Home Mortgage Interest Deduction: Despite Challenges Presented by Complex Tax Rules, IRS Could Enhance Enforcement and Guidance
Highlights
The home mortgage interest deduction is the third most expensive federal income tax expenditure, with the government expected to forgo about $80 billion of revenue for the deduction in 2009.1 Subject to various limitations, taxpayers may deduct interest on home-secured loans, such as mortgages, mortgage refinancings, and home equity loans, including those taken as lump sum amounts and home equity lines of credit. The rules that taxpayers must follow in determining the proper amount of mortgage interest to deduct can be complex. For example, there are limitations on the amount of debt for which interest can be deducted, special rules for refinancing, situations where alternative minimum tax (AMT) considerations apply, and rules on the deductibility of prepaid interest amounts called points. In general, complex tax rules increase the potential for noncompliance. Congress asked us to study the home mortgage interest deduction to determine if there are administrative issues that need to be addressed to improve taxpayer compliance and Internal Revenue Service (IRS) enforcement. For this report, we (1) provide information on how IRS detects taxpayers' noncompliance with the home mortgage interest deduction rules and what it knows about the extent of noncompliance; (2) identify the problems, if any, taxpayers face in attempting to comply with the deduction and describe IRS's challenges in detecting mortgage interest deduction noncompliance; (3) assess options to give IRS more information to enforce compliance with the rules; (4) determine whether IRS's guidance to taxpayers and its examiners' guidance and training on the deduction provide enough information to properly calculate the taxpayers' allowable mortgage interest deduction; and (5) describe how tax-return preparation software programs handle the deduction. Congress also asked us to provide descriptive information on taxpayers' mortgage interest deductions and mortgage interest payments reported on Form 1098, Mortgage Interest Statement. Appendix V provides this information. Consideration of statutory changes was beyond the scope of our report.
Although IRS's enforcement and research programs found some mortgage interest deduction compliance problems, the methods leave gaps in what is known about the extent and specific nature of noncompliance. The four main programs that IRS uses to enforce or research mortgage interest deduction compliance include the following. (1) A computer matching program designed to identify taxpayers whose mortgage interest deduction exceeds amounts reported on Form 1098; (2) IRS's National Research Program (NRP), the main ongoing study of taxpayer compliance based on examinations of a random sample of tax returns; (3) Routine examinations done by correspondence, in an IRS office, or on site; and (4) Two special compliance initiative projects (CIP) primarily examining acquisition debt for a limited segment of individual taxpayers with high mortgage interest deductions or high adjusted gross incomes. The mortgage interest deduction rules create compliance problems for taxpayers, reflecting the deduction's complexity. The effects of the problems, however, are uneven. Although many taxpayers might encounter few problems, others could face many more. Problems cited by tax practitioners and in our review of articles on deducting home mortgage interest included the following: (1) Taxpayers need to distinguish between acquisition and home equity debt but did not always do so. (2) Taxpayers deducted interest on loans exceeding the limitations, including the acquisition, home equity, and two-home limits. (3) Taxpayers who were subject to the AMT and thus not eligible to deduct home equity interest claimed it nonetheless. (4) Tax practitioners also missed the limitations and did not comply with the AMT rules. (5) Depending on the circumstances, some taxpayers and practitioners faced extensive recordkeeping and calculations related to such matters as refinancing, the AMT, business use of the home, other uses of loan proceeds, and the periodic use and repayment of home equity lines of credit. (6) Taxpayers may have been unaware that they might need documentation on matters such as how proceeds of home equity loans are spent to properly determine the amount of the mortgage interest deduction on their tax returns. (7) Mortgage interest deduction limits based on debt amounts are not directly comparable with the information on Form 1098, which lists interest paid. If taxpayers' debts exceed the limits, taxpayers must calculate how much interest they can deduct. Additional information about taxpayers' mortgages could help IRS identify the most productive cases to examine and determine whether taxpayers are claiming the correct amount of mortgage interest deduction. IRS could obtain more helpful information about taxpayers' mortgages by expanding information collected on Form 1098. IRS officials said that in implementing certain additional reporting requirements, the agency would need to meet the terms of the Paperwork Reduction Act, which requires agencies to minimize the paperwork burden they impose on the public and maximize the practical utility of the information they collect. Taken as a whole, IRS taxpayer guidance--Schedule A and its instructions, Publication 17, Your Federal Income Tax, and Publication 936, Home Mortgage Interest Deduction--generally informed taxpayers that mortgage interest deductions are subject to limits. Even though the guidance was generally sufficient, Schedule A does not explicitly mention the limitations. IRS's examiners' guidance and training materials included information for identifying and calculating home-equity and the acquisition-debt limitations. Overall, examiners we interviewed were satisfied with training and guidance on the mortgage interest deduction. The three companies' tax preparation software for individuals that we analyzed differed from each other in how they treated the limitations on the amount of debt for which interest can be deducted.
