
requiring local governments to report the types of charges listed on
their local bills, as discussed earlier, IRS could send a survey to
selected local governments;[Footnote 59] collect the data through its
annual NRP research on individual tax compliance for a sample of tax
returns; choose to do a separate research project; collect data from
annual operational examinations that touch on the real-estate tax
deduction; or query its employees on the types of charges on their own
local tax bills.
Having received information from local governments, IRS could identify
local governments whose bills have nondeductible charges that are large
and unusual enough to make noncompliance and larger tax revenue losses
likely to occur. Knowing which local governments have large
nondeductible charges, IRS could also consider whether and how to use
the data in a targeted fashion. IRS's costs would vary with the uses
pursued and the number of local governments involved. IRS could use
this data to:
* design compliance-measurement studies for those localities;
* begin outreach with these local governments to help determine
deductible charges and help affected taxpayers correctly compute the
deduction;
* target guidance such as mailings or public service announcements to
direct taxpayers to a list of nondeductible charges, or create a tool
to help taxpayers determine a deductible amount for a locality;
* outreach with other third parties such as tax preparers and mortgage
servicers to help them better inform[Footnote 60] and guide taxpayers;
and:
* check the real-estate tax deduction for individual tax returns that
have been selected for examination from taxpayers in those localities
or, at a minimum, use the information when considering whether to
examine one of these returns.
Conclusions:
To fully comply with the current federal law on deducting local real-
estate taxes, many individual taxpayers would need to apply significant
effort to determine whether all charges on a real-estate tax bill are
federally deductible. However, it is likely that some taxpayers do not
invest sufficient time or energy in trying to comply with federal law
for determining deductibility, or may not understand how to comply, or
both. Nevertheless, the total compliance burden taxpayers would bear to
properly comply is one useful reference point for judging the merits of
alternative means of increasing compliance.
Taxpayers are responsible for determining which charges are deductible,
and the burden to be fully compliant can be significant. This burden to
properly comply with current federal law could be shifted from
taxpayers to local governments, IRS, or third parties, or some
combination of each. Along a continuum, this burden shifting could be
major, such as through information reporting, or fairly minor, such as
through providing taxpayers with better information or guidance to help
them determine deductibility. In either case, taxpayer compliance is
likely to improve and the overall compliance burden to society could
possibly be lower to the extent that IRS, local governments, and other
third parties can reduce the costs of overall compliance through
economies of scale.
Because the extent of the compliance problem is not known and some of
the options we identified could significantly increase local-government
or IRS burdens in order to achieve significant compliance gains, a
sensible starting point is options that impose less burden shifting.
Providing taxpayers better guidance on how to comply, including the
information sources they need to consider, is among the least
burdensome and costly means to address noncompliance with the real-
estate tax deduction. Because taxpayers still would have to exercise
considerable effort to comply fully, improved guidance may not
materially reduce noncompliance. Providing taxpayers somewhat better
information, such as real-estate bills that clearly identify ad-valorem
and non-ad-valorem charges would shift more burden to local
governments, but likely would have a larger effect on reducing
noncompliance. Providing taxpayers traditional information reports,
that is, documents that clearly identify federally tax deductible
charges, would shift considerable burden to local governments and
possibly IRS, but also would considerably reduce taxpayers' compliance
burden and likely result in significant compliance gains. If local
governments, possibly with IRS assistance, could determine
deductibility for less cost than the sum of each taxpayer's costs in
doing so, the net compliance burden for society may go down even as
compliance increases.
Significant reductions in noncompliance might also be achieved with
minimum shifting of burdens through targeted use of the identified
options for addressing noncompliance. Targeting, however, requires
information about localities where there are significant risks of
taxpayers claiming large nondeductible charges. If IRS learned which
jurisdictions have the largest dollar amounts of nondeductible charges
on their bills, it could take a number of targeted actions, such as
outreach to the local governments to help them determine deductible
charges, targeted outreach to taxpayers in those jurisdictions to help
them correctly compute the deduction, targeted outreach to the tax-
preparation and mortgage-servicer industries, and targeted examinations
of the real-estate tax deduction in these localities. Low-cost options
are available to obtain this information, such as collecting tax bills
as part of examinations of the real-estate tax deduction that already
occur annually.
In terms of IRS's examinations, IRS could send a more useful signal to
taxpayers of the importance of ensuring that only deductible real-
estate taxes are claimed if IRS examinations more frequently covered
which charges are deductible. At a minimum, IRS can take steps to
ensure that its examiners know about the problems with nondeductible
charges and how to address the noncompliance.
Recommendations for Executive Action:
We are making 10 recommendations to the Commissioner of Internal
Revenue:
To enhance IRS's guidance to help individual taxpayers comply in
claiming the correct real-estate tax deduction, we recommend that the
Commissioner of Internal Revenue:
* place a stronger disclaimer early in the guidance to alert taxpayers
to the need to check whether all charges on their real-estate tax bill
are deductible;
* clarify that real-estate tax bills may be insufficient evidence of
deductibility when bills include nondeductible charges that are not
clearly stated; and:
* provide information or a worksheet on steps to take to get
information about whether bills include nondeductible charges and about
what those charges are.
To help ensure that individual taxpayers are getting the best
information and assistance possible from third parties on how to comply
with the real-estate tax deduction, we recommend that the Commissioner
of Internal Revenue reach out to:
* local governments to explore options for clarifying charges on the
local tax bills or adding disclaimers to these bills that some charges
may not be deductible;
* mortgage servicers to discuss adding disclaimers to their annual
statements that some charges may not be deductible; and:
* tax-preparation software firms and other tax preparers to ensure that
they are alerting taxpayers that some local charges are not deductible
and that they are aware of any enhancements to IRS's guidance.
To improve IRS's guidance to its examiners auditing the real-estate tax
deduction, we recommend that the Commissioner of Internal Revenue
revise the guidance to:
* indicate that evidence of deductibility should not rely on mortgage
escrow statements, Forms 1098, and canceled checks (which can be
evidence of payment), and may require more than reliance on a real-
estate tax bill; and:
* require examiners to ask taxpayers to substantiate the deductibility
of the amounts claimed whenever they are examining the real-estate tax
deduction and they have reason to believe that taxpayers have claimed
nondeductible charges that are large, unusual, or questionable.
To learn more about where tax noncompliance is most likely, we
recommend that the Commissioner of Internal Revenue:
* identify a cost-effective means of obtaining information about
charges that appear on real-estate tax bills in order to identify local
governments with potentially large nondeductible charges on their
bills; and:
* if such local governments are identified, obtain and use the
information, including uses such as compliance research focused on
nondeductible charges; outreach to such local governments to help them
determine which charges are deductible charges and help affected
taxpayers correctly compute the deduction; targeted outreach to the tax-
preparation and mortgage-servicer industries, and targeted examinations
of the real-estate tax deduction in the localities.
