The IRS needs to do a better job of providing guidance on the real estate tax deduction so taxpayers can properly comply, recommends a new report from the Government Accountability Office.
The GAO acknowledged that taxpayers face challenges when itemizing their federal income tax deductions, particularly when their local real estate tax bills include nondeductible charges. Neither local government tax bills nor mortgage servicer documents typically identify what taxpayers can properly deduct. Without that 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 their tax bills and other information sources to make the determination. In addition, using tax software and paid preparers may not ensure that taxpayers only deduct the qualified amounts.
However, the GAO believes that taking too much of a deduction on real estate taxes could contribute significantly to the federal governments estimated net tax gap of $290 billion. According to the Congressional Research Service, the real estate tax deduction was the most frequently itemized federal income tax deduction claimed by individual taxpayers between 1998 and 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. In 2006 alone, individual taxpayers claimed about $156 billion in real estate taxes as an itemized deduction.
There are no reliable estimates for the extent of noncompliance caused by taxpayers claiming nondeductible charges, or the associated federal tax loss, the GAO acknowledged. However, the GAO estimates that almost half of local governments nationwide included generally nondeductible charges on their bills. The GAO surveyed a sample of 1,700 local communities, conducted case studies on five large county governments, and closely analyzed compliance in two counties. While the full extent of overstatement is unknown due to data limitations, the GAO estimates that taxpayers in those two counties collectively overstated their deductions by at least $23 million, or $46 million using broader matching criteria.
The GAO noted that IRS examinations of real estate tax deductions usually focus more on whether the taxpayer owned the property and paid the taxes than on whether the taxpayer claimed only deductible amounts, primarily because the 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, the GAO noted.
However, the lack of information regarding the extent of noncompliance and the associated tax loss makes it difficult to evaluate these options, said the report. The GAO added that if the 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.
The GAO recommended that the IRS change its guidance to taxpayers and also revise the IRS guidance for auditing the deduction. The report also recommended that the IRS 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.
The IRS agreed with most of the recommendations, but disagreed with changing the auditing guidance. The guidance available to examiners provides sufficient information to properly examine this deduction, wrote Deputy Commissioner Linda Stiff. Examiners are expected to use their judgment and to consider available documentary evidence, oral testimony, taxpayer credibility, and all available facts and circumstances to arrive [at] a correct determination.
However, the GAO said it continues to believe the guidance for IRS audits should be improved.
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