About Half of Individual Taxpayers with Rental Real Estate Activities Misreported, Often Because of Overstated or Unsubstantiated Expenses

Based on the unadjusted NRP results, at least an estimated 53 percent of  taxpayers with rental real estate activity (about 4.8 million out of   8.9 million taxpayers) misreported their rental real estate activities for tax  year 2001. Individual taxpayers misreported an estimated $12.4 billion of net income  from rental real estate, before adjusting for tax gap purposes. IRS knows that it does not detect all misreporting  during its examinations. After these adjustments, IRS  estimated that the tax gap for rental real estate and royalty activities was  $13 billion for tax year 2001. Other types of misreporting of expenses. Limited Information Reporting and Complexity Hinder Compliance, and Various Options Exist for Improving Compliance

Limited information reporting, complexity, and the number of taxpayers  misreporting are challenges IRS faces in ensuring compliance with rental  real estate reporting. Various Options Exist for Improving Rental Real Estate Reporting Compliance

Although as previously discussed, implementing broad, new third-party  information reporting requirements for rental real estate activities is not  practical, changing existing requirements is one of various options that  could improve rental real estate reporting compliance. However,  the law for filing information returns does not clearly spell out how to  determine whether taxpayers’ rental real estate activity should be  considered a trade or business, and IRS must make this determination on a  case-by-case basis. Given the magnitude of misreporting for taxpayers  who could not substantiate some rental real estate expenses they  deducted, even small improvements in compliance could yield substantial  revenue. Fourth, improving outreach efforts  could also improve compliance. To elicit more accurate information from taxpayers on their rental real  estate activities, we recommend that the Commissioner of Internal  Revenue  require taxpayers to report on the individual tax return the basis  amount attributed to land versus structure when depreciating rental  real estate;    determine if IRS uses property type information that taxpayers  currently report on Schedule E in its efforts to enforce rental real  estate reporting compliance, and  if it is determined that IRS uses the information, the Commissioner  should require taxpayers to provide specific information on Part I of  Schedule E about the type of properties for which they are  reporting activity, for example by answering a check-the-box  question, and  if it is determined that IRS does not use the information, the  Commissioner should not require taxpayers to report any property  type information; and  require taxpayers to report the exact “address” of their rental real  estate properties on Part I Schedule E instead of property “location,” as  currently worded, and require taxpayers to report property zip codes. To enhance IRS’s outreach efforts, we recommend that the Commissioner  of Internal Revenue    evaluate whether sending notices to some or all taxpayers who report  rental real estate activity would be a cost-effective way to reduce  misreporting of some types of rental real estate activity and    expand outreach efforts to external stakeholders, such as paid tax  return preparers, tax return preparation software providers, and  industry groups related to rental real estate, to include common types  of misreporting for rental real estate activity, such as those identified in  this report. Appendix I: Scope and Methodology

To provide information on the extent and primary types of individual  taxpayer misreporting of rental real estate activities, we relied on data and  examination case files from the Internal Revenue Service’s (IRS) most  recent National Research Program (NRP) study of individual taxpayers.
Why GAO Did This Study

As part of its most recent estimate of the tax gap, for tax year 2001, the Internal Revenue Service (IRS) estimated that individuals underreported taxes related to their rental real estate activities by as much as $13 billion. Given the magnitude of underreporting, even small improvements in taxpayer compliance could result in substantial revenue. GAO was asked to provide information on rental real estate reporting compliance. This report (1) provides information on the extent and primary types of taxpayer misreporting of rental real estate activities and (2) identifies challenges IRS faces in ensuring compliance and assesses options for increasing compliance. For estimates of taxpayer misreporting, GAO analyzed a probability sample of examination cases for tax year 2001 from IRS's most recent National Research Program (NRP) study of individual taxpayer compliance.

What GAO Found

At least an estimated 53 percent of individual taxpayers with rental real estate misreported their rental real estate activities for tax year 2001, resulting in an estimated $12.4 billion of net misreported income. This amount of misreporting is understated because IRS knows it does not detect all misreporting during its NRP examinations and adjusts the amount of misreporting it detects to estimate the tax gap. Also, the rate of misreporting of rental real estate activity was substantially higher than for some other sources of income, such as wages, a disparity that undermines the fairness of the tax system. Misreporting of rental real estate expenses was the most common type of rental real estate misreporting. Limited third-party information reporting for rental real estate activity is among the challenges IRS faces in ensuring compliance for rental real estate reporting. While information reporting, such as financial institutions sending information to IRS about taxpayers' mortgage interest payments, improves compliance, it is not practical to implement and enforce broad, new information reporting requirements for rental real estate activities. However, improving existing information reporting requirements is one of various options that could improve compliance. For example, based on current law, whether rental real estate property owners must file information returns for certain expenses they incur depends on whether the owners' rental activities are considered a trade or business, but the law does not define how to make this determination. Another approach to improving compliance is to require taxpayers to report additional detail about their rental real estate activities on tax returns. For example, requiring taxpayers to report complete property address information, which GAO found that some taxpayers did not report, could help IRS address misreporting. Requiring additional detail on tax returns could also compel paid tax return preparers, used by about 80 percent of individual taxpayers who report rental real estate activity, to obtain more accurate information from taxpayers. Enhanced IRS guidance, such as on required recordkeeping, and additional IRS outreach to paid preparers and others about rental real estate misreporting could also improve compliance.