The Internal Revenue Service (IRS) estimated most recently for tax year 2001 that 9 million taxpayers misreported their federal deductions for local real estate taxes paid. Average overstated real estate tax deductions are small$85 per overstatement in 2001but the net overstatement, which generally would reduce taxes owed, was about $2.5 billion. IRS has not estimated how much these overstated deductions improperly reduced tax liabilities, but the annual total loss could be substantial.
GAO first reported 17 years ago that taxpayers overstated the real estate tax deduction because real estate tax bills did not distinguish between deductible taxes and nondeductible user fees, and IRS education and enforcement activities were inadequate. GAO conducted a follow-up study in 2009 to determine whether taxpayers were continuing to overstate the deduction.
IRS can take several steps to help improve individual taxpayer compliance with the itemized deduction for real estate taxes and thus reduce associated revenue losses. Individuals who wish to comply in claiming a real estate tax deduction face challenges. The rules for deductibility can be complex as illustrated below.
Determining What Qualifies As Deductible Is Complex
aCharges for the repair or maintenance of local benefits and associated interest are deductible.
GAO estimated in 2009 that almost half of local governments nationwide included charges in 2007 on their real estate tax bills that were generally nondeductible (e.g., fees for trash and garbage pickup). About 78 percent of those local governments did not label such charges in a way that would alert individuals that their real estate tax bill might have nondeductible charges. GAO also estimated that taxpayers in Alameda, California, and Hennepin, Minnesota, counties collectively overstated their 2006 real estate tax deductions between $23 million and $46 million depending on the assumptions used in the estimation methodology.
Local governments generally do not identify for taxpayers which charges on real estate tax bills are deductible because local collectors lack the expertise to identify which charges are federally deductible. Further, taxpayers with mortgages may receive information on real estate tax payments made on their behalf by mortgage servicers, but it does not identify deductible amounts.
Tax preparation software and assistance from paid return preparers may not be sufficient to help taxpayers deduct qualified real estate taxes. Two of the three most frequently used tax preparation software programs for 2008 did not alert taxpayers that some charges on real estate tax bills may not be deductible. Paid tax return preparers invested limited time ensuring that taxpayers deducted qualified real estate taxes.
IRS instructions and guidance for taxpayers on claiming the real estate tax deduction had explained the types of charges that can be deducted. However, they had not adequately informed taxpayers that they should check both real estate tax bills and local government resources to collect information about specific bill charges, which is needed to determine deductibility.
When IRS examiners do audit the real estate tax deduction they usually do not focus on deductibility because they believe the effort required does not justify the likely small changes to taxes that may be due. Rather, they focus on whether the amounts deducted were actually paid. IRS's guidance to examiners does not require them to verify that the entire real estate tax deduction amount is deductible. Examiners are authorized to review many documents, but most of these documents verify whether payment was made rather than whether all of a payment is deductible. Finally, IRS does not know which local governments have large nondeductible charges on their real estate tax bills.
 GAO initially selected 5 of the 41 counties with the largest property revenue for its review based on criteria such as the presence of generally nondeductible items on their tax bills. However, GAO limited its analysis to 2 of the 5 counties due to practical limitations with the data from the counties.
 These software firms did make changes to their programs to better inform taxpayers what qualifies as deductible real estate taxes in response to discussions with GAO for its May 2009 report.
To help individual taxpayers comply in claiming the real estate tax deduction, GAO recommended in May 2009 that IRS instructions and guidance need to be strengthened and spotlight for taxpayers that the real estate tax bill may include nondeductible charges and that taxpayers need to check for such charges. GAO also recommended that IRS provide guidance on how to get information about which charges are nondeductible. IRS took steps in 2009 to improve its guidance in response to the recommendations, but the effects of the changes remain to be seen.
To help individual taxpayers get the best information and assistance from third parties, GAO recommended that IRS reach out to local governments, mortgage servicers, and the tax preparation industry about clarifying information they provide to individual taxpayers on what is deductible, and/or providing alerts and disclaimers about nondeductible charges that are or may be on their real estate tax bill. In response to GAO's recommendations, IRS created a brochure in 2010 for distribution to such third parties with information on what they can do to help clarify for taxpayers what is and is not deductible.
As of December 2010, IRS still needs to take actions on other recommendations included in GAO's May 2009 report. For example:
Although no precise estimate is available of the potential increased revenues these actions might generate, a relatively modest reduction in total overstated deductions could generate tens or hundreds of millions of dollars annually.
 For example, IRS's most recent estimate for 2001 indicated that 5.5 million taxpayers overstated their deductions collectively by $5 billion. A 1-percent to 10-percent reduction in this amount would have reduced overstatements by $50 million to $500 million. The resulting actual tax revenue savings would be much less depending on factors such as the tax rate for these noncompliant taxpayers.
The information contained in this analysis is based on the related GAO products listed under the "Related GAO Products" tab.
For additional information about this area, contact James R. White at (202) 512-9110 or firstname.lastname@example.org.
The Joint Committee on Taxation identified improved taxpayer compliance with the real-estate tax deduction as a way to reduce the federal tax gap--the difference between taxes owed and taxes voluntarily and timely paid. Regarding the deduction, GAO was asked to examine (1) factors that contribute to taxpayers including nondeductible charges, (2) the extent that taxpayers may be claiming such charg...
Pursuant to a congressional request, GAO reviewed federal real estate tax deductions in Montgomery County, Maryland, and New Jersey and Minnesota, focusing on the: (1) extent to which taxpayers overstated their federal real estate tax deductions and related tax losses; and (2) reasons for overstated deductions.GAO found that: (1) taxpayers overstated their real estate tax deductions by about $1.5...
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