Taxpayers can claim paid real-estate taxes as an itemized deduction on  Schedule A of the federal income tax return for individuals. We estimate that 38.8 million taxpayers claimed this deduction in 2001. 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. 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. 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. 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. 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. 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. 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. However,  this cost could be justified to ensure compliance with the existing law. 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. 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.
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.