Real Estate Tax Deductions Raise Questions
The Joint Committee on Taxation has proposed new options for closing the so-called “tax gap” — the difference between federal taxes that should be paid under current tax rules and the actual amounts collected by the IRS.
According to syndicated columnist Kenneth Harney, recommendations from the committee carry weight with members of the U.S. Senate and House, getting included in tax legislation on a regular basis.
High on the list of methods to collect more of what’s owed: Tighten up on homeowners’ billowing write-offs of local and state property tax expenses, which currently cost the government about $20 billion a year in revenues.
Under the federal tax code, local real estate taxes levied against homes generally are deductible. However, they are not deductible if the tax payments cover common special assessments designed to pay for improvements that directly benefit the taxpayers’ real estate.
Examples include local “user fees” for water mains, sewer lines, sidewalks, trees and trash collections.
The problem, according to the tax committee staff, is that current law does not require local governments to tell the IRS about property owners’ mixes of regular taxes and non-deductible special-benefit levies.
Local governments often provide annual property tax statements to residents with breakouts of assessments. But many homeowners deduct the bottom-line taxes paid. As a result, homeowners get to write off hundreds of millions of dollars a year for tax payments that are not legally deductible.
In a 1993 study, the Government Accountability Office estimated that $400 million of that year’s $11 billion in property tax write-offs claimed by homeowners were improper. With deductions this year running nearly double that amount, wrongly claimed write-offs may be in the $700 million range.
The committee proposes two possible solutions:
- Require local governments to provide copies of homeowner tax statements to the IRS with breakouts distinguishing between regular and special-benefit assessments.
- Require mortgage lenders and firms providing the loan servicing to report details of owners’ property tax escrows with similar breakouts.
Either way, the IRS would stand to receive property tax information on millions of homeowners every year for possible audit purposes.
MORTGAGE INTEREST DEDUCTIONS
The second target on the committee’s hit list is a much richer lode — home mortgage interest deductions, a nearly $70 billion revenue loss to the U.S. government this year.
One of the problems, according to the staff, is that many homeowners do not distinguish between non-deductible mortgage interest and legally deductible interest.
For example, many refinancers write off “points” — loan fees treated by the IRS as prepaid interest — in the year of the refinancing.
But the IRS interprets the tax code to require that points in a refinancing be written off on a prorated basis over the full term of the loan.
Currently, lenders report annual mortgage interest payments to the IRS, but not whether a loan constitutes mortgage refinancing.
The committee staff recommends the rule be changed to require notification of all homeowner refinancings — again providing potentially useful red flags for IRS audit purposes.
Similarly the committee proposes that lenders report whenever a refinancing led to a new loan amount $100,000 larger than the previous balance. That will alert the IRS to interest write-offs in excess of those permissible under widely misunderstood rules governing “acquisition indebtedness.”
Acquisition debt for most taxpayers is the original home mortgage debt they incurred to make their purchase, plus all subsequent capital improvements, minus payments to reduce that principal over the course of the loan.
Though many taxpayers believe that all mortgage interest is deductible on up to $1 million in mortgage debt, plus another $100,000 in home equity loan debt, that is not the law.
Using an example supplied by the committee, if the owners of a home with a $500,000 mortgage did a “cash out” refi of $700,000 — that is, they pulled out another $200,000 — the IRS might not view all the interest on the $700,000 new debt as deductible.
Auditors might scrutinize whether the owners used more than $100,000 for capital improvements — legitimate and tax-deductible as “acquisition debt.” If substantial sums were spent on new luxury cars or vacations, by contrast, those portions might not qualify for interest deductions.
FLAGGING CASH-OUTS
To red-flag these cash-out refinancings, the committee proposes requiring lenders to alert the IRS in annual mortgage loan interest reports whenever taxpayers increase their loan balances by more than $100,000 through home mortgage refinancing.
The committee says it can’t be certain how many of the recent cash-out refi tidal wave may have produced interest deductions that exceed the rules, but given the amounts involved, even low levels of non-compliance might add up to big bucks.
So where’s this headed? Don’t be surprised to see both proposals surface next year in tax legislation — no matter which party controls Congress.