Small Business Taxes & ManagementTM--Copyright 2009, A/N Group, Inc.
Ever wondered about the purpose of those Form 1098s you receive every year reporting your mortgage interest? The original purpose was to provide proof the mortgage interest you deducted on your return was actually paid. (It's important to keep those 1098s; the IRS will ask for them if you're ever audited. Without it, the IRS can disallow the deduction.) In addition, in the absence of other information from the financial institution it would be difficult to compute your interest deduction.
The IRS and the Treasury Inspector General for Tax Administration (TIGTA) has found another purpose for the forms. The IRS has been using information from the 1098s to find potential nonfilers. How? A taxpayer paying $10,000 in mortgage interest (from 1098 records) during the year who hasn't filed a tax return is likely to be a nonfiler. That is, he should be filing a return but isn't. Why? A taxpayer paying $10,000 in mortgage interest along with essential living expenses is likely to be above the gross income threshold required to file a return.
The TIGTA has just completed a two-part analysis looking for nonfilers and taxpayers who underreport income. In the first test the TIGTA took a sample of 100 individuals with combined Forms 1098 totaling $20,000 or more of mortgage interest that were filed with the IRS for 2005. It matched the taxpayer identification numbers on the forms that met the criteria to the IRS Individual Return Transaction File and found $219,593 individuals who had not filed a tax return. From those, TIGTA randomly selected 100 for review and identified 21 individuals who appeared to have a filing requirement. The study went on to determine the amount of taxes, penalty, and interest the potential nonfilers might owe. They determined that, based on the date, the total number of potential nonfilers to be between 28,500 and 63,729 owing between $351,894,360 and $899,456,350.
In the second sample they matched the taxpayer identification numbers on Forms 1098 meeting their criteria to the accounts in the IRS Individual Return Transaction File and identified 245,535 individuals who reported less adjusted gross income on the returns they filed for 2005 than the amount of mortgage interest reflected on their Forms 1098. After randomly selecting 100 of the 245,535 individual returns for review, they used the IRS' cash transaction analysis process and identified 37 individuals who may have underreported their income because their mortgage interest and basic living expenses appear to exceed their income. Overall, based on the sample results, they estimated that these 37 individuals may owe $265,018 in additional taxes and $61,233 in penalties and interest. When projected to the population of 245,535 filers, the results indicated that 90,848 taxpayers may owe $801 million in additional taxes, penalties, and interest for 2005. They projected the number of individuals with insufficient funds to fall between 67,501 and 114,195 with the amounts owed ranging between $548,757,358 and $1,053,363,428.
How did the TIGTA determine the amount of potential tax due? They first followed the cash transaction analysis process used by the IRS Examination function to obtain an estimate of each individual's income. The cash transaction analysis process is an auditing technique that uses personal living expense estimates published by the Bureau of Labor Statistics in comparing a taxpayer's expenditures to their income sources. If a taxpayer's expenditures exceed their income and the source to pay for such expenditures cannot be explained, the excess represents potential unreported income.
The TIGTA recognized that, given the current state of the economy, many individuals are struggling to meet their mortgages and other financial obligations. Nevertheless, a large number of individuals are paying a significant amount of mortgage interest and either are not filing tax returns or are filing tax returns indicating their income is not sufficient to cover their mortgage obligations and basic living expenses. The considerable difference between expenditures and income raises very serious questions about whether these taxpayers have additional sources of income that should have been reported on their tax returns.
Clearly, there are limits to what can be done with this approach. A taxpayer could easily have substantial mortgage interest, real estate taxes, etc. expense with low income. A taxpayer could be unemployed and closing his budget gap with savings or other legitimate sources. However, that's likely to be the exception rather than the rule and using these techniques could turn up many nonfilers and underreporters.
The TIGTA used a $20,000 threshold for the mortgage interest because the highest gross income a taxpayer could have and still not be required to file a return is $18,400 (for the year in the study). In addition, if they paid at least $20,000 in mortgage interest, it was reasonable to assume they more than likely made at least that much in income. If that threshold were reduced as a result of refinements in methodology, it's probable more taxpayers would come under scrutiny.
Copyright 2009 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 09/04/09