Agency Comments and Our Evaluation:
On April 22, 2009, IRS provided written comments on a draft of this
report (see appendix IV). IRS noted that the report accurately reflects
the difficulty that many taxpayers face when local jurisdictions
include nondeductible charges on real-estate tax bills, particularly
when these charges can vary and are not described in detail. IRS also
noted that determining deductibility can be complex and that neither
the local real-estate tax bills nor mortgage service documents tell
taxpayers what amounts are deductible.
IRS agreed with 7 of our 10 recommendations and identified actions to
implement them. Specifically, IRS agreed with 2 recommendations on
enhancing guidance to taxpayers, saying it would change various
publications to (1) highlight an alert to taxpayers to check for
nondeductible charges on their real-estate tax bills and (2) caution
that the bills may be insufficient evidence of deductibility.
IRS also agreed with three recommendations on outreach to third parties
to ensure that taxpayers are getting the best information possible to
comply in claiming the real-estate tax deduction. IRS agreed to contact
local governments, mortgage servicers, and tax software firms to
explore options to alert taxpayers that some charges might not be
deductible. IRS also said it would work with local governments to
clarify charges on their real-estate tax bills.
Further, IRS agreed with two recommendations on learning more about
where noncompliance in claiming nondeductible charges is most likely
and then taking action to improve compliance. IRS agreed to identify a
cost-effective way to identify local governments that have potentially
large nondeductible charges on their real-estate tax bills. After
identifying these local governments, IRS also agreed to reach out to
them to help determine the deductibility of their charges and help the
affected taxpayers correctly claim the deduction. As part of this set
of actions, IRS agreed to reach out to the tax preparation and mortgage
servicing industries with customers in these localities.
IRS disagreed with three recommendations. However, for one of the
recommendations, IRS did agree to take action consistent with the
intent of the recommendation. We recommended that IRS enhance its
guidance to taxpayers by providing information or a worksheet on steps
taxpayers could take to find out if any charges on a real-estate tax
bill are nondeductible. IRS said its Publication 17 already had a chart
providing guidance on which real-estate taxes can be deducted but
agreed to add a caution advising taxpayers that they must contact the
taxing authority if more information is needed on any charge. We
believe such an action will enhance IRS's current education efforts
related to this issue and may help improve taxpayer compliance,
especially if the addition provides guidance on situations in which a
taxpayer may need to contact the taxing authority.
The other two recommendations IRS disagreed with related to improving
IRS's guidance to its staff who audit the real-estate tax deduction.
IRS did not agree to revise the guidance to clarify that mortgage
escrow statements, canceled checks, Forms 1098, and real-estate tax
bills may not be sufficient evidence of deductibility. IRS also did not
agree that examiners should ask taxpayers for evidence of deductibility
whenever they are auditing the deduction and believe that the taxpayers
have claimed nondeductible charges that are large, unusual, or
questionable. IRS said that the guidance for examiners is sufficient
and that examiners are to use their judgment and consider all available
evidence in coming to a determination.
We appreciate that examiners must exercise judgment about the scope of
an audit. However, in reviewing over 100 examination files and in
talking with examiners, we found that not all examiners focus on the
deductibility of the real-estate charges or ask the taxpayer for
adequate evidence of deductibility, even in situations where
deductibility may be in question. Therefore, when examiners have reason
to believe that taxpayers claimed nondeductible charges that are large,
unusual, or questionable, we continue to believe they should ask
taxpayers for adequate support. We also continue to believe that the
guidance to examiners should clearly state that real-estate bills
should be examined and that other information on the nature and purpose
of tax bill charges may also be needed. This improved guidance may be
especially pertinent when IRS has implemented our recommendations to
identify local governments with large nondeductible charges on their
bills and to take related actions to help taxpayers comply. If IRS does
targeted examinations of taxpayers in those localities, the IRS
examiners will need to clearly understand what evidence is required to
determine the deductibility of the various charges on the real-estate
bills to ensure that taxpayers are correctly claiming the real-estate
tax deduction.
As agreed with your office, 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, Senate Committee on Finance; Chairman and Ranking
Member, House Committee on Ways and Means; the Secretary of the
Treasury; the Commissioner of Internal Revenue; and other interested
parties. This report will be available at no charge on the GAO Web site
at [hyperlink, http://www.gao.gov].
If you or your staff have any questions, please contact me at (202) 512-
9110 or brostekm@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 found in
appendix V.
Signed by:
Michael Brostek:
Director, Tax Issues Strategic Issues Team:
[End of section]
Appendix I: Methodology for Survey of Local Governments:
To learn about real-estate tax billing practices and the proportion of
local government entities with potentially nondeductible charges on
their real-estate tax bills, we conducted a mail-based sample survey of
1,732 local governments primarily responsible for collecting real-
estate taxes due on residential properties. In designing the sample for
our survey, we used the survey population of the U.S. Census Bureau's
Quarterly Property Tax Survey (QPTS) as our sample frame. The QPTS is a
mail survey the Governments Division of the U.S. Census Bureau conducts
quarterly to obtain information on property taxes collected at the
local governmental level.[Footnote 61] The QPTS is part of a larger
data-collection effort that the Census Bureau conducts in order to make
estimates of state and local tax revenue. According to QPTS data,
14,314 local governments bill for property taxes.
The QPTS itself uses a stratified, one-stage cluster sample of local
governments in 606 county areas with 16 strata.[Footnote 62] In
designing a sample based on the QPTS for our survey, we also used a
stratified, one-stage cluster design. Specifically, of the 606 county
areas included in the QPTS sample, we selected 192 county areas
representing 18 strata.[Footnote 63] Our sub-sample consists of a
random selection of approximately 30 percent of the county areas in the
18 GAO strata with a minimum of 5 county areas selected in each
stratum. All of the local governments within the selected county areas
are included in the sample. The total number of local governments
included in the sample was 1,732. Before constructing our sample, we
checked to make sure that QPTS sample data provided to us by the Census
Bureau were internally consistent and reliable for our purposes.
In our survey, we asked the local governments whether they included non-
ad-valorem charges on their real-estate tax bills, how they
differentiated non-ad-valorem charges from ad-valorem charges, and
whether and how they alerted taxpayers to the presence of non-ad-
valorem charges on the bills. We also asked the local governments for a
sample residential real-estate tax bill that included information about
all possible charges for which property owners in that jurisdiction
could be billed.
We conducted two pretests of our draft survey instrument with officials
from Alexandria, Virginia, and Montgomery County, Maryland, to ensure
that (1) the survey did not place an undue burden on the respondent's
time, (2) the questions and terminology were clear and unambiguous, (3)
the respondents were able to obtain data necessary to answer the survey
questions, and (4) our method for requesting sample bills matched any
preferences offered by the respondents.
