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entitled 'Tax Gap: Actions That Could Improve Rental Real Estate 
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Report to the Committee on Finance, U.S. Senate: 

United States Government Accountability Office: 
GAO: 

August 2008: 

Tax Gap: 

Actions That Could Improve Rental Real Estate Reporting Compliance: 

GAO-08-956: 

GAO Highlights: 

Highlights of GAO-08-956, a report to the Committee on Finance, U.S. 
Senate. 

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. 

Table: Estimated Frequency of Types of Individual Taxpayer Misreporting 
of Rental Real Estate Activities That IRS Detected through NRP 
Examinations, Tax Year 2001: 

Type of misreporting: Misreported rental real estate expenses; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 43. 

Type of misreporting: Misreported rent received; Estimated percentage 
of taxpayers with rental real estate activity who misreported: 15. 

Type of misreporting: Reported activity on an incorrect part of the 
individual tax return; Estimated percentage of taxpayers with rental 
real estate activity who misreported: 6. 

Type of misreporting: Misreported loss from rental real estate; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 2. 

Type of misreporting: Other types of misreporting; Estimated percentage 
of taxpayers with rental real estate activity who misreported: 5. 

Type of misreporting: All types of misreporting; Estimated percentage 
of taxpayers with rental real estate activity who misreported: 53. 

Source: GAO analysis of IRS data and examination case files. 

Notes: Some taxpayers misreported rental activity for more than one 
type of misreporting. As such, estimates for types of misreporting do 
not sum to the total percentage of taxpayers who misreported. 

[End of table] 

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. 

What GAO Recommends: 

Congress should consider making all taxpayers reporting rental real 
estate activity subject to the same information reporting requirements 
as other taxpayers with a trade or business. GAO also recommends that 
IRS require the reporting of additional details on tax and information 
returns, provide taxpayers with additional guidance, and enhance its 
outreach efforts. 

In commenting on a draft of this report, IRS agreed with most of our 
recommendations. 

To view the full product, including the scope and methodology, click on 
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-956]. For more 
information, contact James White at (202) 512-9110 or whitej@gao.gov. 

[End of section] 

Contents: 

Letter: 

Results in Brief: 

Background: 

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

Limited Information Reporting and Complexity Hinder Compliance, and 
Various Options Exist for Improving Compliance: 

Conclusions: 

Matter for Congressional Consideration: 

Recommendations for Executive Action: 

Agency Comments and Our Evaluation: 

Appendix I: Scope and Methodology: 

Appendix II: Comments from the Internal Revenue Service: 

Appendix III: GAO Contact and Staff Acknowledgments: 

Related GAO Products: 

Tables: 

Table 1: Distribution of the Estimated Amount of Net Misreported Income 
from Rental Real Estate by Individual Taxpayers, Tax Year 2001: 

Table 2: Estimated Distribution of All Individual Taxpayers and 
Individual Taxpayers Who Reported and Misreported Rental Real Estate 
Activity and Associated Net Misreported Amounts by Adjusted Gross 
Income, Tax Year 2001: 

Table 3: Estimated Frequency of Types of Individual Taxpayer 
Misreporting of Rental Real Estate Activities That IRS Detected through 
NRP Examinations, Tax Year 2001: 

Table 4: Estimated Frequency of Types of Misreporting of Rental Real 
Estate Expenses by Individual Taxpayers, Tax Year 2001: 

[End of section] 

United States Government Accountability Office:
Washington, DC 20548: 

August 28, 2008: 

The Honorable Max Baucus: 
Chairman: 
The Honorable Charles Grassley: 
Ranking Member: 
Committee on Finance: 
United States Senate: 

The Internal Revenue Service (IRS) estimated that individual owners of 
rental real estate underreported their taxes by as much as $13 billion 
for tax year 2001.[Footnote 1] By misreporting their rental real estate 
activities, these taxpayers contribute to the gross tax gap, most 
recently estimated at around $345 billion for tax year 2001. The tax 
gap is the difference between the taxes that taxpayers pay voluntarily 
and on time and the amounts they should pay under the law. 

We have noted in past reports and testimonies that the tax gap has 
multiple causes, spans five types of taxes, and is spread over 
individuals and different business types. For these reasons, addressing 
the tax gap requires understanding the characteristics of specific 
types of misreporting, such as for rental real estate, in order to 
develop potential solutions for closing the gap. Given the magnitude of 
the estimated tax gap from rental real estate misreporting, even small 
improvements in taxpayer compliance could result in substantial 
revenue. Increasing compliance could also improve the fairness of the 
tax system, as misreporting taxpayers increase the burden of funding 
the nation's commitments for those taxpayers who voluntarily pay their 
taxes. 

Given your long-standing concern about the tax gap, you asked us to 
provide information on individual taxpayer compliance in reporting 
rental real estate activity. In response, this report (1) provides 
information on the extent and primary types of individual taxpayer 
misreporting of rental real estate activities and (2) identifies 
challenges IRS faces in ensuring compliance with rental real estate 
reporting and assesses options for increasing compliance. 

To provide information on the extent and primary types of individual 
taxpayer misreporting of rental real estate activities, we selected a 
probability sample of case files from a larger sample of individual tax 
returns IRS examined through its National Research Program (NRP). We 
reviewed case files for 1,000 returns that included rental real estate 
or royalty activity[Footnote 2] and used the results of our case file 
review along with data from IRS's examinations of the tax returns from 
NRP to make estimates for the entire population of individual taxpayers 
with rental real estate activity. Since our estimates are based on a 
sample, we express our confidence in the estimates as a 95 percent 
confidence interval, plus or minus a margin of error. These intervals 
would contain the actual population value for 95 percent of the samples 
we could have selected. Unless otherwise noted, all percentage 
estimates have a margin of error of less than 5 percentage points; 
value estimates have a margin of error of less than 8 percent. To 
identify challenges IRS faces in ensuring rental real estate reporting 
compliance and assess options for increasing compliance, we reviewed 
IRS forms, publications, and other taxpayer guidance related to 
reporting rental real estate activity and reviewed documents and data 
from IRS's enforcement programs. In addition, we interviewed officials 
from IRS's Small Business/Self-Employed; Wage and Investment; and 
Research, Analysis, and Statistics divisions who have knowledge of 
rental real estate compliance issues. We also interviewed 
representatives of the tax return preparation, property management, and 
mortgage banking industries. We conducted this performance audit from 
May 2007 through August 2008 in accordance with generally accepted 
government auditing standards. Those standards require that we plan and 
perform the audit to obtain sufficient, appropriate evidence to provide 
a reasonable basis for our findings and conclusions based on our audit 
objectives. We believe that the evidence obtained provides a reasonable 
basis for our findings and conclusions based on our audit objectives. 

Results in Brief: 

We estimate that at least 53 percent of individual taxpayers with 
rental real estate activity for tax year 2001 misreported their rental 
real estate activity, resulting in an estimated $12.4 billion of net 
misreported income. This amount of misreporting understates the total 
amount of misreported income from rental real estate because IRS knows 
it does not detect all misreporting during its NRP examinations and 
uses various methodologies and other sources of data to adjust the 
amount of misreporting it detects to estimate the tax gap. Also, 
individual taxpayers misreported net income from rental real estate 
more frequently than some other types of income. For example, 10 
percent of taxpayers misreported the amount of wages they earned. This 
disparity in compliance undermines the fairness of our tax system. 
Misreporting of rental real estate expenses was the most common type of 
misreporting of rental real estate activities we found that IRS 
identified through the NRP examinations. One problem was substantiating 
expenses--about one-quarter of taxpayers with rental real estate 
activity could not substantiate some expenses they reported on their 
tax returns. Other types of misreporting included misreporting of rents 
received, reporting activity on the wrong part of the individual tax 
return, and misreporting the amount of loss from rental real estate. 

Limited information reporting for rental real estate activity, the 
complexity involved in reporting the activity, and the number of 
taxpayers misreporting their rental real estate activity are challenges 
IRS faces in ensuring compliance with rental real estate reporting. For 
example, IRS receives information returns from third parties--such as 
those that rental real estate management companies file reporting the 
rent taxpayers receive or that financial institutions file reporting 
the mortgage interest taxpayers pay--for only a small number of 
taxpayers who report rental real estate activity on their tax returns. 
As a result, it can be difficult for IRS to systematically identify 
taxpayers who may have misreported or failed to report their 
activities. While information reporting improves compliance, 
implementing broad, new third-party information reporting for rental 
real estate activities is not practical. For example, requiring all 
renters to report to IRS the amount of rent they pay would place a 
substantial burden on renters and would present enforcement challenges 
for IRS. However, other options exist to improve rental real estate 
reporting compliance. Existing third-party information reporting 
requirements could be improved. Currently, financial institutions do 
not have to provide mortgaged property addresses when reporting to IRS 
on taxpayers' mortgage interest payments. Also, under existing law, 
only taxpayers whose rental real estate activity is considered a trade 
or business are required to report expense payments on information 
returns, but the law for filing the returns does not clearly spell out 
how to determine whether taxpayers' rental real estate activity should 
be considered a trade or business. Another approach to improving 
taxpayer 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 we found that some taxpayers did not report, could help IRS 
address misreporting during examinations. Requiring additional detail 
on tax returns could have the added benefit of compelling paid tax 
return preparers, used by about 80 percent of individual taxpayers who 
report rental real estate activity, to obtain more accurate income and 
expense information from taxpayers. Also, IRS guidance in the 
instructions to the individual tax return could be improved for some 
aspects of rental real estate activity, such as required recordkeeping. 
Finally, IRS officials suggested additional IRS outreach to paid tax 
return preparers and others about common types of rental real estate 
misreporting. 

This report suggests that Congress consider amending the Internal 
Revenue Code to make all taxpayers with rental real estate activity 
subject to the same information reporting requirements as other 
taxpayers operating a trade or business. We are also making several 
recommendations to IRS to help it identify and address misreporting and 
assist taxpayers, and their paid preparers, in accurately reporting 
rental real estate activities, such as requiring third parties to 
report mortgaged property addresses on mortgage interest statements, 
requiring taxpayers to report additional information on their tax 
returns for their rental real estate activities, providing taxpayers 
with additional guidance, and enhancing IRS's outreach efforts with 
regard to rental real estate activity. In commenting on a draft of the 
report, IRS agreed with seven of our nine recommendations. However, IRS 
agreed only to consider implementing our recommendation to require 
third parties to report mortgaged property addresses on the mortgage 
interest statement information return because the requirement would 
increase burden on third parties. Also, IRS disagreed with our 
recommendation to require taxpayers to report on the individual tax 
return the basis amount attributed to land versus structure when 
depreciating rental properties. However, IRS agreed to add information 
in its instructions about allocating basis to land. We believe that 
these two recommendations could improve compliance if implemented. 
Representatives of the mortgage banking industry told us that it would 
be feasible to report property address information on mortgage interest 
statements. Also, we believe that requiring taxpayers to report the 
land values on tax returns could prevent some taxpayers from including 
the value of their land when calculating depreciation for their rental 
properties. Although the instructions to the individual tax return 
state that land is not depreciable, we found that about 166,000 
taxpayers included the value of land when depreciating their rental 
properties for tax year 2001. 

