Feds plan to tinker with mortgage interest reporting

Taxpayer problems in complying with the rules are legendary. Homeowners might have to answer up to seven questions just to determine if their mortgage interest is deductible. And that’s only “if.” They might need to answer up to 13 questions to figure out how much.

Well, if it’s any consolation, the complexity of the tax rules concerning the cherished deduction also pose challenges to the Internal Revenue Service. So much so, according to a new report from the Government Accountability Office, that the IRS often doesn’t have enough information to catch owners who don’t comply.

In its report to the Joint Committee on Taxation, the GAO, the investigative arm of Congress, made several recommendations to improve compliance with and enforcement of the rules on the mortgage-interest deduction. And the IRS has agreed to at least consider most of them.

The suggestions have nothing to do with changes in the tax code laid out last month by the Congressional Budget Office. Those ideas -- to cut or cap the mortgage-interest deduction and eliminate the write-offs for property taxes, among others -- are part of a regular CBO exercise and have little chance of being enacted any time soon.

But most of the GAO’s proposals won’t take an act of Congress to put in place. And because the only ways the IRS has of detecting noncompliance -- matching software and examinations -- are faulty and expensive, the agency has embraced the GAO’s ideas.

Taxpayers have deducted mortgage-interest payments on their federal returns since Congress enacted the federal income tax in 1913. And although the rules were changed in 1987 to limit the write-off, it is still the third most expensive income-tax break. In 2009, for example, Uncle Sam is expected to forgo about $80 billion in revenue because of the deduction.

Under the rules, homeowners may deduct the interest they pay on loans secured by qualified homes -- their main residence and a second property. The loans include first or second mortgages as well as home-equity loans and lines of credit.

But here is where things start to get a little complicated. Only two kinds of debt qualify: acquisition debt and home-equity debt.

Acquisition debt is incurred when buying, building or substantially improving a qualified home, as long as it is secured by that property. Since Oct. 13, 1987, the limit on acquisition debt interest deductions has been $1 million annually.

Home-equity debt is any non-acquisition debt secured by the home, as long as it is not used to buy, build or improve the home. Equity debt interest deductions -- not to be confused with a home-equity loan, which can be either acquisition debt or home-equity debt, depending on how the proceeds are used -- are capped at $100,000 a year for tax purposes.

Noncompliance with the rules isn’t rampant, the GAO study found. But some 12% to 14% of all taxpayers were routinely found to misreport the amount of mortgage interest claimed, with half underreporting the deduction and the other half over-reporting it.

In 2005, the last year for which data is available, the IRS followed up on just 135,000 of the 1.7 million returns in which there were questions about the deduction, changing the assessments or granting refunds in about 53,000.

So what does the GAO have in mind? It’s simple, really. Just a few revisions to Form 1098, the document that mortgage servicers send to both borrowers and the IRS that shows how much interest was paid during the year. The GAO said the one-page sheet should be expanded to include the address of the mortgaged property, the outstanding mortgage-debt balances, an indicator of whether the interest is on a loan refinanced during the year and an indicator of whether the interest was on an acquisition loan or a home-equity loan.

By including the address, the IRS could use an automated process to determine whether the interest claimed corresponded to a qualified residence and was eligible for the write-off. By adding beginning and ending loan balances, or even an average annual balance, the agency could identify taxpayers whose deductions appear out of sync with their debt amounts.

To implement these changes, the IRS must comply with the Paperwork Reduction Act, which requires agencies to minimize the burden they impose on the public. But mortgage business representatives told the GAO that it is “feasible” to report both the property address and debt balances.

A check box for taxpayers to show whether a mortgage was refinanced would help the government identify those who might not be complying with the rules, such as how to amortize points paid on the mortgage. Generally, points -- a point is 1% of the loan amount -- are considered prepaid interest, and the deduction is allocated over the life of the loan. But under certain conditions, they may be deducted in total in the year they were paid.

A mortgage-industry representative told the GAO that the burden of a refinancing check box wouldn’t be so bad if the servicer was required only to complete a box in the year the loan was made. This would eliminate the need to track the loan over time, the industry spokesman said, noting that most servicers don’t uniformly maintain records as to whether the loan was either an acquisition or a refinancing.

Even more problematic is the GAO’s call for an indicator to distinguish between home-equity debt and acquisition debt. Having Form 1098 filers identify types of debt “would create challenges,” the report conceded, because they don’t always have that information.

Last but not least, for routine examination purposes, the GAO would have the IRS obtain information about taxpayers from private firms. Several companies, the report said, analyze loan information that the nation’s tax collector might find useful in determining compliance. One such outfit found that home-equity debt over the tax limitation was in the billions, according to the report.

The IRS would still have to check returns. But it could use private-sector databases to pinpoint taxpayers for examination and conduct outreach to paid tax preparers.

Distributed by United Feature Syndicate Inc.