In late April 2008, we mailed questionnaires to our survey sample
population using addresses of the local government entities provided to
us from the Census Bureau's Governments Division. At the end of May, we
sent a reminder letter with an additional copy of the questionnaire to
all governments in our survey from which we had not yet received a
response. If a survey respondent's answers required clarification
(e.g., if a respondent did not follow the directions given in the
survey), a follow-up call was conducted. Survey answers were then
edited to reflect the additional information obtained in the calls.
Of the 1,732 surveys sent, we received 1,450 responses for an
unweighted response rate of 84 percent. Response rates for the
jurisdictions in each of our 18 strata ranged from 67 percent to 100
percent. All percentage estimates from our survey are surrounded by 95
percent confidence intervals.
In addition to sampling error, the practical difficulties of conducting
any survey may introduce errors commonly referred to as nonsampling
errors. For example, difficulties in how a particular question is
interpreted, in the sources of information that are available to
respondents, or in how the data are entered into a database or were
analyzed, can introduce unwanted variability into the survey results.
We took steps in the development of the questionnaire, the data
collection, and the data analysis to minimize these nonsampling errors.
For example, a social science survey specialist helped us design the
questionnaire. Then, as stated earlier, the draft questionnaire was
pretested with two local jurisdictions. Data entry was conducted by a
data entry contractor and a sample of the entered data was verified.
Finally, when the data were analyzed, independent analysts checked all
computer programs.
[End of section]
Appendix II: Methodology for Review of Real-Estate Tax Bills:
One of the objectives of this report was to describe factors that
contribute to the inclusion of nondeductible items in real-estate tax
deductions. In our 1993 report, we determined that one cause of
taxpayers overstating their deductions was confusing real-estate tax
bills that don't clearly distinguish taxes from user fees.[Footnote 64]
To update our previous work and to determine the extent to which real-
estate tax bills currently distinguish between taxes on real property
and user fees, we reviewed a sample of real-estate tax bills from local
governments across the United States. This appendix outlines the
methodology that we used to review these bills.
The sample of real-estate tax bills that we reviewed was a subset of
the responses to our mailed survey of local governments, which was a
stratified, random sample of 1,732 localities (see appendix I). A
question in our survey asked whether the local government included non-
ad-valorem items in their bills, which are generally nondeductible. In
another part of our survey, we asked respondents to attach a sample of
a real-estate tax bill to their completed survey. We received a total
of 1,450 responses to our survey. We did not generalize the results of
this bill review because not all survey respondents provided bills as
requested,[Footnote 65] and because we did not know how the bills that
were submitted had been selected by the respective responding
governments.[Footnote 66] We received over 643 bills from governments
which included nondeductible charges on their bills. Of these bills, we
deemed 486 to be usable.[Footnote 67] We performed two reviews of the
usable bills.
First, we used three criteria to determine if a real-estate tax bill
clearly distinguished taxes from user fees:
1. Does the bill differentiate ad-valorem from non-ad-valorem charges?
2. Are all the charges in the bill clearly identified and explained?
3. Does the bill contain a disclaimer warning that some of the charges
included in the real-estate tax bill may not be deductible for federal
tax purposes?
A bill met our first criterion if either of the following applied:
* The bill differentiated by labeling each item as ad valorem or non-ad
valorem.
* The bill provided millage rates for items.[Footnote 68]
A bill met our second criterion if all of the line items were
individually broken out AND either of the following applied:
* Line item descriptions were spelled out and clearly identified.
* Additional information or explanations regarding line items are
available in paper form or electronically.
A bill met our third criterion if either of the following applied:
* The bill contained a disclaimer stating that all items appearing on
the bill may not be deductible.
* The bill contained a disclaimer stating that taxpayers should consult
IRS code and publications or their tax advisor for assistance in
determining deductibility.
Through our review, we found that about 60 percent of the bills
satisfied our first criterion, with almost all of these using millage
rates to differentiate ad-valorem from non-ad-valorem charges. Only
about 30 percent of bills satisfied our second criterion. The main
reason bills did not meet our second criterion was because line-item
descriptions were not easily identifiable (e.g., a taxpayer could not
determine the respective charge's use based solely on the information
on the bill). None of the bills satisfied our third criterion.
In our second bill review, we determined whether the real-estate tax
bills provided taxpayers with either of the following:
* A total for the charges that are deductible for federal income tax
purposes.
* A warning that some of the charges on the bill may be nondeductible
for federal income tax purposes.
* Of the 486 usable bills we reviewed, none satisfied either of these
two criteria.[Footnote 69]
Although our sample of real-estate tax bills is not representative of
local governments nationally, the results of our review illustrate that
many taxpayers would face challenges in determining what is deductible
if they were to rely solely on the information provided on their real-
estate tax bills.
[End of section]
Appendix III: Methodology for Case Studies of Taxpayer Noncompliance:
This appendix describes the methodology, including sample selection, we
used to (1) determine the deductibility of charges on tax bills in five
counties: Alameda County, California; Franklin County, Ohio; Hennepin
County, Minnesota; Hillsborough County, Florida; King County,
Washington; and (2) calculate the extent of overstated deductions in
two of those counties--Alameda County, California and Hennepin County,
Minnesota--for tax year 2006.
Sample Selection:
We derived our list of local governments that collect property taxes
from the survey population of the U.S. Census Bureau's Quarterly
Property Tax Survey (QPTS). The QPTS sample consists of local
governments in 606 county areas[Footnote 70] with 312 of those counties
selected with certainty. The 312 counties had a population of at least
200,000 people and annual property taxes of at least $100 million in
1997. We decided that large counties would be best for this study
because they were more likely to have large property tax revenue and to
maintain property tax data in electronic formats that we could more
easily obtain and manipulate than paper records. We started with the 41
largest counties based on property tax revenue. We randomly sorted
these 41 large collectors and picked the first 5 from the sorted list
that fit the team's inclusion criteria:
(1) presence of user fees, special assessments, special district taxes,
or other non-ad-valorem items on real-estate tax bills for most or all
residential property owners;[Footnote 71]
(2) willingness of the local government to participate; and:
(3) usability and reliability of the data.
Using these criteria, we selected Alameda County, California; Franklin
County, Ohio; Hennepin County, Minnesota; Hillsborough County, Florida;
and King County, Washington for our initial analyses.[Footnote 72]
Deductibility Determinations:
We collaborated with officials from the Internal Revenue Service's
(IRS) Office of Chief Counsel to determine the deductibility of charges
on the five counties' real-estate tax bills. IRS agreed to review
information we provided about the charges on these tax bills in order
to provide an opinion on the deductibility of the charges. IRS did not
seek additional information from the counties regarding the charges,
and IRS based its determinations solely on the materials we submitted.
Additional information could result in conclusions different from those
IRS reached as a result of the data we provided IRS.