Background: 

Individuals report their rental real estate activities on their tax 
returns, including for the rental of residential, vacation, and 
commercial properties. Individuals own and manage a large amount of 
residential properties in the United States. According to a study by 
the Department of Housing and Urban Development and the U.S. Census 
Bureau (Census), individuals owned an estimated 83 percent of the 15.7 
million rental housing properties with fewer than 50 units in 2001 
(with the remainder owned by partnerships or other entities). 
Individuals owned 13 percent of the estimated 71,000 rental properties 
with 50 units or more.[Footnote 3] 

Likewise, according to a Census study of rental property management 
characteristics for 1995, an estimated 67 percent of rental housing 
properties with fewer than 50 units were managed by their owners as 
opposed to management companies or another type of manager. Owners 
managed an estimated 5 percent of rental properties with 50 units or 
more.[Footnote 4] According to IRS data, the estimated number of 
individual taxpayers who reported rental real estate activity for 
properties they owned directly was 8.7 million in 2001 and 9.1 million 
in 2005.[Footnote 5] 

Individual taxpayers generally must report as income any rent they 
receive from the use or occupation of real estate on Part I of Schedule 
E, which they attach to the individual tax return--Form 1040.[Footnote 
6] The amount of income taxpayers must report includes rent payments 
and other amounts, such as kept security deposits or the fair market 
value of services taxpayers receive from tenants in lieu of rent. 
Taxpayers ordinarily are allowed to deduct the expenses of renting 
property from their rental income on Part I of Schedule E.[Footnote 7] 
However, the costs of property improvements that add to the value of a 
property or extend its useful life, such as a bathroom addition or new 
built-in appliances, must be depreciated, meaning that taxpayers must 
deduct such costs on their tax returns over multiple years. Likewise, 
taxpayers must depreciate the cost of acquiring a rental property. The 
amount of depreciation that a taxpayer can deduct for both property 
improvements and the cost of rental property depends on the taxpayer's 
basis in the property, among other factors. A taxpayer's basis in a 
rental property is generally the cost of the property when it was 
acquired, excluding the cost of land, which is not depreciable (in 
practice, taxpayers must determine what portion of the cost of their 
properties is attributed to land versus actual structures in order to 
determine their depreciable basis). 

If individual taxpayers use their properties for both rental and 
personal purposes in a given tax year the expenses they can deduct may 
be limited.[Footnote 8] Personal use of a property includes the use by 
the taxpayer or any other person who has an interest in the property or 
use of the property by a family member of either, even if the property 
is rented at a fair rental price.[Footnote 9] Personal use also 
includes use by nonowners and non-family members if the rental is at 
less than a fair rental price. However, in general, renting property to 
a family member or another person is not considered to be personal use 
if the property is rented at a fair rental price and is used by the 
renter as his or her principal residence. Taxpayers who use their 
properties for both rental and personal purposes, but whose personal 
use is not enough for the property to be considered a residence, must 
allocate their expenses between rental and personal use based on the 
number of days used for each purpose. 

To assist in filing their tax returns, individual taxpayers are 
expected, and in some cases required, to keep records, including those 
for rent received and expenses. Additionally, taxpayers must keep 
records to substantiate items on their tax returns in case IRS has 
questions about the items. Taxpayers who, upon IRS examination, cannot 
produce evidence to support items they reported on their tax returns 
may be subject to additional taxes and penalties. For example, 
taxpayers who cannot substantiate their rental real estate expenses 
with appropriate records may have their expenses disallowed, resulting 
in additional taxes owed. 

Information reporting provides taxpayers, as well as IRS, with some 
records of rent received and expenses from rental real estate. For 
example, when an individual taxpayer receives rent of $600 or more 
through a rental agent, such as a rental management company, the agent 
is required to report the amount of rent received to the taxpayer and 
IRS on a Form 1099-MISC. Payees of rent payments of $600 or more made 
in the course of a trade or business, such as renting office space, are 
also required to report those payments on Form 1099-MISC.[Footnote 10] 
Likewise, financial institutions are required to report to taxpayers 
and IRS on Form 1098 the amount of interest taxpayers paid on mortgages 
they held on their rental properties. A taxpayer whose rental real 
estate activity is a trade or business is required to report service 
payments of $600 or more on Form 1099-MISC. However, according to IRS, 
whether a taxpayer's rental real estate activity is considered a trade 
or business is determined on a facts and circumstances basis. 
Generally, taxpayers currently do not have to file Form 1099-MISC for 
payments made to corporations. 

IRS relies on both enforcement and taxpayer service programs to ensure 
compliance by taxpayers with rental real estate activity. Two 
enforcement programs IRS uses to ensure compliance are the Automated 
Underreporter program (AUR) and examinations. Through AUR, IRS matches 
information that taxpayers report on Schedule E for rent received and 
mortgage interest to amounts that third parties report for these items 
on Forms 1099-MISC and 1098, respectively. When mismatches arise 
between amounts on tax returns and Forms 1099-MISC and 1098, IRS may 
send notices asking taxpayers to explain the discrepancies or pay 
additional taxes. Examinations may address any type of misreporting and 
come in three forms. Correspondence examinations are conducted through 
the mail and usually cover a narrow issue or two. Office examinations 
are also limited in scope but involve taxpayers going to an IRS office. 
For field examinations, IRS sends a revenue agent to a taxpayer's home 
or business to examine the misreporting that IRS suspects it has 
identified. During examinations, IRS uses information from third 
parties, taxpayers, and external sources, such as public records. 

Through its taxpayer service programs, IRS provides publications, 
forms, and instructions to help taxpayers understand and comply with 
their rental real estate reporting requirements.[Footnote 11] IRS also 
disseminates relevant information to tax professionals, such as tax 
return preparer associations, and business organizations. For example, 
in July 2007, IRS released a fact sheet on the requirements for 
reporting rental real estate activity. In addition to publishing the 
fact sheet on its Web site, IRS disseminated the information to the 
media and a wide network of tax professional and small business 
organizations. IRS also provides assistance to taxpayers through its 
toll-free telephone service where taxpayers can call and speak directly 
with IRS staff about their tax issues. 

IRS periodically measures taxpayer compliance and the tax gap that 
results from misreporting, including those for individual taxpayers 
with rental real estate activity. The portion of IRS's 2001 tax gap 
estimate caused by individual underreporting is based on NRP. Through 
NRP, IRS conducted a review and examination of a representative sample 
of about 46,000 individual tax returns from tax year 2001. IRS 
generalized from the NRP sample results to compute estimates of 
underreporting of income and taxes for all individual tax returns. 
Because even the detailed NRP reviews could not detect all 
misreporting, IRS adjusted the NRP results to account for undetected 
misreporting when estimating the tax gap, as will be discussed in the 
next section of this report. 

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 their rental real 
estate activities more frequently than some other types of income for 
tax year 2001. For example, we previously reported that an estimated 10 
percent, 17 percent, and 22 percent of individual taxpayers with wage 
and salary, dividend, and interest income, respectively, misreported 
their income from these sources.[Footnote 12] This disparity in 
compliance undermines the fairness of the tax system, because when some 
taxpayers fail to pay the amount of taxes they should pay under the 
law, the burden of funding the nation's commitments falls more heavily 
on compliant taxpayers. 

Individual taxpayers misreported an estimated $12.4 billion of net 
income from rental real estate, before adjusting for tax gap purposes. 
[Footnote 13] The unadjusted NRP results understate the amount of net 
misreported income from rental real estate, as they represent only what 
IRS detected through NRP examinations. IRS knows that it does not 
detect all misreporting during its examinations. As such, it uses 
various methodologies and other sources of data to adjust the aggregate 
NRP results for tax gap purposes to estimate net misreporting for 
categories of income or activities, such as rental real estate and 
royalties (total rental real estate income or loss is reported on the 
same line of Schedule E). After these adjustments, IRS estimated that 
the tax gap for rental real estate and royalty activities was $13 
billion for tax year 2001. Misreported rental real estate likely 
accounted for most of the $13 billion because taxpayers misreported an 
estimated $23.7 million of net income from royalties[Footnote 14] 
compared to the $12.4 billion of net income from rental real estate 
that taxpayers misreported. 

Of the 4.8 million taxpayers who misreported their rental real estate 
activities, an estimated 75 percent underreported their net income from 
rental real estate (by either understating rent received or overstating 
expenses or loss). For these taxpayers, a relatively small number 
underreported $10,000 or more in net income from rental real estate, 
but these taxpayers accounted for a large amount of misreported net 
income, as shown in table 1. Conversely, nearly one-third of 
underreporting taxpayers (about 1.2 million out of about 3.6 million 
underreporting taxpayers) underreported less than $1,000. By 
comparison, an estimated 25 percent of taxpayers who misreported rental 
real estate activities overreported their net income from rental real 
estate (by overstating rent received or understating expenses or loss), 
although the amounts they misreported were relatively small. For 
example, the estimated median amount of net income that misreporting 
taxpayers overreported was $518,[Footnote 15] about one-quarter of the 
median amount of net income of $1,981[Footnote 16] that misreporting 
taxpayers underreported. Some taxpayers who misreported did so in a way 
that may not have affected the amount of income tax they owed but may 
have affected the amount of employment tax they owed, as discussed 
later in this report. 

Table 1: Distribution of the Estimated Amount of Net Misreported Income 
from Rental Real Estate by Individual Taxpayers, Tax Year 2001: 

Net misreported amount: Overreporting taxpayers; Less than $1,000; 
Number of misreporting taxpayers (millions): 0.7; 
Percentage of misreporting taxpayers: 16; 
Net misreported income (billions of dollars): -$0.2. 

Net misreported amount: Overreporting taxpayers; $1,000 and greater; 
Number of misreporting taxpayers (millions): 0.4; 
Percentage of misreporting taxpayers: 9; 
Net misreported income (billions of dollars): -$1.9. 

Net misreported amount: Underreporting taxpayers; Less than $1,000; 
Number of misreporting taxpayers (millions): 1.2; 
Percentage of misreporting taxpayers: 24; 
Net misreported income (billions of dollars): $0.4. 

Net misreported amount: Underreporting taxpayers; $1,000 to $9,999; 
Number of misreporting taxpayers (millions): 2.1; 
Percentage of misreporting taxpayers: 45; 
Net misreported income (billions of dollars): $7.8. 

Net misreported amount: Underreporting taxpayers; $10,000 and greater; 
Number of misreporting taxpayers (millions): 0.3; 
Percentage of misreporting taxpayers: 6; 
Net misreported income (billions of dollars): $6.3. 

Net misreported amount: Total; 
Number of misreporting taxpayers (millions): 4.8; 
Percentage of misreporting taxpayers: 100; 
Net misreported income (billions of dollars): $12.4. 

Source: GAO analysis of IRS data and examination case files. 

Notes: Figures for the number of misreporting taxpayers do not sum to 
the total because of rounding. Percentage estimates have margins of 
error of less than 5 percentage points. Value estimates have margins of 
error of less than 40 percent. 

