Property Transactions of Individuals Can Contribute to the Tax Gap
Congress and IRS seem quite serious about implementing various strategies to reduce the tax gap. New information reporting requirements may be enacted. Are you up to speed?
September 13, 2007
by Annette Nellen, CPA/JD
Hundreds of billions of tax dollars go uncollected each year at the federal and state levels. Legislators and tax administrators are pursuing ways to understand the reasons better and to implement techniques for reducing the tax gap. Here are some ways that property transactions of individuals can contribute to the tax gap and what strategies Congress and the IRS might pursue to address the problem.
The Tax Gap
The annual federal tax gap (PDF) is estimated to be about $345 billion. States also face budget challenges due to their inability to collect all taxes owed. Increased attention is being directed to the problem and to finding ways to effectively reduce the gap.
The IRS and GAO have been studying the tax gap, its causes and possible solutions for years. Yet, there is uncertainty as to the amount of the gap because all of the causes are not known. Challenges also exist in measuring the gap, such as estimating the tax liabilities of non-filers.
One technique the IRS is using to help reduce the tax gap is taxpayer education. The IRS maintains a Web site on the gap with links to key reports and fact sheets that remind taxpayers of particular tax rules in an effort to ensure proper compliance.
Property Transactions and the Tax Gap
Property transactions, such as dispositions and acquisitions, can represent significant dollar amounts. These transactions can also be complicated in terms of facts and applicable tax rules. Recordkeeping over many years is often required to determine proper tax consequences, and can easily be missing or incomplete. Thus, unintentional errors are possible. The desire to lessen tax consequences might also lead to intentional errors. Explained below are a few examples of areas prone to errors that taxpayers and practitioners should pay attention to so as not to contribute to the tax gap and face possible penalties and interest.
Sale of a principal residence: Two potential tax gap generating areas related to home ownership involve basis. First, homeowners need to keep records of capitalizable improvements in order to calculate realized gain upon sale. They must also be able to properly distinguish between nondeductible repairs (such as painting) and capitalizable improvements (such as a new roof). Homeowners unfamiliar with the rules may tend to err on the side of capitalization in order to reduce their future gain upon sale of the home, particularly in parts of the country where gains beyond the IRC §121 exclusion amount are likely. A tax gap strategy (PDF) proposed by the GAO is to require information reporting by organizations and individuals for work performed on their property if the payment is to be used for increasing basis. This technique enlists motivated parties to help the IRS verify contractor revenues.
Example: Abe hires X Construction Company to install new electrical wiring in his residence. Abe would be required to file a Form 1099 noting the amount paid to X for the year and X’s tax identification number. If the form is not filed, Abe would not be able to add the cost of the improvement to the basis of his home.
The GAO acknowledges both advantages and disadvantages of this strategy. One advantage is that a significant amount of gross receipts would be reported to the IRS. Disadvantages include that the parties may agree to reduce the cost of the work in exchange for not filing the 1099 (and thereby foregoing the addition to basis). Also, it may be difficult for the IRS to use the information unless an electronic reporting technique is used.
Another tax gap issue related to home ownership involves individuals who rolled over gains under IRC §1034 (before repeal by the Revenue Act of 1997). Some homeowners (and perhaps even their tax advisers) have forgotten that the gain (PDF) rolled over continues to reduce basis.
Example: Mr. and Mrs. Green purchased their first home in 1980 for $25,000. In 1994, they sold the home for $125,000, rolling over their $100,000 realized gain under IRC §1034. They purchased a new home costing $220,000. In 2007, they sold that home for $1 million. With the new exclusion rules added in 1997, the Greens may believe that their realized gain upon sale of the home is $780,000 ($1 million less $220,000) with $500,000 excludable under IRC §121 and $280,000 taxable as a capital gain. However, their basis is not $220,000, but instead is $120,000 (cost of $220,000 less previously deferred gain of $100,000). Thus, their taxable gain is $380,000, not $280,000.
On-line auction sales: Today, many individuals buy and sell items on auction Web sites such as eBay. For individuals selling items they might otherwise donate to charity or sell at a garage sale, most of the sales probably generate non-deductible losses. However, individuals may occasionally have items, such as collectibles, that produce taxable gains. Many individuals may not be aware that the gains are taxable or may not maintain sufficient records to determine the tax consequences.
The National Taxpayer Advocate (PDF) has recommended information reporting (Form 1099) for all or some auction sales. For casual sellers, this would require keeping detailed records of items sold and their basis in order to determine reportable gains and nondeductible losses. Otherwise, taxpayers risk having to pay tax on the gross proceeds of a sale.
Online auction sellers must also evaluate the nature of their activity to determine if it rises to the level of a trade or business raising other tax compliance matters including self-employment tax, sales-and-use tax and business license tax. Gaps exist for these taxes as well.
Property donations: Some type of valuation is usually needed in order for individuals to determine their charitable contribution deduction when property is donated to charity. Sloppy valuation work can widen the tax gap. For example, individuals may tend to minimize the effect on value of used or damaged goods, such as a car that does not work or used clothing. Congress has tightened some rules under IRC §170, such as for clothing and household goods, to lessen the likelihood of overvalued charitable deductions, but tax gap producing problems remain.
Congress and IRS seem quite serious about implementing various strategies to reduce the tax gap. New information reporting requirements may be enacted. Practitioners will want to keep abreast of proposals and perhaps provide comments. Also, once implemented, clients will need assistance to comply. Now is a good time to expand questions asked of clients, such as about online auction activities and to be sure clients have adequate recordkeeping systems in place to lessen their chance of contributing to the tax gap and incurring penalties and interest.
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Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the AICPA and ABA. She has several reports on federal and state tax reform and a blog. Nellen is a contributing writer of AICPA Tax Insider. Her views as expressed in this article do no necessarily reflect the views of the AICPA or the AICPA Tax Insider.