The 1986 act was  amended the next year to include dollar limits on the amount of home  mortgage debt for which interest payments can be deducted. Table 1 also summarizes the deductibility of points. IRS’s Enforcement and Research Programs Do Not Provide an Overall Picture of Mortgage Interest Deduction Noncompliance

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. IRS’s National Research Program (NRP), the main ongoing study of  taxpayer compliance based on examinations of a random sample of  tax returns: IRS found that between 12 and 14 percent of individual  taxpayers who claimed home mortgage interest on line 10 of Schedule  A misreported the amount. 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: About 9,000 examinations were closed in fiscal year  2008 for both projects. 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:    Taxpayers need to distinguish between acquisition and home equity  debt but did not always do so. Taxpayers deducted interest on loans exceeding the limitations,  including the acquisition, home equity, and two-home limits. Taxpayers who were subject to the AMT and thus not eligible to deduct  home equity interest claimed it nonetheless. Tax practitioners also missed the limitations and did not comply with  the AMT rules. 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. 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. 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. Options Exist for Expanding Mortgage Information Reporting and Using Private Sector Data to Enhance Enforcement

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. IRS’s Guidance to Taxpayers and Training Materials for Examiners Did Not Indicate the Range of Possible Mortgage Interest Deduction Situations

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. Overall, examiners we interviewed were satisfied with training  and guidance on the mortgage interest deduction. Tax Software Differed in the Ease of Navigating Mortgage Interest Deduction Instructions

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. However, consideration of  statutory changes was beyond the scope of this report. Specifically, we recommend that  the Commissioner of Internal Revenue  revise NRP’s 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;   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; investigate whether using information from private sources would be  productive in detecting mortgage interest noncompliance, especially  for home equity debt; revise the wording on Schedule A to clearly state that the mortgage  interest deduction is subject to limitations;   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;    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; and 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. Appendix I: Scope and Methodology

To provide information on how IRS detects taxpayers’ noncompliance  with the home mortgage interest deduction rules and what IRS knows  about the extent of noncompliance and to identify problems, if any, that  taxpayers face in attempting to comply with the deduction and describe  IRS’s challenges in detecting mortgage interest deduction noncompliance,  we    reviewed IRS documents and interviewed agency officials to determine  how IRS checks taxpayers’ compliance with deduction rules and if  there were issues affecting its ability to detect noncompliance.
Why GAO Did This Study

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.

What GAO Found

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.