Prior to assembling information for IRS's review, we interviewed
officials from IRS's Office of Chief Counsel to gain a better
understanding of what information IRS needed to make the
determinations. IRS officials provided a list of the types of
information they would need to determine whether a particular
assessment levied by a taxing jurisdiction was a deductible real-
property tax. Specifically, IRS asked us to provide information related
to the following for each charge:
(1) Is the tax imposed by a State, possession, or political subdivision
thereof, against interests in real property located in the jurisdiction
for the general public welfare?
(2) Is the assessment an enforced contribution, exacted pursuant to
legislative authority in the exercise of the taxing power? Is payment
optional or avoidable?
(3) The purpose of the charge. Is it collected for the purpose of
raising revenue to be used for public or governmental purposes?
(4) Is the tax assessed against all property within the jurisdiction?
(5) Is the tax assessed at a uniform rate?
(6) Whether the payer of the assessment is entitled to any privilege or
service as a result of the payment. Is the assessment imposed as a
payment for some special privilege granted or service rendered? Is
there any relationship between the assessment and any services provided
or special privilege granted?
(7) Is use of the funds by the tax authority restricted in any way? Are
the funds earmarked for any specific purpose?
(8) Is the assessment for local benefits of a kind tending to increase
the value of the property assessed? Does the assessment fund
improvements to or benefiting certain properties or certain types of
property? If so, is a portion of the assessment allocable to separately
stated interest or maintenance charges?
IRS officials also indicated that the following materials would be
helpful in making their determinations:
(1) A copy of the statute imposing the tax.
(2) Materials published by the local government or tax-collecting
authority describing the levy, including taxpayer guides, publications,
or manuals describing the tax.
(3) The forms and instructions relating to the tax.
(4) A printed copy of the Web pages maintained by the jurisdictions
related to the tax.
To collect this information, we interviewed county officials and
reviewed documentation either provided by county officials or found on
county Web sites. Most of the selected counties' Web sites provided tax
rate tables or a list of the taxing authorities for the ad-valorem
charges found on the tax bills; some also had information for the non-
ad-valorem charges. For each of the year 2006 tax bill charges, we
searched the counties' Web sites and used online search engines to
collect supporting documentation. We also searched state constitutions
and statutes to identify the legal authority for each charge on real-
estate tax bills; to a varying degree, county officials provided
citations to the specific statutes that provided the legislative
authorities for the charges. In addition to the real-estate tax
information found online, we interviewed local tax officials in each of
the five local counties to gather the requested information.
Based on the materials we submitted, IRS concluded that some charges
were deductible, some were nondeductible, and others required
information for IRS to determine their deductibility. Table 1 below
summarizes the results of IRS's determinations.
Table 5: Summary of IRS's Deductibility Determinations for Five
Selected Jurisdictions:
IRS determination regarding charges on 2006 tax bills: Bills contained
deductible ad-valorem charges;
Local jurisdiction: Alameda County, CA: [Check];
Local jurisdiction: Hennepin County, MN: [Check];
Local jurisdiction: Hillsborough County, FL: [Check];
Local jurisdiction: King County, WA: [Check];
Local jurisdiction: Franklin County, OH: [Check].
IRS determination regarding charges on 2006 tax bills: Bills contained
nondeductible ad-valorem charges;
Local jurisdiction: Alameda County, CA: [Empty];
Local jurisdiction: Hennepin County, MN: [Check];
Local jurisdiction: Hillsborough County, FL: [Check];
Local jurisdiction: King County, WA: [Check];
Local jurisdiction: Franklin County, OH: [Check].
IRS determination regarding charges on 2006 tax bills: Additional
information required for IRS to make a determination about at least one
ad-valorem charge on the bills;
Local jurisdiction: Alameda County, CA: [Check];
Local jurisdiction: Hennepin County, MN: [Check];
Local jurisdiction: Hillsborough County, FL: [Empty];
Local jurisdiction: King County, WA: [Check];
Local jurisdiction: Franklin County, OH: [Empty].
IRS determination regarding charges on 2006 tax bills: Bills contained
nondeductible non-ad-valorem charges;
Local jurisdiction: Alameda County, CA: [Check];
Local jurisdiction: Hennepin County, MN: [Check];
Local jurisdiction: Hillsborough County, FL: [Check];
Local jurisdiction: King County, WA: [Check];
Local jurisdiction: Franklin County, OH: [Check].
Source: GAO analysis of IRS data.
[End of table]
Computation:
Using IRS data on real-estate tax deductions claimed by taxpayers in
the selected counties and county data on real-estate taxes billed to
property owners, we identified how much taxpayers likely overstated
their real-estate tax deductions by claiming nondeductible charges in
two counties--Alameda County, California, and Hennepin County,
Minnesota--for tax year 2006. We restricted our analysis to these two
counties due to limitations in resources. While taxpayers can claim
deductions for real-estate taxes paid on multiple IRS schedules, we
limited our analysis to the amount claimed on IRS Form 1040, Schedule
A, which generally does not include deductions for real estate used for
business purposes.
We used the SAS SQL procedure (PROC SQL) to merge the IRS data to the
tax-roll data we received from our two selected counties. To conduct
the match, we parsed the last name, first name, street address, city,
state, and zip code from the IRS data and the local data. We
conditioned the PROC SQL merge to include in the output data set only
those records in which the parsed first names, last names, and zip
codes matched.
Prior to the match, we controlled for taxpayers who own multiple
properties within each of our selected jurisdictions by using a unique
identifier for each taxpayer and subtotaling the taxpayers' ad-valorem
and non-ad-valorem charges by the unique identifier. To the extent we
were able, we used existing, numerical identifiers in the data--such as
property number and account numbers--to produce a subtotal for each
taxpayer. When the numeric identifiers available in the data were not
available, we used the parsed name and address fields to create a
unique identifier.
After the PROC SQL merge, we controlled for duplicate records by
keeping only those records where the last name, first name, street
address, city, state, and zip codes matched. It is still possible that
some duplicates exist in the data, since the names and address fields
were recorded in disparate ways in the data we received from the
counties. We used programming logic to parse the names; due to the
inconsistencies in the names and address fields in the data, the name
and address information may not have parsed the same way for all
taxpayers.
For each taxpayer that we were able to match to the county data, we
compared the amount the taxpayer claimed as a real-estate tax deduction
on the Schedule A return to the total ad-valorem amount each taxpayer
was billed by the county and which was due in 2006. We then calculated
the difference between the amount claimed on Schedule A and the ad-
valorem portion of the amount billed by the county for each taxpayer.