[End of table] 

In terms of income levels, the distribution of taxpayers who 
misreported rental real estate activity did not vary greatly from the 
income levels for all taxpayers who reported rental real estate 
activity for tax year 2001, as shown in table 2. However, taxpayers who 
reported--and misreported--rental real estate activity were generally 
of higher income levels than all individual taxpayers. Most of the 
misreporting, in dollar terms, was attributed to taxpayers with more 
than $50,000 of adjusted gross income. 

Table 2: Estimated Distribution of All Individual Taxpayers and 
Individual Taxpayers Who Reported and Misreported Rental Real Estate 
Activity and Associated Net Misreported Amounts by Adjusted Gross 
Income, Tax Year 2001: 

Adjusted gross income: Less than $25,000; 
Percentage of all individual taxpayers: 46; 
Percentage of individual taxpayers reporting rental real estate 
activity: 24; 
Percentage of individual taxpayers misreporting rental real estate 
activity: 20; 
Net misreported income (billions of dollars): $2.5. 

Adjusted gross income: $25,000 to $49,999; 
Percentage of all individual taxpayers: 25; 
Percentage of individual taxpayers reporting rental real estate 
activity: 22; 
Percentage of individual taxpayers misreporting rental real estate 
activity: 23; 
Net misreported income (billions of dollars): $1.7. 

Adjusted gross income: $50,000 to $99,999; 
Percentage of all individual taxpayers: 20; 
Percentage of individual taxpayers reporting rental real estate 
activity: 31; 
Percentage of individual taxpayers misreporting rental real estate 
activity: 34; 
Net misreported income (billions of dollars): $3.9. 

Adjusted gross income: $100,000 or greater; 
Percentage of all individual taxpayers: 9; 
Percentage of individual taxpayers reporting rental real estate 
activity: 24; 
Percentage of individual taxpayers misreporting rental real estate 
activity: 23; 
Net misreported income (billions of dollars): $4.3. 

Adjusted gross income: Total; 
Percentage of all individual taxpayers: 100; 
Percentage of individual taxpayers reporting rental real estate 
activity: 100; 
Percentage of individual taxpayers misreporting rental real estate 
activity: 100; 
Net misreported income (billions of dollars): $12.4. 

Source: GAO analysis of IRS data and examination case files. 

Notes: Estimates for individual taxpayers reporting rental real estate 
activity do not sum to 100 percent because of rounding. For 
misreporting taxpayers, estimates have margins of error of less than 5 
percentage points. For taxpayers reporting rental real estate activity 
and all individual taxpayers, estimates have margins of error of less 
than 2 percentage points. For net misreported amounts, estimates have 
margins of error of less than 49 percent. 

[End of table] 

Misreporting of Rental Real Estate Expenses Was the Most Common Type of 
Misreporting We Found That IRS Detected during NRP Examinations: 

As shown in table 3, misreporting of rental real estate expenses was 
the most common type of misreporting that we found through our file 
review that IRS detected through the NRP examinations of taxpayers with 
rental real estate activity. The figures in table 3 do not include 
additional misreporting that IRS assumes to have taken place, which it 
takes into account when estimating the tax gap. Following table 3 we 
discuss the specific types of misreporting that we found IRS to have 
detected through NRP. 

Table 3: Estimated Frequency of Types of Individual Taxpayer 
Misreporting of Rental Real Estate Activities That IRS Detected through 
NRP Examinations, Tax Year 2001: 

Type of misreporting: Misreported rental real estate expenses; 
Number of misreporting taxpayers (millions): 3.9; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 43; 
Net misreported income (billions of dollars): $9.0. 

Type of misreporting: Misreported rent received; 
Number of misreporting taxpayers (millions): 1.3; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 15; 
Net misreported income (billions of dollars): [A]. 

Type of misreporting: Reported activity on an incorrect part of the 
individual tax return; 
Number of misreporting taxpayers (millions): 0.5; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 6; 
Net misreported income (billions of dollars): [A]. 

Type of misreporting: Misreported loss from rental real estate; 
Number of misreporting taxpayers (millions): [A]; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 2; 
Net misreported income (billions of dollars): [A]. 

Type of misreporting: Other types of misreporting; 
Number of misreporting taxpayers (millions): 0.4; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 5; 
Net misreported income (billions of dollars): [A]. 

Type of misreporting: All types of misreporting; 
Number of misreporting taxpayers (millions): 4.8; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 53; 
Net misreported income (billions of dollars): $12.4. 

Source: GAO analysis of IRS data and examination case files. 

Notes: Some taxpayers misreported rental real estate activity for more 
than one type of misreporting. As such, estimates for types of 
misreporting do not sum to totals. Estimates in this table do not 
include some instances of misreporting from 10 cases where we could not 
determine the type of misreporting. Other types of misreporting 
included taxpayers who made errors elsewhere on their tax returns that 
led to errors in reporting rental real estate activities or errors that 
were made by taxpayers' paid tax return preparers. Estimates for 
numbers of taxpayers have margins of error of less than 34 percent. 
Estimates for percentages of taxpayers have margins of error of less 
than 4 percentage points. The estimate for net misreported income due 
to misreported rental real estate expenses has a margin of error of 
less than 24 percent. 

[A] We could not provide a reliable estimate for this type of 
misreporting. 

[End of table] 

Misreported Rental Real Estate Expenses: 

The most common reason why taxpayers misreported their rental real 
estate expenses was because they lacked documentation to substantiate 
some of the expenses they deducted, as shown in table 4.[Footnote 17] 

Table 4: Estimated Frequency of Types of Misreporting of Rental Real 
Estate Expenses by Individual Taxpayers, Tax Year 2001: 

Type of expense misreporting: Did not substantiate a reported expense; 
Number of misreporting taxpayers (millions): 2.1; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 24; 
Net misreported income (billions of dollars): $5.2. 

Type of expense misreporting: Did not report or fully report an allowed 
expense; 
Number of misreporting taxpayers (millions): 1.7; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 19; 
Net misreported income (billions of dollars): -$2.6. 

Type of expense misreporting: Miscalculated depreciation; 
Number of misreporting taxpayers (millions): 1.0; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 11; 
Net misreported income (billions of dollars): [A]. 

Type of expense misreporting: Improperly deducted personal expenses; 
Number of misreporting taxpayers (millions): 1.0; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 11; 
Net misreported income (billions of dollars): $3.2. 

Type of expense misreporting: Deducted an expense in full that should 
have been depreciated; 
Number of misreporting taxpayers (millions): 0.5; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 5; 
Net misreported income (billions of dollars): $1.7. 

Type of expense misreporting: Misreported rental expenses for other 
reasons; 
Number of misreporting taxpayers (millions): 1.0; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 12; 
Net misreported income (billions of dollars): $1.9. 

Type of expense misreporting: All types of misreporting of expenses; 
Number of misreporting taxpayers (millions): 3.9; 
Estimated percentage of taxpayers with rental real estate activity who 
misreported: 43; 
Net misreported income (billions of dollars): $9.0. 

Source: GAO analysis of IRS data and examination case files. 

Notes: Some taxpayers misreported rental real estate activity for more 
than one type of misreporting. As such, estimates for types of expense 
misreporting do not sum to totals. Estimates for numbers of taxpayers 
have margins of error of less than 32 percent. Estimates for 
percentages of taxpayers have margins of error of less than 3 
percentage points. Dollar estimates have margins of error of less than 
41 percent. 

[A] We could not provide a reliable estimate for net misreported income 
from miscalculated depreciation. 

[End of table] 

For taxpayers who did not substantiate expenses, some may have incurred 
the expenses they could not document while other taxpayers may simply 
have made up expenses. Generally, we could not discern from our case 
file review why taxpayers did not substantiate reported expenses. 

We found two scenarios for taxpayers who did not report or fully report 
all allowable expenses. During the course of IRS's examinations, some 
taxpayers discovered additional expenses for properties that they 
reported on their tax returns. For other taxpayers, unreported expenses 
were related to properties for which they received rent that they did 
not report on their tax returns--and that IRS subsequently identified. 
For these properties, IRS required the taxpayers to report the rent 
that they received and allowed them to deduct related expenses that 
they could document. We could not estimate the frequency of these 
scenarios because we could not always determine whether the unreported 
expenses were related to unreported rent. 

Taxpayers misreported depreciation expenses in a variety of ways. We 
estimate that about 166,000 taxpayers included the value of their land 
within the depreciable basis of their properties.[Footnote 18] Other 
types of misreported depreciation included taxpayers deducting 
depreciation for properties that they had already fully depreciated or 
miscalculating depreciation by using an incorrect length of time 
(useful life) over which to depreciate property. 

Additional ways in which taxpayers misreported rental real estate 
expenses included the following: 

* Deducting expenses in full that should have been depreciated. For 
example, taxpayers deducted expenses related to improving a property or 
deducted the full expense of buying an item, such as a washing machine, 
instead of depreciating these costs. 

* Improperly deducting personal expenses. Some taxpayers deducted 
expenses that were completely personal in nature while others made 
errors in how they divided expenses that were for both personal and 
rental real estate purposes. 

* Other types of misreporting of expenses. These included taxpayers 
deducting unallowable expenses, such as penalties or interest related 
to real estate taxes, or making mathematical errors on their tax 
returns. 

Misreported Rent Received: 

We identified three scenarios for taxpayers who misreported rent 
received. 

* Taxpayers who did not report any rental activity. 

* Taxpayers who reported receiving rent for some properties but not for 
others. 

* Taxpayers who reported receiving rent for all of their properties but 
reported incorrect rent amounts. Some examples of misreporting rent in 
this manner included taxpayers failing to count certain items as rent, 
such as expenses paid by tenants or kept security deposits, or having 
inadequate records. 

We could not estimate the frequency of these scenarios because we could 
not always determine the exact nature of the misreported rent. 

Reported Activity on an Incorrect Part of the Individual Tax Return: 

This type of misreporting includes taxpayers who reported income or 
expenses as rental real estate activity on Part I of Schedule E that 
they should have reported elsewhere on their tax returns and taxpayers 
who reported an activity elsewhere on their tax returns that they 
should have reported on Part I of Schedule E. For example, some 
taxpayers reported business activities as rental real estate activities 
on Part I of Schedule E that IRS determined should have been reported 
on the schedule to the individual tax return for profit and loss from 
business (Schedule C). We also found taxpayers who reported income or 
expenses on Schedule C that should have been reported as rental real 
estate activity on Part I of Schedule E. This type of misreporting may 
not have affected the calculation of the amount of income tax owed. 
However, reporting activities on the wrong schedule could have affected 
the amount of self-employment tax these taxpayers owed, as net income 
from a trade or business is subject to self-employment tax whereas net 
income from rental real estate reported on Schedule E generally is not. 
IRS estimated that underreported self-employment tax accounted for $39 
billion of the 2001 tax gap. 

