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More information on the types and uses of canceled debt could help IRS limit revenue losses on forgiven mortgage debt

Why Area Is Important

The housing market downturn is resulting in billions of dollars of forgiven mortgage debt. In tax year 2008 (the most current data available), the Internal Revenue Service (IRS) estimates that individual taxpayers excluded $6.4 billion to $11.8 billion in forgiven mortgage debts on principal residences. While most forgiven debt is treated as a financial gain and included in taxable income, forgiven mortgage debt is, according to complex rules, sometimes excluded from taxable income.

Through 2012, taxpayers may exclude forgiven mortgage debts from taxable income if the mortgage proceeds were used to buy, build, or substantially improve a principal residence. Forgiven mortgage amounts used for other purposes, including purchases of vacation or investment properties, would generally still be considered taxable income unless the taxpayer is bankrupt or insolvent.

What GAO Found

Housing market data show the potential for significant revenue losses from failure to pay taxes on certain forgiven mortgage debt, but IRS is not collecting enough information to assess compliance. Complex rules governing forgiven mortgage debt may lead individual taxpayers to exclude such debt erroneously from taxable income. For example, only forgiven mortgage debts that were used to buy, build, or substantially improve a principal residence may be excluded from taxable income. However, in recent years many taxpayers cashed out equity from their primary residences and used the proceeds for personal consumption or to consolidate other debts—not to buy, build, or improve the home. In addition, taxpayers losing investment or vacation homes through foreclosure are still liable for taxes on forgiven mortgages secured by these properties. Vacation home and investment property purchases are estimated to be well over a quarter of all house purchases in recent years. Despite the financial hardship that leads to forgiven debt, recent housing market analyses suggest that thousands of taxpayers with forgiven mortgage debt not eligible for exclusion (debt forgiven on second homes or investment property) may be able to pay the taxes legally due on such debt.

Current forms used to collect information from lenders and taxpayers on forgiven debts do not provide adequate information for IRS to assess compliance with the mortgage debt forgiveness provision. For example, neither lenders nor taxpayers are required to disclose the address of the secured property—potentially a key source of information for determining whether the property is the taxpayer's principal residence. Also, taxpayers with multiple forgiven debts only need to indicate the types of forgiven debts and the total amount to be excluded from income, but not the individual amounts of each forgiven debt. Without this information, it is difficult for the IRS to estimate the extent of noncompliance and determine whether additional resources for compliance are needed.

Actions Needed

GAO, in its August 2010 report cited the need to obtain better information to determine the revenue losses due to incorrectly excluded mortgage debts, and recommended that IRS modify existing forms to capture more information from taxpayers and lenders about forgiven debt and any securing property. IRS initially agreed with most of GAO's recommendations but, after further analysis, indicated that making changes to the forms would not generate benefits that exceed the costs of doing so. However, GAO continues to believe that without first revising the associated forms, any review of a sample of tax returns using only currently available data risks understating the benefits of additional information reporting. GAO continues to recommend that by taking some relatively low-cost steps, including revising the associated forms, collecting more information from taxpayers and lenders, and using third-party data to determine whether taxpayers are correctly excluding mortgage debt from taxable income, IRS could determine how much additional revenue could be gained from refocusing its enforcement efforts. Since lenders already maintain property address records, reporting this additional information to IRS is not expected to impose significant burdens on lenders. Further, as GAO previously recommended, IRS should also determine if other available data would allow it to identify taxpayers with multiple homes.

The potential for increased revenue from increased IRS enforcement related to forgiven mortgage debt is uncertain because IRS does not know the extent of noncompliance with the complex rules. Nonetheless, given the billions in forgiven mortgage debt annually, if only a small portion of the excluded amount is improperly avoiding taxation, the impact on revenue could be significant.

Framework for Analysis

The information contained in this analysis is based on the related GAO products listed under the "Related GAO Products" tab.

Area Contact

For additional information about this area, contact James White at (202) 512-9110 or whitej@gao.gov.

Related GAO Products

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Expanded Information Reporting Could Help IRS Address Compliance Challenges with Forgiven Mortgage Debt
GAO-10-997:
Published: Aug 31, 2010. Publicly Released: Sep 30, 2010.

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Despite Challenges Presented by Complex Tax Rules, IRS Could Enhance Enforcement and Guidance
GAO-09-769:
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Tax Gap:

Actions That Could Improve Rental Real Estate Reporting Compliance
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