As indicated above, we worked with IRS to determine which charges
billed by the county were deductible under federal tax law. The
counties we selected for analysis did not maintain their tax data in a
way that would allow us to itemize all of the charges, particularly the
ad-valorem charges, on individuals' tax bills. As a result, we were not
able to take into account ad-valorem charges that may not be deductible
in our lower-bound computation of overstated real-estate tax
deductions. Instead, we used the ad-valorem portion of the amount
billed as a proxy for the deductible amount. While the proxy is
imperfect, it is our understanding that the non-ad-valorem charges in
our selected counties were not imposed at a uniform rate and thus did
not appear to be deductible as taxes under Section 164 of the Internal
Revenue Code. Given the limitations of the data, this approach allowed
us to take into account those charges that are least likely to be
deductible. Also, the approach produced a lower-bound computation of
potential noncompliance in our two counties. We can only produce a
lower-bound computation due to uncertainty of noncompliance for those
taxpayers where we could not match IRS and local records.
To develop the lower-bound computations of potential noncompliance, we
excluded those taxpayers whose claimed deduction was greater than 1.15
times the total amount billed; this was chosen as a cutoff point to
account for taxpayers who may own multiple properties and therefore
deduct on their federal tax return a higher amount than is shown on the
local tax bills. We also excluded taxpayers whose claimed deduction was
less than the ad-valorem portion of the amount billed by the county
(within a small margin of error), since we did not have conclusive data
to determine whether the taxpayers held only a partial ownership in the
real estate covered by the local bill.
We then summed the difference between the claimed Schedule A deduction
and the ad-valorem portion of the amount billed by the county to
develop a lower-bound computation of noncompliance for the population
of taxpayers in each county that we were able to match to the county
data.
For the purposes of our analysis, we created two separate categories
for those taxpayers who claimed a deduction that was approximately
equal to the billed amount up to 1.15 times the total amount billed. We
defined those taxpayers who claimed a deduction within $2 of the full
amount billed, when the bill contained non-ad-valorem amounts, as "very
likely overstated." We defined those taxpayers who claimed a deduction
that was greater than $1 less than the total ad-valorem amount billed
but less than 1.15 times the total billed amount as "likely
overstated."
Results:
Table 6: Summary of Taxpayer Records Matched from IRS Data to Alameda
County Data and Hennepin County Data for 2006:
Records[A] In IRS data:
Alameda County: 221,524;
Hennepin County: 241,523.
Records matched from county data to IRS data:
Alameda County: 99,630;
Hennepin County: 95,793.
Matched records not included in analysis because amount claimed lower
than $2 less than total billed amount or $1 less than the ad-valorem
amount billed:
Alameda County: 12,814;
Hennepin County: 23,597.
Matched records not included in analysis because amount claimed higher
than 1.15 times total billed amount:
Alameda County: 13,940;
Hennepin County: 11,603.
Matched records with non-ad-valorem charges;
Alameda County: 99,521;
Hennepin County: 9,519.
Matched records with non-ad-valorem charges not included in analysis
because amount claimed lower than $2 less than total billed amount or
$1 less than the ad-valorem amount billed:
Alameda County: 12,806;
Hennepin County: 2,367.
Matched records with non-ad-valorem charges not included in analysis
because amount claimed higher than 1.15 times total billed amount:
Alameda County: 13,896;
Hennepin County: 1,055.
Source: GAO analysis of IRS, Alameda County, and Hennepin County data.
[A] Each IRS record is based on an individual tax return for tax year
2006 with a real-estate tax deduction on Schedule A.
[End of table]
Table 7: Number and Dollar Amounts of Likely Overstated Real-Estate Tax
Deductions by Individual Taxpayers in Alameda County and Hennepin
County for Tax Year 2006:
Alameda County:
Very likely overstated[A]: Number: 37,168;
Very likely overstated[A]: Dollars in millions: $20.9;
Likely overstated[B]: Number: 35,651;
Likely overstated[B]: Dollars in millions: $23.2;
Total: Number: 72,819; Total:
Dollars in millions: $44.1.
Hennepin County:
Very likely overstated[A]: Number: 4,603;
Very likely overstated[A]: Dollars in millions: $1.6;
Likely overstated[B]: Number: 1,494;
Likely overstated[B]: Dollars in millions: $0.5;
Total: Number: 6,097;
Total: Dollars in millions: $2.1.
Total:
Very likely overstated[A]: Number: 41,771;
Very likely overstated[A]: Dollars in millions: $22.5;
Likely overstated[B]: Number: 37,145;
Likely overstated[B]: Dollars in millions: $23.7;
Total: Number: 78,916;
Total: Dollars in millions: $46.2.
Source: GAO analysis of IRS, Alameda County, and Hennepin County data.
[A] We defined "very likely overstated" as those taxpayers who claimed
a deduction that is within $2 of total billed amount in 2006.
[B] We defined "likely overstated" as those taxpayers who claimed a
deduction that was greater than $1 less than the ad-valorem amount
billed in 2006 but less than 1.15 times the total billed amount.
[End of table]
[End of section]
Appendix IV: Comments from the Internal Revenue Service:
Department Of The Treasury:
Deputy Commissioner:
Internal Revenue Service:
Washington, D.C. 20224:
April 22, 2009:
Mr. Michael Brostek:
Director, Tax Issues Strategic Issues Team:
U.S. Government Accountability Office:
441 G Street, N.W.
Washington, D.C. 20548:
Dear Mr. Brostek:
I reviewed your draft GAO report entitled Real Estate Tax Deduction:
Taxpayers Face Challenges in Determining What Qualifies; Better
Information Could Improve Compliance: (GAO-09-521). The report
accurately reflects the difficulty many taxpayers face when their local
jurisdictions include nondeductible charges on their tax bills. These
charges can vary across local jurisdictions and are often not described
in detail on real estate tax bills.
As noted in your report, you surveyed a sample of 1,700 local
communities and studied compliance in two jurisdictions. You found that
neither local government tax bills nor mortgage service documents
identify what taxpayers can properly deduct. As you indicate, without
this information, determining deductibility can be complex and involve
significant effort. Any significant compliance improvement in this area
would require local and other jurisdictions to review and revise their
current bills, which they may not be able or willing to do. In order to
enhance our current educational and outreach efforts on this issue, we
will add a caution to the instructions for Schedule A (Form 1040),
Itemized Deductions, advising taxpayers to look closely at their real
estate tax bills, as some items may not be deductible, and to contact
the taxing authority if they have any questions.
Responses to your specific recommendations are enclosed. We appreciate
the continued and valuable support from you and your staff on this
issue. If you have any questions, or would like to discuss this
response in more detail, please contact Don Mainwaring, Director,
Reporting Compliance, Wage and Investment Division, at (404) 338-8983.
Sincerely,
Signed by:
Linda E. Stiff:
Enclosure:
[End of letter]
Enclosure:
Recommendation:
To enhance IRS's guidance to help individual taxpayers comply in
claiming the correct real-estate tax deduction, we recommend that the
Commissioner of Internal Revenue: place a stronger disclaimer early in
the guidance to alert taxpayers to the need to check whether all
charges on their real-estate tax bill are deductible.