Misreported Loss from Rental Real Estate: 

The most common reason why taxpayers misreported loss from their rental 
real estate activities was because they also used their rental property 
as a residence--including taxpayers who rented their properties at less 
than a fair rental price--and claimed a loss to which they were not 
entitled. Other reasons why taxpayers misreported loss were because 
they were not actively participating in their rental real estate 
activities or exceeded applicable income limitations for deducting a 
loss from rental real estate.[Footnote 19] 

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. IRS receives information returns for a 
relatively small number of taxpayers with rental real estate activity. 
For tax year 2001, for example, IRS received Forms 1099-MISC reporting 
rent received for about 327,000 taxpayers who reported rent on their 
tax returns.[Footnote 20] By comparison, there were about 8.2 million 
taxpayers who reported rent on their tax returns for whom IRS did not 
receive a corresponding Form 1099-MISC from a third party reporting the 
rent. For taxpayers who deduct rental real estate expenses, IRS 
generally receives information returns from third parties only for 
mortgage interest that taxpayers pay. For tax year 2001, about 55 
percent of taxpayers who reported rental real estate activity deducted 
mortgage interest, accounting for about 36 percent of the total amount 
of all rental expenses, including depreciation, that taxpayers deducted 
for that year. As a result, about 64 percent of the total amount of all 
rental real estate expenses taxpayers reported may not have been 
subject to information reporting. 

IRS enforcement officials cited limited information reporting as a 
major challenge in ensuring compliance for the reporting of rental real 
estate activities because without third-party information reporting it 
is difficult for IRS to systematically detect taxpayers who fail to 
report any rent or determine whether the rent and expense amounts 
taxpayers report are accurate. The officials also told us that because 
third parties are not required to include on Form 1098 the address of 
the property for which they are reporting mortgage interest, IRS is 
less able to determine if the interest is for a property used for 
rental or personal purposes. 

In addition, limited information reporting on rental real estate 
activities results in lower levels of taxpayer voluntary compliance in 
reporting rental real estate activities when compared to other types of 
income or activities covered by more extensive information reporting. 
Taxpayers tend to more accurately report income that third parties 
report on information returns--such as Forms 1099-MISC and 1098-- 
because the income is transparent to taxpayers as well as to IRS. As 
shown in figure 1, individual taxpayers misreport receiving rent to a 
greater extent than they misreport income subject to more extensive 
information reporting. 

Figure 1: Individual Net Income Misreporting Categorized by the Extent 
of Income Subject to Information Reporting, Tax Year 2001: 

[See PDF for image] 

This figure is a vertical bar graph depicting the following data: 

Substantial information reporting and withholding: 
* Wages and salaries; 
Net misreporting percentage: 1.2. 

Substantial information reporting: 
* Pensions and annuities; 
* Dividend income; 
* Interest income; 
* Unemployment compensation; 
* Social Security benefits; 
Net misreporting percentage: 4.5. 

Some information reporting: 
* Deductions; 
* Partnership/S-Corp income; 
* Exemptions; 
* Capital gains; 
* Alimony income; 
Net misreporting percentage: 8.6. 

Little or no reporting: 
* Rents and royalties; 
* Nonfarm proprietor income; 
* Informal supplier income; 
* Other income; 
* Farm income; 
* Form 4947 income; 
* Adjustments; 
Net misreporting percentage: 53.9. 

Source: IRS. 

[End of figure] 

Although information reporting tends to lead to high rates of 
compliance, requiring all individuals who pay rent to report to IRS the 
annual amount of rent they pay to property owners or their 
intermediaries is not practical. Officials at IRS and representatives 
from the tax return preparation industry told us that although such a 
requirement would likely improve compliance, it would place a 
substantial burden on taxpayers, who may not have any incentive to 
comply. Likewise, the requirement would be very difficult for IRS to 
enforce given the large number of potential information return filers. 

IRS compliance officials and representatives of the paid tax return 
preparer industry told us that the complexity involved in reporting 
rental real estate activities also hampers compliance. For example, the 
rules surrounding whether to file Forms 1099-MISC or how to accurately 
depreciate property may be challenging for some taxpayers to 
understand. 

Due to limited information reporting and the complexity of reporting 
for rental real estate activity, IRS primarily addresses rental real 
estate misreporting through field and office examinations. IRS 
supplements examination coverage for rental real estate misreporting 
through AUR, to a limited extent, based on rental income amounts 
reported on Form 1099-MISC or mortgage interest reported on Form 1098. 
[Footnote 21] 

Given the limited extent of information reporting, it can be difficult 
for IRS to identify misreporting taxpayers. Also, field examinations 
are resource intensive and on average address relatively large amounts 
of misreporting compared to the misreported amounts for most taxpayers 
who misreported rental real estate activity. For example, for fiscal 
year 2006, the average tax assessment IRS recommended for field 
examinations of individual taxpayers was about $18,000 per taxpayer. We 
found that taxpayers who underreported their net income from rental 
real estate misreported an average of $4,055[Footnote 22]. As a 
consequence, field examinations may not be a cost-effective tool for 
targeting most rental real estate misreporting. Further, the number of 
individual taxpayers misreporting rental real estate activity (4.8 
million) is large relative to the approximately 300,000 field 
examinations of individual taxpayers IRS conducted in fiscal year 2006. 
According to IRS's examination program, relatively small amounts of 
misreporting are more likely to be addressed through correspondence 
examinations. 

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. One change 
to current information reporting requirements that could improve rental 
real estate income reporting compliance is to require third parties to 
include mortgaged property addresses when reporting taxpayers' mortgage 
interest payments on Form 1098. As previously noted, not having 
property addresses on Form 1098 hinders IRS's efforts to enforce rental 
real estate reporting compliance. IRS officials told us that having 
third parties consistently report property addresses on Form 1098 would 
help them in their enforcement efforts, for example, by allowing them 
to better distinguish between owner-occupied and rental properties. 
Also, taxpayers who receive Forms 1098 that include the addresses of 
their rental properties could be deterred from failing to report 
activity for their properties. Representatives of the mortgage banking 
industry told us that it would be feasible to report property address 
information on Form 1098 because mortgage lenders maintain this 
information. The representatives also told us that reporting this 
information would involve costs because lenders would have to change 
their reporting systems. They said that such costs would be lessened if 
lenders were only required to send property address information to IRS, 
which they would send electronically, and not to taxpayers, for whom 
the lenders may send Forms 1098 on paper, as changing systems for 
electronic submissions is less costly than changing systems for printed 
forms. However, excluding property address information from Forms 1098 
sent to taxpayers might eliminate any deterrent effect. 

Another potential change to existing information reporting requirements 
is to expand the requirement for taxpayers to file Forms 1099-MISC for 
certain payments they deduct as expenses, for example, when taxpayers 
pay contractors to perform repair work on their rental properties. 
Existing law on whether taxpayers must file information returns on 
selected rental real estate expenses they incur requires a case-by-case 
analysis that depends on the facts and circumstances for each taxpayer. 
Currently, only taxpayers whose rental real estate activity is 
considered a trade or business are required to report payments on Form 
1099-MISC. However, the law for filing information returns[Footnote 23] 
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. Without concrete 
statutory language, it may be difficult for taxpayers who report rental 
real estate activity to determine if they are required to file Forms 
1099-MISC for certain expense payments they make. As a result, it is 
possible that some taxpayers who should file Forms 1099-MISC for 
payments they make in the course of renting out real estate may not 
file the forms. IRS does not have data on the number of taxpayers who 
file Form 1099-MISC reporting expense payments from rental real estate 
activities. Taxpayers are not required to indicate on Form 1099-MISC 
the type of activity for which they are filing the form (e.g., business 
activity on Schedule C versus rental real estate activity on Schedule 
E). Therefore, under current statutory and regulatory guidance, it is 
not possible for IRS to determine the activities for which Forms 1099- 
MISC are filed. 

Although it would be a departure from the trade or business 
requirement, making all taxpayers with rental real estate activity 
subject to the Form 1099-MISC filing requirement would provide clear 
guidance for who must file Forms 1099-MISC.[Footnote 24] Such clarity 
could benefit both IRS and taxpayers. Taxpayers would have clear 
direction on whether they had to file the form. As previously 
discussed, we found through our file review that a large amount of 
misreported net income from rental real estate was from taxpayers for 
whom IRS disallowed expenses that the taxpayers could not substantiate. 
It is likely that some of these taxpayers reported on their tax returns 
expenses that they did not incur. Requiring taxpayers to file 
information returns for certain rental real estate expense payments 
could deter these taxpayers from reporting expenses they did not incur 
because IRS would have a record of expenses it could use as part of an 
enforcement action. 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. 

Also, a change to the Form 1099-MISC filing requirement would put 
taxpayers reporting rental real estate on par with other individual 
taxpayers, such as sole proprietors of other types of trades or 
businesses, who are generally required to file Forms 1099-MISC. 
Currently taxpayers reporting rental real estate expenses whose 
activities are not considered a trade or business and sole proprietors 
of other types of business who generate similar amounts of gross income 
from their activities are treated differently based on the information 
return statutes. For example, a taxpayer with rental real estate 
activities not considered a trade or business would not have to file an 
information return reporting a payment made to an individual contractor 
for repair services whereas a sole proprietor engaged in a trade or 
business would have to file for a similar service, assuming the 
payments exceeded the minimum reportable amount threshold. It is 
questionable whether, without additional statutory authority, IRS can 
require all taxpayers with rental real estate activities to report 
expense payments on Forms 1099-MISC regardless of whether their 
activities are trades or businesses. 

An expansion of the Form 1099-MISC filing requirement could have the 
added benefit of improving compliance among payment recipients, such as 
contractors who are sole proprietors, because additional payments would 
be transparent to IRS and the payment recipients. IRS estimated that 
sole proprietors misreport at a relatively high rate and accounted for 
a significant portion--$68 billion--of the tax gap for tax year 2001. 

Extending the Form 1099-MISC filing requirement to additional taxpayers 
who report rental real estate involves costs and burdens for taxpayers. 
Many taxpayers who were not required to file in the past or were 
unaware of the filing requirement would have to learn the reporting 
rules and file Form 1099-MISC. However, not all individual taxpayers 
with rental activity would have to file Form 1099-MISC because not all 
will have paid $600 or more to a single individual during the tax year, 
which is the threshold for the reporting requirement.[Footnote 25] One 
way to further limit the number of taxpayers with rental real estate 
activity that would be required to file Form 1099-MISC would be to 
increase the exemption amount for payments to a single person. The $600 
or more threshold for reporting payments made in the course of a trade 
or business has not been updated since the 1950s, and as such a greater 
percentage of payments are likely subject to reporting than when the 
requirement was first put in place because of inflation. 