Recommendations
Recommendations for Executive Action
| Agency Affected | Recommendation | Status |
|---|---|---|
| Internal Revenue Service | The Commissioner of Internal Revenue should revise the National Research Program's (NRP) case selection system so that a tax return's mortgage interest deduction is not automatically excluded as an examination issue if it matches information reported on Form 1098. |
In August 2009, IRS changed its National Research Program (NRP) examination guidance and training to ensure that not all returns would automatically be excluded from classification even when the deduction amount and information return matched. IRS specifically cited GAO as an impetus for the change in its guidance. Because of the change, IRS should have more accurate research on the extent of mortgage interest deduction noncompliance, be able to allocate enforcement program resources more efficiently, and ultimately reduce the tax gap.
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| Internal Revenue Service | The Commissioner of Internal Revenue should revise Form 1098 to require third parties to provide information on mortgage balances, the address of a home securing a mortgage, and an indicator of whether the mortgage is for a current year refinancing. |
Legislative action has been taken on this recommendation, which GAO made in July 2009. In July 2015, Congress adopted the Surface Transportation and Veterans Health Care Choice Improvement Act (Public Law 114-41) requiring IRS to collect information on the origination date of the mortgage, amount of outstanding principal at the end of the calendar year, and property's address. In response to the legislation, IRS included a place to report this information on the 2016 edition of Form 1098 Mortgage Interest Statement. This new reporting requirement applies to returns and statements made after December 31, 2016 (returns that would be filed in 2017). The new form is available for the 2017 filing season. These changes address GAO's recommendation.
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| Internal Revenue Service | The Commissioner of Internal Revenue should investigate whether using information from private sources would be productive in detecting mortgage interest noncompliance, especially for home equity debt. |
In August 2011, IRS said that it investigated the use of private information, as per our recommendation, and had two findings. First the recommended vendor's information duplicated information it already had on systems IRS used. Second, IRS said that the vendor did not provide social security numbers, and without those numbers, it could not match the vendor's data with IRS's data. As a result the acquisition of the data would not enhance IRS's ability to detect mortgage interest noncompliance.
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| Internal Revenue Service | The Commissioner of Internal Revenue should revise the wording on Schedule A to clearly state that the mortgage interest deduction is subject to limitations. |
For tax year 2010, the Internal Revenue Service published Form 1040 Schedule A Itemized Deductions with a warning that states, "Your mortgage interest deduction may be limited (see instructions)."
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| Internal Revenue Service | The Commissioner of Internal Revenue should conduct a test to evaluate whether mortgage interest deduction-related outreach programs to taxpayers and tax return preparers could be a cost-effective way to reduce noncompliance; outreach might include sending correspondence covering key rules and common mistakes or promoting seminars on common types of misreporting. |
IRS has said it continues to perform outreach with relevant parties but determined that conducting a test would not be feasible.
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| Internal Revenue Service | The Commissioner of Internal Revenue should set a date to complete the Chief Counsel determination on whether the acquisition debt limit is $1 million or $1.1 million when used in combination with the home equity debt limit. |
In July 2009, we issued a report that discusses how IRS instructions and training on mortgage interest deduction debt limits were inconsistent with a tax court ruling, which may have caused taxpayers to claim less than their entitled deduction amount or caused IRS to collect less revenue. We recommended that IRS set a date to complete a Chief Counsel decision on what the limit should be, and IRS agreed. In August 2009, IRS announced their interpretation of the ruling. As a result, taxpayers will more easily be able to comply with the mortgage interest deduction debt limits, and examiners will be able to apply the rules more consistently during audits.
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| Internal Revenue Service | The Commissioner of Internal Revenue should revise examiner training materials by adding examples cited as common problems by auditors and paid tax return preparers, such as those involving multiple homes or home-based businesses, and after the Chief Counsel's final determination on the acquisition limit, revise examiner training and the worksheet in guidance to reflect the project's outcome. |
As of August 2013, IRS had updated its training materials to better distinguish allowable mortgage-interest deductions on $1 million in acquisition debt and $100,000 in home equity debt. The new training, however, did not include examples of common problems cited by auditors that taxpayers have deducting home mortgage interest.
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