Comment:
The IRS agrees with this recommendation. Publication 17, Your Federal
Income Tax (For Individuals), and Publication 530, Tax Information for
First-Time Homeowners, contain a caution advising taxpayers they must
look at their real estate tax bill to determine if any nondeductible
charges are included in the bill. The IRS will add this caution to the
instructions for Schedule A, (Form 1040) Itemized Deductions.
Recommendation:
To enhance IRS's guidance to help individual taxpayers comply in
claiming the correct real-estate tax deduction, we recommend that the
Commissioner of Internal Revenue: clarify that real-estate tax bills
may be insufficient evidence of deductibility when bills include
nondeductible charges that are not clearly stated.
Comment:
The IRS agrees with this recommendation. As discussed above, the IRS
will add a caution to the instructions for Schedule A (Form 1040),
Itemized Deductions. This information, in addition to guidance
currently available to taxpayers in various publications, should
further clarify this issue.
Recommendation:
To enhance IRS's guidance to help individual taxpayers comply in
claiming the correct real-estate tax deduction, we recommend that the
Commissioner of Internal Revenue: provide information or a worksheet on
steps to take to get information about whether bills include
nondeductible charges and about what those charges are.
Comment:
The IRS does not agree with this recommendation. This information is
provided in the 2008 Publication 17 in a chart on page 149 entitled
"Which Taxes Can You Deduct?" The chart lists various items you either
can or cannot deduct for the different taxes, and includes links to
obtain additional information. In order to further educate taxpayers,
the IRS will add the following sentence to the caution in Publication
17, Publication 530, and the instructions for Schedule A (Form 1040),
which advises taxpayers they must look at their real estate tax bill to
determine if any nondeductible charges are included in the bill:
"Contact the taxing authority if you need additional information about
a specific charge on your real estate tax bill."
Recommendation:
To help ensure that individual taxpayers are getting the best
information and assistance possible from third parties on how to comply
with the real-estate tax deduction, we recommend that the Commissioner
of Internal Revenue reach out to local governments to explore options
for clarifying charges on the local tax bills or adding disclaimers to
these bills that some charges may not be deductible.
Comment:
The Wage and Investment Division (W&I) will coordinate with Small
Business/Self Employed Division (SB/SE) Communications, Liaison and
Disclosure (CLD) to explore options with local governments to clarify
charges on the local tax bills or adding disclaimers to these bills
that some charges may not be deductible.
Recommendation:
To help ensure that individual taxpayers are getting the best
information and assistance possible from third parties on how to comply
with the real-estate tax deduction, we recommend that the Commissioner
of Internal Revenue reach out to mortgage escrow firms to discuss
adding disclaimers to their annual statements that some charges may not
be deductible.
Comment:
The W&I Division will coordinate with SB/SE CLD to explore options with
mortgage escrow firms to add disclaimers to these bills that some
charges may not be deductible.
Recommendation:
To help ensure that individual taxpayers are getting the best
information and assistance possible from third parties on how to comply
with the real-estate tax deduction, we recommend that the Commissioner
of Internal Revenue reach out to tax preparation software firms and
other tax preparers to ensure that they are alerting taxpayers that
some local charges are not deductible and that they are aware of any
enhancements to IRS' guidance.
Comment:
The W&I Division will explore options with tax preparation software
firms and other tax preparers to ensure they are alerting taxpayers
that some local charges are not deductible.
Recommendation:
To improve IRS's guidance to its examiners auditing the real-estate tax
deduction, we recommend that the Commissioner of Internal Revenue
revise the guidance to: indicate that evidence of deductibility should
not rely on mortgage escrow statements, Forms 1098, and canceled checks
(which can be evidence of payment), and may require more than reliance
on a real-estate tax bill.
Comment:
We do not agree with this recommendation. The guidance available to
examiners in IRM 4.19.15.23.2, Taxes Paid, provides sufficient
information to properly examine this deduction. Examiners are expected
to use their judgment and to consider available documentary evidence,
oral testimony, taxpayer credibility, and all facts and circumstances
to arrive a correct determination.
Recommendation:
To improve IRS's guidance to its examiners auditing the real-estate tax
deduction, we recommend that the Commissioner of Internal Revenue
require examiners to: ask taxpayers to substantiate the deductibility
of the amounts claimed whenever they are examining the real-estate tax
deduction and they have reason to believe that taxpayers claimed
nondeductible charges that are large, unusual, or questionable.
Comment:
We do not agree with this recommendation. The guidance available to
examiners in IRM 4.19.15.23.2, Taxes Paid, provides sufficient
information to properly examine this deduction. Examiners are expected
to use their judgment and to consider available documentary evidence,
oral testimony, taxpayer credibility, and all facts and circumstances
to arrive a correct determination.
Recommendation:
To learn more about where tax noncompliance is most likely, we
recommend that the Commissioner of Internal Revenue: identify a cost-
effective means of obtaining information about charges that appear on
real-estate tax bills in order to identify local governments with
potentially large nondeductible charges on their bills.
Comment:
The W&I Division will coordinate with SB/SE CLD to identify a cost-
effective means of obtaining information about charges that appear on
real-estate tax bills in order to identify local governments with
potentially large nondeductible charges on their bills.
Recommendation:
To learn more about where tax noncompliance is most likely, we
recommend that the Commissioner of Internal Revenue: if such local
governments are identified, obtain and use the information, including
uses such as compliance research focused on nondeductible charges;
outreach to such local governments to help them determine which charges
are deductible charges and help affected taxpayers correctly compute
the deduction; targeted outreach to the tax preparation and mortgage
escrow industries with customers in the affected localities, and
targeted examination of the real estate tax deduction in the
localities.
Comment:
The W&I Division will coordinate with SB/SE CLD to provide outreach to
local governments identified through research activities. Such outreach
will assist these local governments, in determining which charges are
deductible and help affected taxpayers correctly compute the deduction.
In addition, we will provide outreach to the tax preparation and
mortgage escrow industries with customers in the affected localities.
[End of section]
Appendix V: GAO Contact and Staff Acknowledgments:
GAO Contact:
Michael Brostek, (202) 512-9110 or brostekm@gao.gov:
Acknowledgments:
In addition to the contact named above, Tom Short (Assistant Director),
Paula Braun, Jessica Bryant-Bertail, Tara Carter, Hayley Crabb, Sara
Daleski, Melanie Helser, Mollie Lemon, and Albert Sim made
contributions to this report. Stuart Kauffman, John Mingus, Karen
O'Conor, and Andrew Stephens also provided key assistance.
[End of section]
Footnotes:
[1] IRS estimates that the net tax gap is $290 billion, assuming that
it will eventually recover some of the gross tax gap through late
payments.