One obstacle for taxpayers in determining if they are required to file 
Form 1099-MISC is that generally taxpayers do not have to file the 
forms for payments made to corporations. As such, taxpayers must figure 
out whether the persons or businesses to which they make payments are 
incorporated to determine whether they need to file Form 1099-MISC. A 
way to remove this obstacle is to expand information reporting to 
include payments made to corporations. In the past, we have identified 
requiring information reporting on payments made to corporations as a 
way to improve compliance.[Footnote 26] Also, the administration in its 
fiscal year 2009 budget proposed requiring information reporting on 
payments to corporations.[Footnote 27] 

Additionally, IRS would need to inform taxpayers and others of the 
expanded Form 1099-MISC filing requirement. Communicating the 
requirement could be complicated by the different deadlines for filing 
Form 1099-MISC and the individual tax return. Taxpayers must send Form 
1099-MISC to payment recipients by January 31, whereas the deadline to 
file tax returns is April 15.[Footnote 28] Filing Form 1099-MISC past 
the deadline may result in a penalty. Taxpayers who are newly required 
to file Form 1099-MISC may not learn of the requirement until they 
begin to prepare their tax returns, which some may not begin to do 
until after the January 31 Form 1099-MISC filing deadline. IRS 
compliance officials told us that taxpayers who realize that they are 
late in filing required Forms 1099-MISC may choose not to file them 
rather than run the risk of incurring penalties from filing late. One 
way to lessen the impact of potential penalties on taxpayers who are 
newly required to file Form 1099-MISC would be to waive penalties for 
late filers the first year they are required to file. 

We are examining issues involved with filing Form 1099-MISC in a 
forthcoming report. As such, we did not examine in depth some of the 
issues involved with filing Form 1099-MISC that we highlighted in this 
report, such as increasing the reporting threshold, requiring reporting 
for payments made to corporations, and penalties. 

Requiring Taxpayers to Report Additional Information on Tax Returns for 
Rental Real Estate Activity Could Improve Rental Real Estate Reporting 
Compliance: 

Requiring taxpayers to report additional information on their tax 
returns for their rental real estate activity could improve rental real 
estate reporting compliance by eliciting more accurate information from 
taxpayers and providing IRS with additional information to detect 
misreporting. As previously discussed, the requirements for reporting 
rental real estate activities are complex. Such complexity may be why 
individual taxpayers reporting this activity use paid preparers more 
frequently than other individual taxpayers. For example, for tax year 
2001, an estimated 77 percent of individual taxpayers reporting rental 
real estate activity used a paid tax return preparer.[Footnote 29] By 
comparison, an estimated 56 percent of all individual taxpayers used a 
paid preparer for that tax year.[Footnote 30]As we have said in past 
reports, paid preparers are a critical quality-control checkpoint for 
the tax system and the quality of service they provide is important. 
[Footnote 31] However, taxpayers with rental real estate activity who 
used a paid preparer were statistically as likely to have misreported 
as taxpayers with rental real estate activity who prepared their 
returns themselves.[Footnote 32] 

One of the challenges that paid preparers encounter when preparing 
returns for taxpayers with rental real estate activity is that the 
preparers do not always receive complete or accurate information from 
taxpayers. Requiring preparers to verify taxpayers' documentation of 
rental real estate expenses or perform increased due diligence of 
taxpayers' rental real estate activities could improve the accuracy of 
what taxpayers report. However, both of these requirements would 
involve substantial costs and burdens for paid preparers, taxpayers, 
and IRS that could outweigh any related compliance benefits. 

Requiring taxpayers to report additional information for their rental 
real estate activities on their tax returns is an alternative way to 
elicit more accurate and complete information from taxpayers who use 
paid preparers--as well as taxpayers who self-prepare. These additions 
would add a level of due diligence because paid preparers would have to 
obtain additional information on taxpayers' income and expenses in 
order to complete the taxpayers' returns. For example, requiring 
taxpayers to report on Part I of Schedule E if they filed a Form 1099- 
MISC for one or more deducted expenses, such as through a check-the-box 
question, could increase taxpayer awareness of the requirement and 
prompt paid preparers to ask taxpayers questions about the nature of 
their clients' expenses, which could improve the accuracy of the 
expenses taxpayers report. IRS compliance officials were uncertain if 
having this information for use in its enforcement efforts would 
provide additional compliance benefits. As we are examining issues 
involved with filing Form 1099-MISC in a forthcoming report, we did not 
examine whether requiring taxpayers to indicate on their tax returns if 
they filed a Form 1099-MISC would be a cost-effective way to improve 
compliance. 

As previously mentioned, about 166,000 taxpayers improperly included 
the value of land when depreciating their rental properties. Requiring 
taxpayers to report on their tax returns the basis amount attributed to 
land versus structure when depreciating rental property could further 
improve compliance. With such a requirement, IRS could identify 
taxpayers who depreciated land or may have undervalued their land when 
calculating depreciation.[Footnote 33] This requirement would not be 
unprecedented, as IRS currently requires taxpayers to report the value 
of their land when determining the amount of depreciation to deduct for 
the business use of their homes.[Footnote 34] 

Also, through our file review, we found that taxpayers do not always 
report on their tax returns the type of property they rented out. The 
instructions to Schedule E currently provide the example of "townhouse" 
as the type of information taxpayers should report on property type on 
Part I of Schedule E. The instructions do not ask the taxpayer to 
report if the house was rented for residential, vacation, commercial, 
or other purposes, for example. If IRS is to use information on 
property type in its enforcement efforts, it needs to receive 
consistent information, such as that which taxpayers could provide by 
answering a check-the-box question that included the various types of 
properties taxpayers might rent out. 

Although such a check-the-box question would provide IRS with more 
consistent information on property type, including such a question on 
Part I of Schedule E would involve challenges. For example, IRS would 
need to clearly define the different types of properties taxpayers 
might report, and some rental properties could be used for multiple 
purposes. Also, IRS compliance officials were uncertain to what extent 
IRS could use this information in its enforcement efforts. 

Finally, we found that about 36 percent of taxpayers reporting rental 
real estate activity did not include the complete address of their 
rental properties on their tax returns for tax year 2001. Although the 
instructions to Schedule E direct taxpayers to report the street 
address, city or town, and state for their properties (the instructions 
state that taxpayers do not have to report zip codes), the language on 
the actual form directs taxpayers to list the "location" of their 
rental real estate properties. Specifically directing taxpayers to 
report complete property addresses could increase the number of 
taxpayers reporting addresses, rather than general location 
information. According to IRS examination officials, having complete 
address information would allow IRS examiners to use commercially 
available data sources on property values to help determine fair rental 
prices for taxpayers whose returns are selected for examination. 
Whether having complete address information could also cost effectively 
enhance IRS's examination selection process is less clear, according to 
the officials. 

Providing Taxpayers with Additional Guidance on Rental Real Estate 
Reporting Requirements Could Improve Compliance, Although to What 
Extent Is Difficult to Measure: 

Another way to help taxpayers to more accurately report their rental 
real estate activities is by providing them with additional guidance to 
help them complete their tax returns. The impact on the tax gap from 
providing additional guidance may be difficult to measure, as IRS 
researchers have found it difficult to determine the extent to which 
taxpayer services, such as tax form instructions, improve compliance 
among taxpayers who want to comply. Likewise, providing taxpayers with 
additional guidance does not guarantee that the taxpayers will actually 
read the guidance, especially those who use paid preparers, and would 
not affect taxpayers who willfully misreported. Regardless, providing 
taxpayers with additional guidance could produce compliance benefits 
among taxpayers who want to comply that exceed the related 
implementation costs, which may be low relative to other actions IRS 
could take to improve compliance, such as increased enforcement 
efforts. Providing additional guidance could be particularly helpful 
for taxpayers who use tax return preparation software to prepare their 
returns if the software included or is based on the guidance. 

For example, regardless of whether the requirement for who must file a 
Form 1099-MISC changes in the future, at least some taxpayers who 
reported rental real estate activity are currently required to file. 
However, the instructions to Schedule E do not discuss this 
requirement. Including guidance on the Form 1099-MISC filing 
requirement in the instructions to Schedule E could inform taxpayers of 
the requirement and could result in more taxpayers filing the form. 

Likewise, IRS's publication on residential rental property[Footnote 35] 
discusses that land cannot be depreciated and provides guidance on how 
taxpayers can determine the value of their land. Although the 
instructions to Schedule E also state that land cannot be depreciated, 
they do not provide guidance on how to determine the value of land. 
Representatives from the tax return preparation industry told us that 
taxpayers are more likely to review tax form instructions than IRS 
publications. As such, providing guidance on resources available to 
taxpayers for determining how to distinguish between the cost of land 
versus the cost of structures in the instructions to Schedule E could 
help taxpayers more accurately determine the value of their land, which 
could help them more accurately report depreciation. 

With regard to recordkeeping, IRS produces a publication with general 
guidance for individual taxpayers.[Footnote 36] However, recordkeeping 
requirements for expense deductions are only discussed in the 
instructions to Part I of Schedule E with regard to deducting mortgage 
or other interest. Providing general guidance on recordkeeping 
requirements in the instructions to Part I of Schedule E could 
encourage taxpayers to keep better records, which could lead to more 
accurate reporting. The instructions could also include language 
similar to that in IRS's publication on recordkeeping, explaining that 
taxpayers who, upon IRS examination, cannot produce records to 
substantiate items they report on their tax returns may be subject to 
additional taxes and penalties. Including this language could increase 
voluntary compliance by deterring taxpayers from reporting expenses 
they did not incur. 

Outreach to Taxpayers and Other Stakeholders Could Improve 
Understanding of Reporting Requirements and Common Types of 
Misreporting: 

Given that some taxpayers may not read IRS's guidance, an additional 
way to inform taxpayers of the reporting requirements is to send them 
notices covering key requirements and common mistakes taxpayers make 
with regard to reporting rental real estate activity. In addition to 
making taxpayers aware of the reporting requirements, such notices 
could serve as a reminder to taxpayers that IRS is aware that they have 
rental real estate activity, which in turn could serve as a deterrent 
to intentional misreporting. These notices could be sent to some 
taxpayers, such as taxpayers reporting rental real estate for the first 
time, or all taxpayers who report rental real estate activity. Sending 
these notices to taxpayers could also help inform paid preparers of the 
requirements and common types of misreporting given that taxpayers who 
received such notices would likely share them with their paid 
preparers, according to representatives of the tax return preparation 
industry. 

However, the cost-effectiveness of sending notices like these is not 
clear. IRS would have to dedicate resources to take calls from 
taxpayers who receive the notices and have questions, which would be a 
likely scenario according to IRS communications officials and 
representatives of the tax return preparation industry. Producing and 
sending the notices would also involve costs. Also, IRS would not 
necessarily be able to target taxpayers who potentially misreported 
their rental real estate activities when sending the notices. Given 
these limitations, it would be important for IRS to test the 
effectiveness of sending notices to taxpayers to determine if they can 
increase compliance in a cost-effective manner. 

A way to indirectly inform taxpayers of the reporting requirements and 
common types of misreporting for rental real estate is for IRS to 
enhance its focus on rental real estate in its outreach efforts to paid 
preparers and other external stakeholders. Outreach to paid preparers 
could be particularly important given that about 80 percent of 
individual taxpayers who report rental real estate use a paid preparer, 
[Footnote 37] but these taxpayers were as likely to have misreported as 
taxpayers who self-prepared their tax returns. As previously discussed, 
IRS produced and disseminated a fact sheet on the requirements for 
reporting rental real estate activity, although the fact sheet did not 
include information on common types of misreporting. Providing 
additional information on the common types of misreporting, such as 
those we found that IRS identified through NRP examinations, in 
outreach efforts could help paid preparers assist individual taxpayers 
to comply with the reporting requirements. 

