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The staff of the non-partisan Joint
Committee on Taxation has proposed new options for closing the
so-called “tax gap” — the difference between
federal taxes that should be paid under current tax rules and the
actual amounts collected by the IRS. Recommendations from the
committee staff carry substantial weight with members of the Senate
and House, and frequently get included in tax legislation.
High on the list of methods to collect
more of what’s owed: Tighten up on homeowners’
billowing write-offs of local and state property taxes, which
currently cost the government about $20 billion a year in
revenues.
Under the federal tax code, local real
estate taxes levied against homes generally are deductible.
However, they are not deductible if the tax payments cover
commonplace special assessments designed to pay for improvements
that directly benefit taxpayers’ real estate. Examples
include local “user fees” for water mains, sewer lines,
sidewalks, trees and trash collections.
The problem, according to the tax
committee staff, is that current federal law does not require local
governments to tell the IRS about property owners’ mixes of
regular taxes and non-deductible special-benefit levies. Local
governments often provide annual property tax statements to
residents with breakouts of assessments. But many homeowners simply
deduct the bottom-line taxes paid.
As a result, according to the committee,
homeowners get to write off hundreds of millions of dollars a year
for tax payments that are not legally deductible. In a 1993 study,
the Government Accountability Office estimated that $400 million of
that year’s $11 billion in property tax write-offs claimed by
homeowners were improper. With deductions this year running nearly
double that amount, wrongly claimed write-offs could be in the $700
million range or more.
The committee proposes two possible
solutions: Require local governments to provide copies of homeowner
tax statements to the IRS with breakouts distinguishing between
regular and special-benefit assessments; or require mortgage
lenders and loan servicers to report details of homeowners’
property tax escrows with similar breakouts.
Either way, the IRS would receive property
tax information on millions of homeowners every year for possible
audit purposes.
The second target on the committee’s
hit list is a much richer lode — home mortgage interest
deductions, a nearly $70 billion revenue loss to the government
this year. One of the problems, according to the staff, is that
many homeowners do not distinguish between non-deductible mortgage
interest and legally deductible interest.
For example, many re-financers write off
mortgage “points” — loan fees treated by the IRS
as prepaid interest — in the year of the refinancing. But the
IRS interprets the tax code to require that points in a refinancing
be written off on a prorated basis over the full term of the
loan.
Currently, lenders report annual mortgage
interest payments to the IRS, but not whether a loan was a
refinancing. The committee staff recommends the rule be changed to
require a notification of all homeowner re-financings — again
providing potentially useful red flags for IRS audit purposes.
Similarly, the committee proposes that
lenders report whenever a refinancing led to a new loan amount
$100,000 larger than the previous balance. That will alert the IRS
to interest write-offs in excess of those permissible under widely
misunderstood rules governing “acquisition
indebtedness.”
Acquisition debt for most taxpayers is the
original mortgage debt they incurred to make their home purchase,
plus all subsequent capital improvements, minus payments to reduce
that principal over the course of the loan. Though many taxpayers
believe that all mortgage interest is deductible on up to $1
million in mortgage debt plus an additional $100,000 in home equity
debt, that is not the law.
Using an example supplied by the
committee, if the owners of a home with a $500,000 mortgage did a
“cash out” re-financing of $700,000 — that is,
they pulled out $200,000 extra — the IRS might not view all
the interest on the $700,000 new debt as deductible. Auditors might
scrutinize whether the owners used more than $100,000 for capital
improvements — legitimate and tax-deductible as
“acquisition debt.”
If substantial sums were spent on new
luxury cars or vacations, by contrast, those portions might not
qualify for federal interest deductions.
To red-flag these cash-out re-financings,
the committee proposes requiring lenders to alert the IRS in annual
mortgage interest reports whenever taxpayers increase their loan
balances by more than $100,000 through refinancing. The committee
says it cannot be certain how many of the recent tidal wave of
cash-out re-financings may have produced interest deductions that
exceed the rules, but given the sheer amounts involved, even low
levels of non-compliance might add up to big bucks.
Where’s this all headed? Don’t
be surprised to see both proposals surface soon in tax legislation,
without regard to the party in control.
• • •
This information is provided as a public
service and should not be construed as individual accounting or tax
planning advice. For information on how these general principles
apply to your situation, please consult an accounting or tax
professional.
Harry Rabb is a C.P.A. and owner of
Accounting Services, Inc., 935 Main Street, Suite D-1, Safety
Harbor. Call 727-725-4121.
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