[2] See GAO, Tax Administration: Overstated Real Estate Tax Deductions
Need To Be Reduced, [hyperlink,
http://www.gao.gov/products/GAO/GGD-93-43] (Washington, D.C.: Jan. 19,
1993).
[3] Taxpayers can overstate or understate their real-estate tax
deduction. Although examining understatements of this deduction is
outside of the scope of this review, we provide a few examples of
reasons for understating this deduction later in this report.
[4] Property taxes are made up of real-estate taxes and personal-
property taxes, such as taxes on vehicles. In 2006, personal-property
taxes accounted for only about $6.5 billion, or approximately 2 percent
of the total of about $359.1 billion for property taxes, meaning that
real-estate taxes accounted for about 98 percent of property taxes
collected by state and local governments. These 2006 numbers are based
on data that the U.S. Census Bureau received from state and local
governments about their respective fiscal years that ended from July 1,
2005, to June 30, 2006.
[5] These were the most current estimates available from the U.S.
Census Bureau at the time we conducted our work.
[6] Own-source revenue is all revenues collected by the local
governments from their own sources, and it excludes federal transfers.
These were the most current estimates available at the time we
conducted our work.
[7] See Congressional Research Service, Federal Deductibility of State
and Local Taxes (Washington, D.C.: Sept. 30, 2008).
[8] The Joint Committee on Taxation estimated that real-estate tax
deductions in 2006 cost the federal government $20 billion in lost tax
revenue.
[9] IRS Form 1040, Schedule A - Itemized Deductions.
[10] See Congressional Research Service, Federal Deductibility of State
and Local Taxes (Washington, D.C.: Sept. 30, 2008).
[11] There are multiple ways in which taxpayers should report the use
of their property for business purposes. Taxpayers who rent a property
or a part of this property are instructed to report this rental income
on Schedule E, and to deduct real-estate taxes related to that property
on that form. Taxpayers who use a portion of their home as the primary
place of conducting business are instructed to use Form 8829 to
calculate the real-estate taxes that they can deduct as a business
expense, and to record that amount on Form 1040 Schedule C.
[12] 26 U.S.C. § 164(a)(1).
[13] Payment of taxes during the tax year is a requirement for those
taxpayers who file their returns on a cash basis. Most taxpayers are
cash-basis taxpayers.
[14] 26 C.F.R. § 1.164-3(b).
[15] Not all ad-valorem taxes may be deductible because they may not
meet the other requirements for deductibility.
[16] 26 C.F.R. § 1.164-4(a).
[17] 26 U.S.C. § 164(c)(1); 26 C.F.R. §§ 1.164-3(b), 1.164-4(a).
[18] 26 U.S.C. § 164(c)(1); 26 C.F.R. § 1.164-4(b)(1). In such cases,
the burden is on the taxpayer to show the amounts assessed for
maintenance, repair, and associated interest. 26. C.F.R. § 1.164-
4(b)(1).
[19] For example, buyers and sellers should divide paid real-estate
taxes between them according to the number of days in the appropriate
year that each owned the property. The taxes can still be deducted even
if either the buyer or seller did not actually make the payment to the
taxing authority.
[20] See GAO, Tax Administration: Overstated Real Estate Tax Deductions
Need To Be Reduced, [hyperlink,
http://www.gao.gov/products/GAO/GGD-93-43] (Washington, D.C.: Jan. 19,
1993).
[21] See GAO, Tax Administration: IRS's 2008 Filing Season Generally
Successful Despite Challenges, although IRS Could Expand Enforcement
During Returns Processing, [hyperlink,
http://www.gao.gov/products/GAO-09-146] (Washington, D.C.: Dec. 12,
2008).
[22] For more details on the methodology of this survey, see appendix
I.
[23] For more details on the methodology of this review, see appendix
II.
[24] Mortgage servicers assist borrowers to pay real-estate-related
charges, because they collect funds from the property owners whose
mortgages they service (borrowers) and hold these funds in escrow
accounts. They then draw from the funds to pay real-estate taxes and
related charges on the properties as they are due.
[25] We selected 5 of the largest 41 local governments that met our
selection criteria for our analysis. We then analyzed taxpayer
noncompliance in 2 of these 5 local governments because of constraints
in resources and usability of local data. See appendix III for details.
[26] The almost 500 bills are associated with a stratified, random
sample of about 1,700 localities. We did not generalize the results of
the review because not all respondents to the survey sent in a bill as
requested and we did not know how the bill we reviewed was selected.
Although none of the bills that we reviewed indicated what amounts were
deductible for federal real-estate taxes, it is possible there are
localities that do provide this information on their bills. See
appendix II for details.
[27] Some larger local governments (e.g., counties) include taxes and
other charges imposed by smaller entities (e.g., school districts,
cities, townships) within the larger jurisdiction on one bill.
[28] Mortgage interest is reported on IRS's Form 1098. Because the
space for escrow payments on the form is optional and can be used to
include the address of the mortgaged property or insurance paid from
escrow instead of taxes paid from escrow, IRS does not track or
otherwise use this information.
[29] This estimate of 43 percent has a 95 percent confidence interval
of 36 to 50.
[30] Local governments can disclose information about charges to
mortgage servicers in a variety of ways. Based on the responses from
our survey, we estimate that only 36 percent break out all line items
on a bill for mortgage servicers (with a 95 percent confidence interval
of 29 to 43).
[31] This estimate of 25 percent has a 95 percent confidence interval
of 15 to 37. We estimate that 66 percent of local governments (with a
95 percent confidence interval of 53 to 79) do provide property owners
a courtesy copy of their tax bill. We are not clear what the remaining
8 percent do because of survey responses that were not straightforward.
[32] For more details on the results, see appendix III.
[33] These are the instructions for Schedule A of the IRS Form 1040--
the section of the income tax return for individuals relating to
itemized deductions, including the deduction for real-estate taxes.
[34] The general guide for individuals filing an income tax return is
IRS Publication 17 and the guide for first-time homeowners is IRS
Publication 530.
[35] These 3 companies are among 34 tax-preparation companies that
electronically file tax returns.
[36] 11 three programs provided information on nondeductible charges in
screens accessible from their sections on real-estate taxes via links.
[37] We spoke with a group of paid tax preparers at a conference
sponsored by the National Association of Enrolled Agents, which
represents paid tax preparers, to understand what steps they took to
ensure that taxpayers only deducted qualified real-estate taxes.
[38] We did not identify any examples of deductible non-ad-valorem
charges in any of our research. When we discussed this issue with IRS's
Office of Chief Counsel, they also did not identify any specific
examples of a deductible non-ad-valorem charge.
[39] This estimate of 45 percent has a 95 percent confidence interval
of 31 to 59.