An IRS examination official told us that outreach, such as contacting 
national paid preparer groups or providing information at IRS 
Nationwide Tax Forums and other conferences that paid preparers attend 
to fulfill their continuing professional education requirements, could 
be a good approach to improving paid preparer due diligence. An IRS 
official involved with outreach to external stakeholders told us that 
although in the past IRS had targeted its outreach efforts primarily to 
individual paid preparers, IRS is starting to reach out to tax return 
preparation companies and tax preparation software vendors as well. 
These outreach efforts could include providing information on common 
types of rental real estate misreporting. Likewise, IRS compliance and 
stakeholder liaison officials suggested including property managers 
within IRS outreach efforts for this area of compliance. 

Conclusions: 

The disparity in individual taxpayer reporting compliance between net 
income from sources subject to minimal information reporting, such as 
rental real estate, and income that is subject to extensive information 
reporting, such as wages, results in substantial revenue loss and 
undermines the fairness of our tax system. However, significant 
obstacles stand in the way of improving tax compliance by owners of 
rental real estate. There are few practical opportunities for 
additional third-party information reporting. Some taxpayers may not 
fully understand the complex rules governing the reporting of rental 
real estate activity, in part because their heavy reliance on paid 
preparers means that many taxpayers may not read IRS guidance. 
Detecting misreporting often requires face-to-face examinations, which 
are costly to IRS and reach relatively few individual taxpayers. 

Nevertheless, opportunities exist to improve compliance by individual 
taxpayers who own rental real estate. First, existing information 
reporting requirements could be improved. For example, under current 
law, only taxpayers whose rental real estate activity is considered a 
trade or business are required to report expense payments on Form 1099- 
MISC, but the law for filing the form does not clearly spell out how to 
determine whether taxpayers' rental real estate activity should be 
considered a trade or business. To hold taxpayers with rental real 
estate to the same requirements for filing Form 1099-MISC as taxpayers 
whose activities are considered a trade or business would provide 
clarity about who is required to file. Likewise, requiring property 
addresses on Forms 1098 that report mortgage interest could provide IRS 
with additional information to identify taxpayers who may not have 
reported rental real estate activity and could deter taxpayers from 
failing to report. Second, requiring taxpayers to report additional 
information on their tax returns for their rental real estate 
activities could force taxpayers to pay more attention to IRS guidance 
or seek advice from paid preparers, act as a deterrent to intentional 
misreporting, and compel paid preparers to obtain more accurate income 
and expense information from taxpayers. Third, although it is unclear 
the extent to which individual taxpayers read guidance on reporting 
requirements, especially taxpayers who use paid preparers, enhancements 
to IRS's guidance on rental real estate reporting requirements could 
reduce unintentional misreporting. Such enhancements might also be 
useful to paid preparers and could be reflected in tax preparation 
software. Fourth, improving outreach efforts could also improve 
compliance. Given the uncertainty about whether individual taxpayers 
read IRS guidance, researching the effectiveness of outreach to 
taxpayers could be beneficial. Also, given the heavy reliance on paid 
preparers by owners of rental real estate, additional outreach to paid 
preparers, among others, could be an effective way to indirectly reach 
large numbers of taxpayers. 

Matter for Congressional Consideration: 

To provide clarity for which taxpayers with rental real estate activity 
must report expense payments on information returns and to provide 
greater information reporting, Congress should consider amending the 
Internal Revenue Code to make all taxpayers with rental real estate 
activity subject to the same information reporting requirements as 
other taxpayers operating a trade or business. 

Recommendations for Executive Action: 

We are making nine recommendations to the Commissioner of Internal 
Revenue. 

To help IRS identify taxpayers who may have misreported their rental 
real estate activity, we recommend that the Commissioner of Internal 
Revenue require third parties to report mortgaged property addresses on 
Form 1098 mortgage interest statements. 

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 help taxpayers understand the requirements related to certain 
aspects of reporting rental real estate activities, we recommend that 
the Commissioner of Internal Revenue include guidance within the 
instructions to Part I of Schedule E on: 

* the requirement for some taxpayers with rental real estate activity 
to report on Form 1099-MISC certain payments made in the course of 
renting out real estate; 

* resources available to taxpayers for determining how to distinguish 
between the cost of land versus the cost of structures; and: 

* recordkeeping requirements and the potential for disallowed expenses 
and penalties if taxpayers cannot produce documentation for reported 
expenses upon examination by IRS. 

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. 

Agency Comments and Our Evaluation: 

In written comments on a draft of this report, which are reprinted in 
appendix II, IRS agreed with seven of our nine recommendations. 
However, IRS agreed only to consider implementing our recommendation to 
require third parties to report mortgaged property addresses on Form 
1098 mortgage interest statements citing the burden the requirement 
could place on third parties. Although it is important to take third- 
party burden into account when considering whether to require 
information reporting, representatives of the mortgage banking industry 
told us that it would be feasible to report property address 
information on Form 1098 because mortgage lenders already maintain this 
information. Also, IRS disagreed with our recommendation to require 
taxpayers to report on the individual tax return the basis amount 
attributed to land versus structure when depreciating rental real 
estate properties. Specifically, IRS stated that taxpayers report 
depreciation on Form 4562 and not on Schedule E to the individual tax 
return, and that the basis of land is not used in calculating 
depreciation. However, taxpayers are not required to report the basis 
amount attributable to land on Form 4562. Further, we did not 
specifically recommend on which form or schedule taxpayers should be 
required to report the value of their land for properties they 
depreciate. Also, we believe that, in effect, the basis of land is used 
in calculating depreciation because taxpayers must subtract the value 
of land from the overall basis of their properties. We found that for 
tax year 2001, about 166,000 individual taxpayers included the value of 
land when calculating depreciation for their rental properties. We 
believe that requiring taxpayers to report the value of land in 
conjunction with reporting depreciation calculations--whether on Form 
4562, Schedule E, or elsewhere--would serve to reduce the number of 
taxpayers who improperly include the value of land when calculating 
depreciation for their rental properties. We agree with IRS that more 
guidance to taxpayers is needed about allocating basis to land. 

As agreed with your offices, unless you publicly announce its contents 
earlier, we plan no further distribution of this report until 30 days 
from its issue date. At that time, we will send copies to the Chairman 
and Ranking Member, House Committee on Ways and Means; the Secretary of 
the Treasury; the Commissioner of Internal Revenue; and other 
interested parties. Copies will be made available to others upon 
request. This report will also be available at no charge on GAO's Web 
site at [hyperlink, http://www.gao.gov]. 

If you or your staff have any questions, please contact me at (202) 512-
9110 or whitej@gao.gov. Contact points for our Offices of Congressional 
Relations and Public Affairs may be found on the last page of this 
report. Key contributors to this report are listed in appendix III. 

Signed by: 

James White: 
Director, Tax Issues: 
Strategic Issues Team: 

[End of section] 

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. Through NRP, IRS selected and reviewed a stratified random 
sample of 45,925 individual income tax returns from tax year 2001. We 
selected a sample of cases that included taxpayers with rental real 
estate activity from this NRP sample. The NRP sample is divided across 
30 strata by the type of individual tax return filed and income levels. 
IRS accepted as filed some of the NRP returns, accepted others with 
minor adjustments, and examined the remainder of returns either through 
correspondence or face-to-face meetings with taxpayers. If IRS 
examiners determined that taxpayers misreported any aspect of the 
selected tax returns, they adjusted the taxpayers' income accordingly 
and assessed additional taxes. 

IRS captured data from tax returns and examination results in the NRP 
database, including data for rental real estate activities. However, 
because taxpayers report expenses from both rental real estate and 
royalty activities on the same lines of Part I of Schedule E, it is not 
possible to determine with certainty whether adjustments examiners made 
in the NRP database to these expense lines were for rental real estate 
or royalty activities. Likewise, the data do not include detailed 
information on why examiners made adjustments to rental real estate 
activities. Therefore, to distinguish between misreporting for rental 
real estate versus royalty expenses and to identify the primary types 
of misreporting of rental real estate activities, we selected a 
statistical sample of NRP examination case files to review. 

We selected a sample of 1,202 cases from the tax returns IRS examined 
from its NRP sample. We selected tax returns for taxpayers who reported 
rental real estate or royalty activity on Part I of Schedule E. 
[Footnote 38] Our sample was made up of four groups: (1) taxpayers for 
whom IRS made adjustments to rental real estate activity, (2) taxpayers 
who reported rental real estate activity for whom IRS did not make 
adjustments to rental real estate activity, (3) taxpayers for whom IRS 
made adjustments to royalty activity, and (4) taxpayers who reported 
royalty activity for whom IRS did not make adjustments to royalty 
activity. We included cases for taxpayers who accurately reported 
rental real estate activity in order to make comparisons between 
taxpayers for whom IRS did and did not make adjustments to rental real 
estate activity. We selected cases with royalty activity to estimate 
misreporting from royalties, which IRS combines with misreporting from 
rental real estate to estimate the tax gap for these two activities. 

The first group of cases consisted of 752 cases of taxpayers for whom 
IRS made an adjustment to rents received, expenses, or loss reported on 
Part I of Schedule E. Within this group we included, where possible, 
the 10 cases in each stratum for which the adjustments examiners made 
had the largest impact on the total amount of these adjustments for all 
taxpayers when weighted for the entire population of individual 
taxpayers (a total of 204 cases). We focused on cases with the largest 
adjustments, in weighted terms, because including these cases would 
improve the level of confidence of any estimates of the total amount of 
adjustments to taxpayers' rental real estate activities. We selected 
the remaining 548 cases in this first group of cases at random and in 
proportion to the number of NRP returns for which IRS made adjustments 
to taxpayers' rent, expenses, or loss reported on Part I of Schedule E. 
Because our sample is a subsample of the NRP sample and is subject to 
sampling error, we added cases, where applicable, to ensure that each 
stratum contained a minimum of 5 randomly selected cases. 

For the second group of cases we selected 248 cases for taxpayers who 
reported rents received, expenses, or loss on Part I of Schedule E that 
IRS did not adjust. We selected these cases at random and in proportion 
to the NRP sample through an iterative process ensuring, where 
possible, that a minimum of 5 cases was included in each stratum. 

The third group of cases included 102 cases where IRS made an 
adjustment to taxpayers' royalties received. The aggregate of these 102 
cases and 30 cases with adjustments to royalties received selected as 
part of the first group of cases account for all 132 cases in the NRP 
database where examiners made adjustments to taxpayers' royalties 
received. The fourth group consisted of 100 cases, selected at random 
and in proportion to the NRP sample, for taxpayers who did not report 
rents received and reported royalties received that IRS did not adjust. 
We ensured, where possible, that a minimum of 5 cases were included in 
each stratum. 

Of the 1,202 cases we selected for our sample, we reviewed 1,000 cases. 
We did not review the remaining 202 cases because either IRS did not 
provide the files in time to include in our review (185 cases) or the 
files did not contain examination workpapers essential to determine if 
or why examiners made adjustments to taxpayers' rental real estate 
activities (17 cases).[Footnote 39] We requested the cases at two 
points, in late-May 2007 and late-June 2007, and periodically checked 
on the status of our requests with IRS. We were only able to review 
cases that arrived by January 11, 2008, in order to meet our agreed- 
upon issue date for the report. 

We recorded information from the case files using a data collection 
instrument (DCI) that we developed. To ensure that our data collection 
efforts conformed to GAO's data quality standards, each DCI entry that 
a GAO analyst completed was reviewed by another GAO analyst. The 
reviewers compared the data recorded within the DCI entry to the data 
in the corresponding case file to determine whether they agreed on how 
the data were recorded. When the analysts' views on how the data were 
recorded differed, they met to reconcile any differences. 

The estimates we included in this report were based on the NRP database 
and the data we collected through our file review and were generated 
using statistical software. All computer programming for the resulting 
statistical analyses were checked by a second, independent analyst. Our 
final sample size was large enough to generalize the results of our 
review for the entire population of individual taxpayers with rental 
real estate activity or had margins of error small enough to produce 
meaningful estimates, unless otherwise noted in the report.[Footnote 
40] 

Because we followed a probability procedure based on random selection, 
our sample is only one of a large number of samples that we might have 
selected. Since each sample could have resulted in different estimates, 
we express our confidence in the precision of our particular sample's 
results as a 95 percent confidence interval, plus or minus the margin 
of error. These intervals would contain the actual population value for 
95 percent of the samples we could have selected. Unless otherwise 
noted, all percentage estimates have a margin of error of less than 5 
percentage points; value estimates have a margin of error of less than 
8 percent. 

We assessed whether the examination results and data contained in the 
NRP database were sufficiently reliable for the purposes of our review. 
For this assessment, we interviewed IRS officials about the data, 
collected and reviewed documentation about the data and the system used 
to capture the data, and compared the information we collected through 
our case file review to corresponding information in the NRP database 
to identify inconsistencies. Based on our assessment, we determined 
that the NRP database was sufficiently reliable for the purposes of our 
review. 

We also used IRS's Statistics of Income (SOI) file for individual 
taxpayers from tax years 2001 through 2005, which relies on a 
stratified probability sample of individual income tax returns, to 
develop estimates on characteristics for taxpayers who reported rental 
real estate activity. Where possible, we compared our analyses against 
published IRS data to determine that the SOI database was sufficiently 
reliable for the purposes of our review. 

To identify challenges IRS faces in ensuring rental real estate 
reporting compliance and to assess options for increasing compliance, 
we reviewed IRS forms, publications, and other taxpayer guidance 
related to reporting rental real estate activity and documents from 
IRS's enforcement programs. We also reviewed data from the Automated 
Underreporter program and published data on examinations to determine 
the extent of IRS's enforcement efforts. We also examined data on 
individual taxpayers from SOI to determine the extent to which (1) 
individual taxpayers use paid tax return preparers and (2) third 
parties report information on rental real estate activity on Form 1099- 
MISC. In addition, we interviewed officials from IRS's Small Business/ 
Self-Employed; Wage and Investment; and Research, Analysis, and 
Statistics divisions who have knowledge of rental real estate 
compliance issues. We also spoke with representatives of the American 
Institute of Certified Public Accountants, National Association of 
Enrolled Agents, National Association of Residential Property Managers, 
and Mortgage Bankers Association to get their perspectives on issues 
related to rental real estate reporting compliance. 

We conducted this performance audit from May 2007 through August 2008 
in accordance with generally accepted government auditing standards. 
Those standards require that we plan and perform the audit to obtain 
sufficient, appropriate evidence to provide a reasonable basis for our 
findings and conclusions based on our audit objectives. We believe that 
the evidence obtained provides a reasonable basis for our findings and 
conclusions based on our audit objectives. 

[End of section] 

Appendix II: Comments from the Internal Revenue Service: 

Department Of The Treasury: 
Internal Revenue Service: 
Deputy Commissioner: 
Washington, D.C. 20224: 

August 26, 2008: 

James R. White: 
Director, Tax Issues: 
United States Government Accountability Office: 
Washington, DC 20548: 

Dear Mr. White: 

Thank you for the opportunity to review the Government Accountability 
Office (GAO) draft report entitled "Tax Gap - Actions That Could 
Improve Rental Real Estate Reporting Compliance (GAO-08-956)." 

We appreciate your comprehensive report and the suggestions to address 
noncompliance in this area. They will assist us as we strive to address 
the tax gap through a balanced approach. 

We agree there are opportunities to expand our outreach efforts 
regarding proper reporting for rental real estate activity. We will 
issue an updated fact sheet on rental real estate, which will include 
common types of misreporting. We will post this fact sheet on 
[hyperlink, http://www/irs.gov] and include the information on the real 
estate industry web page. This message will also be used in educational 
outreach to tax professionals and software providers, and appropriate 
industry organizations, such as rental owner associations. 

We also appreciate your suggestions to revise several forms and 
instructions related to real estate reporting. Unfortunately, due to 
the complexity of rental real estate issues and limitations of the 
forms, we are unable to implement all of them. 

The enclosed response addresses each of your recommendations 
separately. 

If you have any questions, please contact Christopher Wagner, Acting 
Commissioner, Small Business/Self-Employed Division at (202) 622-0600. 

Sincerely, 

Signed by: 

Linda E. Stiff: 

Enclosure: 

GAO Recommendations and IRS Responses to GAO Draft Report: Tax Gap - 
Actions That Could Improve Rental Real Estate Reporting Compliance
GAO-08-956: 

Recommendation: Require third parties to report mortgaged property 
addresses on Form 1098 mortgage interest statements. 

Comments: We will consider requiring third parties to report mortgaged 
property addresses on Form 1098 mortgage interest statements. 
Currently, the Form 1098 provides optional reporting of the mortgaged 
property address. However, it will be an increase in burden to the 
third parties. 

Recommendation: Require taxpayers to report on the individual tax 
return the basis amount attributed to land versus structure when 
depreciating rental real estate. 

Comments: We do not agree with this recommendation. The depreciation 
calculation is reported on Form 4562, Depreciation and Amortization, 
and not on Schedule E (Form 1040) and the basis of land is not used to 
compute depreciation. However, we will add information to the 
instructions for Schedule E (Form 1040) about allocating basis to land. 

Recommendation: Determine if IRS uses property type information that 
taxpayers currently report on Schedule E in its efforts to enforce 
rental real estate reporting compliance. 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 types of 
properties for which they are reporting activity, for example by 
answering a check-the-box question. If it is determined that IRS does 
not use the information, the Commissioner should not require taxpayers 
to report any property type information. 

Comments: We agree to evaluate the use of property type information, 
currently reported by the taxpayer on Schedule E, in our compliance 
efforts. As recommended, if it is determined IRS uses property type 
information in its efforts to enforce rental real estate reporting 
compliance, we will revise Part I of Schedule E (Form 1040). If it is 
determined the IRS does not use the information, we will not require 
taxpayers to report any property type information. 

Recommendation: 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. 

Comments: We agree that reporting the exact "address" versus "location" 
of rental real estate will elicit more accurate information from 
taxpayers on their rental real estate activities, while not imposing a 
burden. We will change the wording on Part I Schedule E to read, 
"address, city, state, and zip code." 

Recommendation: Include guidance within the instructions to Part I of 
Schedule E on the requirement for some taxpayers with rental real 
estate activity to report on Form 1099-MISC certain payments made in 
the course of renting out real estate. 

Comments: We agree to adopt this recommendation. 

Recommendation: Include guidance within the instructions to Part I of 
Schedule E on resources available to taxpayers for determining how to 
distinguish between the cost of land versus the cost of a structure. 

Comments: We agree to add guidance in the instructions to Part I of 
Schedule E (Form 1040) on how to allocate the basis between land versus 
the cost of a structure. 

Recommendation: Include guidance within the instructions to Part I of 
Schedule E on recordkeeping requirements and the potential for 
disallowed expenses and penalties if taxpayers cannot produce 
documentation for expenses upon examination by the IRS. 

Comments: We agree to add guidance within the general instructions of 
the Schedule E (Form 1040) on recordkeeping requirements and penalties. 

Recommendation: 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. 

Comments: We agree with this recommendation and will conduct a test of 
approximately 31,000 soft notices for tax year 2007. The sample will 
include some rent and royalty information documents. IRS will evaluate 
the results of the soft notice test in FY 2009 and make decisions on 
its effectiveness and whether it should be expanded in subsequent 
years. 

Recommendation: 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. 

Comments: We agree that we can further expand our outreach efforts 
regarding proper reporting for rental real estate activity. We will 
issue an updated fact sheet on rental real estate, which will include 
common types of misreporting. We will post this fact sheet on irs.gov 
and will include the information on the real estate industry web page. 
We will also utilize this message in educational outreach to tax 
professionals, software providers, and to appropriate industry 
organizations, such as rental owner associations. 

[End of section] 

Appendix III: GAO Contact and Staff Acknowledgments: 

GAO Contact: 

James White, (202) 512-9110 or whitej@gao.gov: 

Acknowledgments: 

In addition to the contact named above, Charlie Daniel, Assistant 
Director; Jeff Arkin; Ellen Grady; Laura Henry; Shirley Jones; Winchee 
Lin; John Mingus; Karen O'Conor; Ellen Rominger; Jeff Schmerling; 
Andrew Stephens; and Elwood White made key contributions to this 
report. 

[End of section] 

Related GAO Products: 

Highlights of the Joint Forum on Tax Compliance: Options for 
Improvement and Their Budgetary Potential. [hyperlink, 
http://www.gao.gov/cgi-bin/getrpt?GAO-08-703SP]. Washington, D.C.: June 
2008. 

Tax Administration: The Internal Revenue Service Can Improve Its 
Management of Paper Case Files. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-07-1160]. Washington, D.C.: September 28, 2007. 

Tax Gap: A Strategy for Reducing the Gap Should Include Options for 
Addressing Sole Proprietor Noncompliance. [hyperlink, 
http://www.gao.gov/cgi-bin/getrpt?GAO-07-1014]. Washington, D.C.: July 
13, 2007. 

Using Data from the Internal Revenue Service's National Research 
Program to Identify Potential Opportunities to Reduce the Tax Gap. 
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-423R]. Washington, 
D.C.: March 15, 2007. 

Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax Gap. 
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-488T]. Washington, 
D.C.: February 16, 2007. 

Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax Gap. 
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-391T]. Washington, 
D.C.: January 23, 2007. 

Tax Compliance: Opportunities Exist to Reduce the Tax Gap Using a 
Variety of Approaches. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-06-1000T]. Washington, D.C.: July 26, 2006. 

Tax Compliance: Challenges to Corporate Tax Enforcement and Options to 
Improve Securities Basis Reporting. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-06-851T]. Washington, D.C.: June 13, 2006. 

Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost 
Basis Would Improve Compliance if Related Challenges Are Addressed. 
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-603]. Washington, 
D.C.: June 13, 2006. 

Tax Gap: Making Significant Progress in Improving Tax Compliance Rests 
on Enhancing Current IRS Techniques and Adopting New Legislative 
Actions. [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-453T]. 
Washington, D.C.: February 15, 2006. 