[40] We cannot determine the proportion of this property tax revenue
that consists of non-ad-valorem charges. We used the results of the
Census Bureau's Quarterly Property Tax Survey to develop these
estimates. The Census data include both real-estate and personal-
property taxes for both residential and commercial properties and do
not separate out any of these taxes.
[41] This estimate of 72 percent has a 95 percent confidence interval
of 60 to 85.
[42] This estimate of 22 percent has a 95 percent confidence interval
of 13 to 33. We estimate from survey responses that 78 percent of local
governments (with a 95 percent confidence interval of 67 to 87) do not
label their charges as non ad-valorem.
[43] We attempted this analysis because IRS's last measurement of
individual tax compliance, which was developed through its National
Research Program for tax year 2001, did not estimate how much of the
overstated real-estate tax deduction was attributable to individuals
claiming nondeductible charges.
[44] We limited our estimates to two jurisdictions because of these
practical limitations.
[45] Taxpayers who have a home office can choose to deduct real-estate
taxes as part of a home-office deduction. Taxpayers who own real estate
for which they receive rental income can reduce their net income by the
amount of applicable real-estate taxes.
[46] We excluded those records where the amount claimed was more than
15 percent greater than the billed amount to minimize the likelihood of
including a deduction for real-estate taxes paid for multiple
properties. See appendix III for more details.
[47] Of those local governments that do have such items on their bills,
some local governments limit these charges to a small population or to
a few properties in a specific geographic area (for example, one or two
new construction developments). Such governments did not meet our
criteria for selection.
[48] Form 1040 Schedule E Supplemental Income and Loss is used to
report income or loss from rental real-estate, royalties, partnerships,
S corporations, estates, trusts, and other entities.
[49] Form 1040 Schedule C Profit or Loss From Business is used to
report income or loss from a business that the respective taxpayer
operated or from a profession practiced as a sole proprietor. Taxpayers
who use a portion of their home as the primary place of conducting
business are instructed to use Form 8829 to calculate the real-estate
taxes that they can deduct as a business expense, and to record that
amount on Schedule C.
[50] We developed the options by reviewing our prior reports and other
reports, analyzing local government bills that include nondeductible
charges, and interviewing knowledgeable local government and IRS
officials, as well as other knowledgeable stakeholders. This work,
along with our efforts to match data from a few large localities to
federal real-estate tax deduction data, helped to identify trade-offs
and challenges to consider in implementing the options.
[51] Policymakers may also want to consider the extent to which
taxpayers are understating their real-estate tax deductions. Any
estimates of taxpayer compliance or noncompliance with the real-estate
tax deduction should take understatements into consideration.
[52] NRP face-to-face audits were designed to resemble enforcement
audits in that NRP examiners were to determine whether the information
reported on an audited return was accurate, and to assess additional
taxes if they determined that a taxpayer's tax liability was
understated. Unlike enforcement audits however, NRP audits were not
limited to line items initially identified for audit. Further, NRP
examiners were expected to document all tax changes, regardless of
amount, but not to ask taxpayers to pay additional taxes owed that fell
below a predetermined amount. Given the research purpose of the NRP,
IRS also created additional guidelines, training, and procedures to,
for example, ensure specialized reviews of the quality of the audit and
data.
[53] IRS's Statistics of Income data for individual returns filed for
tax year 2006 estimated that about 43 million individuals deducted
about $156 billion in real-estate taxes.
[54] In our illustrative example, we assume that each taxpayer would
need an hour to access information and use this information to make
determinations about the charges in question. In reality, some
taxpayers would not need this much time because they have few
questionable charges on their bills, the bills are clear, and any
needed information is readily accessible. At the other extreme, some
taxpayers would need more time if they have many questionable charges
on unclear bills and have difficulties accessing the necessary
information. Also, taxpayers may not have to expend the same amount of
time in future years, unless the local charges on the bills change.
Because many taxpayers likely do not take all the necessary steps to
ensure compliance, the actual burdens borne could be less than what
would be needed in order for taxpayers to full comply.
[55] See Office of Management and Budget, Draft Report to Congress on
the Costs and Benefits of Federal Regulations, 67 Fed. Reg. 15014 (Mar.
28, 2002).
[56] These two options for reporting information on deductible charges
would address both overstatements and understatements of the real-
estate tax deduction.
[57] As discussed in the next option, mortgage companies could place
similar disclaimers on their mortgage-related documents that report
payments to local governments from escrow accounts.
[58] Taxpayers are responsible for determining which charges are
deductible.
[59] IRS could survey the selected local governments itself, or it
could have the U.S. Census Bureau's Governments Division, which already
surveys local governments on a quarterly basis, survey the local
governments on its behalf.
[60] If mortgage firms received information on local governments having
potentially nondeductible charges on bills, they could target their
disclaimers regarding nondeductible charges to particular escrow
statements.
[61] For the QPTS, property taxes include both taxes on real property
and taxes on personal property.
[62] A county area is a contiguous, nonoverlapping area based on county
boundaries.
[63] We developed 18 strata from the QPTS' original 16 strata by
dividing 1 of the QPTS strata into 3 for our purposes.
[64] See GAO, Tax Administration: Overstated Real Estate Tax Deductions
Need To Be Reduced, [hyperlink,
http://www.gao.gov/products/GAO/GGD-93-43] (Washington, D.C.: Jan. 19,
1993).
[65] Over 85 percent of the local governments that responded to our
survey attached a bill to their survey responses. However, not all of
the attached bills were usable for our analysis. We excluded bills that
did not include non-ad-valorem charges from our bill review.
[66] Because we do not know how respondents to our survey chose the
bills they attached, we do not know for sure if the bills we were
provided are representative of the bills from those jurisdictions.
There may be biases in the bills submitted.
[67] We did no review if the attached bill or item (a) had insufficient
information to answer our three criteria, (b) was for a commercial
property, (c) was not a real-estate tax bill from a local government in
our survey, (d) was blank, (e) was not actually a real-estate tax bill,
or (f) had incomplete information.
[68] A millage rate is a tax rate expressed in dollars per thousand.
[69] Although none of the real-estate tax bills that we reviewed
indicated what amounts were deductible or warned about potentially
nondeductible charges, it is possible that there are localities that do
provide this information on their bills.
[70] By county areas, we mean counties or their nonoverlapping county-
equivalents.
[71] Of the 41 jurisdictions we researched, we determined from
interviews and sample bills that we obtained that user fees, special
assessments, or other non-ad-valorem charges were present on most or
all real-estate tax bills in 16 jurisdictions.
[72] In selecting the five counties we did not include those
jurisdictions that charged more than $500 for the needed data. Also,
once we selected a jurisdiction from a state, we did not include other
jurisdictions from that state to achieve geographical diversity. In
addition, due to time constraints, we also included jurisdictions
according to the order in which we received data.
[End of section]
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