Tax Gap: Multiple Strategies, Better Compliance Data, and Long-Term 
Goals Are Needed to Improve Taxpayer Compliance. [hyperlink, 
http://www.gao.gov/cgi-bin/getrpt?GAO-06-208T]. Washington, D.C.: 
October 26, 2005. 

Tax Compliance: Better Compliance Data and Long-term Goals Would 
Support a More Strategic IRS Approach to Reducing the Tax Gap. 
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-753]. Washington, 
D.C.: July 18, 2005. 

Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal 
Sustainability but Will Require a Variety of Strategies. [hyperlink, 
http://www.gao.gov/cgi-bin/getrpt?GAO-05-527T]. Washington, D.C.: April 
14, 2005. 

Tax Administration: IRS Is Implementing the National Research Program 
as Planned. [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-03-614]. 
Washington, D.C.: June 16, 2003. 

Tax Administration: New Compliance Research Effort Is on Track, but 
Important Work Remains. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-02-769]. Washington, D.C.: June 27, 2002. 

Tax Administration: Status of IRS' Efforts to Develop Measures of 
Voluntary Compliance. [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-
01-535]. Washington, D.C.: June 18, 2001. 

[End of section] 

Footnotes: 

[1] This $13 billion portion of the tax gap includes misreported net 
income from royalties--such as from oil, gas, or mineral properties; 
copyrights; and patents--because individual taxpayers are required to 
report net income from rental real estate and royalties on the same 
part of the individual tax return (Part I of Schedule E). The estimate 
does not distinguish what part of the $13 billion is attributed to 
rental real estate misreporting. We do not evaluate royalties in this 
report. Likewise, net income or loss from rental real estate held 
through a partnership, S corporation, estate, or trust or for farm 
rentals is to be reported elsewhere on Schedule E, and IRS includes 
misreporting from these activities in a separate portion of the tax gap 
estimate. Accordingly, our analyses in this report only cover rental 
real estate activities that were, or should have been, reported on Part 
I of Schedule E. 

[2] We selected cases with royalty activity to estimate misreporting 
from royalties, which IRS combines with misreporting from rental real 
estate to estimate the tax gap for these two activities. 

[3] Department of Housing and Urban Development and Department of 
Commerce, U.S. Census Bureau, Residential Finance Survey: 2001 
(Washington, D.C.: 2005). These estimates include rented and vacant 
single-family and multifamily houses, condominiums, mobile homes and 
complexes, and rental or cooperative apartment buildings. Certain 
properties, such as some publicly owned properties or properties with 
more than 50 percent of the floor space used for business, industrial, 
or nonresidential purposes, were not included in the estimate. 

[4] U.S. Census Bureau, 1995 Property Owners and Managers Survey, 
[hyperlink, http://www.census.gov/hhes/www/housing/poms/poms.html] 
(accessed Apr. 17, 2007). Certain properties, such as those owned by a 
public housing authority or properties used primarily as second or 
vacation homes, were not included in the estimate. 

[5] Figures do not include taxpayers who reported activity from rental 
real estate held by a partnership or other entity. According to an IRS 
technical advisor, a large percentage of partnerships are engaged in 
rental real estate activity. 

[6] Income from other types of rental activities, such as rentals where 
significant services (such as maid services) are provided, the rental 
of personal property or farm rentals, and rental properties held by a 
partnership or other entity, are reported elsewhere on the individual 
tax return. 

[7] Deductible expenses include advertising, auto and travel, cleaning 
and maintenance, commissions, insurance, legal and professional fees, 
management fees, mortgage and other interest, repairs, supplies, taxes, 
utilities, and other miscellaneous expenses. 

[8] The tax treatment of rental property that taxpayers also use for 
personal purposes depends on whether taxpayers use the property as a 
residence. For the purposes of this requirement, a property is 
considered to be used as a residence if the taxpayer uses it for 
personal purposes more than the greater of (1) 14 days or (2) 10 
percent of the number of days the unit is rented at a fair rental 
price. 26 U.S.C. § 280A(d). 

[9] Fair rental price for a given property is generally the amount of 
rent that a person not related to the property owner(s) would be 
willing to pay to rent the property. 

[10] Direct payments of rent to rental agents and rent payments made to 
corporations are excluded from the Form 1099-MISC reporting 
requirement. 

[11] In addition to Schedule E and its associated instructions, IRS 
produces publications that cover rental real estate issues, such as 
Publication 527, Residential Rental Property, and Publication 925, 
Passive Activity and At-Risk Rules. 

[12] GAO, Capital Gains Tax Gap: Requiring Brokers to Report Securities 
Cost Basis Would Improve Compliance if Related Challenges Are 
Addressed, [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-603] 
(Washington, D.C.: June 13, 2006). 

[13] Estimate has a margin of error of less than 21 percent. 

[14] We are 95 percent confident that taxpayers who misreported their 
net income from royalties misreported from -$15.5 million to $63.0 
million, meaning that these taxpayers may have reported more net income 
from royalties than they should have. 

[15] Estimate has a margin of error of less than 44 percent. 

[16] Estimate has a margin of error of less than 26 percent. 

[17] For the purposes of this report, we characterize taxpayers who 
could not substantiate expenses that IRS ultimately disallowed as 
having misreported. 

[18] Estimate has a margin of error of less than 17 percent. We could 
not reliably estimate net misreported income for taxpayers who included 
the value of land within depreciable basis because of the small number 
of cases in our sample for which we identified this type of 
misreporting. 

[19] Rental real estate activities are generally considered passive 
activities, and the amount of loss that taxpayers can deduct for these 
activities is limited. Generally, taxpayers cannot deduct losses from 
rental real estate activities unless they have income from other 
passive activities. Taxpayers may be able to deduct some rental real 
estate losses without regard to whether they have income from other 
passive activities if they actively participate in their rental 
activities (such as by selecting tenants or deciding on rental terms) 
and own at least 10 percent, by value, of their rental properties. 
Taxpayers who actively participate in a rental real estate activity can 
deduct up to $25,000 of loss from their nonpassive income ($12,500 for 
taxpayers who are married but file separate tax returns) if they do not 
exceed certain income limits. Losses for taxpayers who are real estate 
professionals and materially participated in their rental activities 
are not limited by these passive activity rules. To qualify as a real 
estate professional for the purposes of this exception, taxpayers must 
perform more than 750 hours of services in real property trades or 
businesses in which they materially participate during the tax year and 
more than half of all the personal services they perform during the tax 
year must have been for real property trades or businesses in which 
they materially participated. They also must materially participate in 
each of their rental activities for the activities to be considered 
nonpassive. 26 U.S.C. § 469. 

[20] Estimate has a margin of error of less than 11 percent. 

[21] Rent and royalty information is combined in AUR. Through AUR, IRS 
assessed an average of about $12 million in additional taxes for about 
5,100 taxpayers who misreported rent and royalties from 2001 through 
2005. We could not determine how often IRS assessed additional taxes 
for taxpayers who misreported mortgage interest for their rental 
properties because Form 1098 does not indicate if reported mortgage 
interest is from rental properties versus other types of properties, 
such as personal residences. 

[22] Estimate has a margin of error of less than 15 percent. 

[23] 26 U.S.C. § 6041. 

[24] An expansion of this requirement could also apply to other 
entities that report rental real estate activity, such as partnerships. 

[25] For example, for tax year 2001, an estimated 5.3 million taxpayers 
reported expenses of $600 or more for any line item on Part I of 
Schedule E, not including mortgage interest, which is already reported 
by third parties, and taxes, because tax payments to municipal 
governments generally do not have to be reported on information 
returns. By comparison, 8.9 million individual taxpayers reported 
rental real estate activity on Part I of Schedule E. The 5.3 million 
figure likely overstates the number of taxpayers who paid $600 or more 
to a single individual because (1) some expenses reported on Part I of 
Schedule E could have related to royalty rather than rental real estate 
activity and (2) some expenses of $600 or more in the aggregate for a 
given line item may have been for payments to multiple individuals. For 
example, if a taxpayer reported a repair expense of $1,000 dollars, we 
concluded that the taxpayer could have been required to file a Form 
1099-MISC because he or she could have contracted the repair service 
from one individual. However, this taxpayer may have paid two separate 
individuals $500 each, in which case the taxpayer would not have had to 
file Forms 1099-MISC reporting the payments for either individual. It 
is also possible, however, that a taxpayer could have made payments to 
a single individual that the taxpayer reported on more than one line 
item. 

[26] GAO, Tax Compliance: Opportunities Exist to Reduce the Tax Gap 
Using a Variety of Approaches, [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-06-1000T] (Washington, D.C.: July 26, 2006). 

[27] Executive Office of the President, Office of Management and 
Budget, Analytical Perspectives, Budget of the United States 
Government, Fiscal Year 2009. 

[28] Taxpayers must file Forms 1099-MISC with IRS by February 28 or by 
March 31 if filing electronically. 

[29] For 2005, use of paid preparers by taxpayers with rental real 
estate activity was about 81 percent. In addition, an unknown number of 
taxpayers who self-prepared their tax returns may use tax return 
preparation software. 

[30] For 2005, use of paid preparers by all individual taxpayers was 
about 60 percent. 

[31] GAO, Tax Administration: 2007 Filing Season Continues Trend of 
Improvement, but Opportunities to Reduce Costs and Increase Tax 
Compliance Should be Evaluated, [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-08-38] (Washington, D.C.: Nov. 15, 2007). 

[32] Fifty-three percent of taxpayers who had rental real estate 
activity and used a paid preparer misreported their rental real estate 
activity (estimate has a margin of error of less than 5 percentage 
points), and 55 percent of taxpayers who had rental real estate 
activity and prepared their own returns misreported (estimate has a 
margin of error of less than 8 percentage points). The difference 
between these two estimates is not statistically significant. We 
previously reported that some tax return preparers made serious errors 
when completing returns. See GAO, Paid Tax Return Preparers: In a 
Limited Study, Chain Preparers Made Serious Errors, GAO-06-563T 
(Washington, D.C.: Apr. 4, 2006). 

[33] An IRS technical advisor told us that allocating the value of a 
property attributed to land can vary greatly depending on the type and 
location of the property. 

[34] Taxpayers use Form 8829 to deduct business expenses from the use 
of their homes. 

[35] IRS Publication 527, Residential Rental Property, and IRS 
Publication 946, How to Depreciate Property. 

[36] IRS Publication 552, Recordkeeping for Individuals. 

[37] As previously discussed, 77 percent and 81 percent of individual 
taxpayers who reported rental real estate activity used paid preparers 
in 2001 and 2005, respectively. 

[38] We used IRS's database of NRP results to identify these taxpayers. 

[39] We previously reported on difficulties IRS has had in managing 
paper case files. See GAO, Tax Administration: The Internal Revenue 
Service Can Improve Its Management of Paper Case Files, [hyperlink, 
http://www.gao.gov/cgi-bin/getrpt?GAO-07-1160] (Washington, D.C.: Sept. 
28, 2007). 

[40] We considered margins of error of less than 10 percentage points 
for percentage estimates and less than 50 percent for value estimates 
small enough to produce meaningful estimates. 

[End of section] 

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