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Annette Nellen

Rental Real Estate Issues

The real message in a recent GAO report on the tax gap from misreporting of rental real estate is that the tax law is too complex.

January 15, 2009
by Annette Nellen, CPA/Esq.

One element of the $345 billion estimated annual tax gap is misreporting of rental real estate (RRE) income by individuals. While the misreporting is just under four percent of the total tax gap, it is significant in terms of the percentage of contributing taxpayers and in comparison to other tax gap elements.

In September 2008, the Government Accountability Office (GAO) released a report on the RRE tax gap with recommendations on how to improve compliance. This article reviews and critiques the RRE tax gap data and the GAO recommendations.

Tax Gap Data

GAO analysis of the IRS estimate of a $345 billion tax gap for 2001 noted the following details (GAO-07-423R (PDF), March 2007 and GAO-08-956 (PDF), August 2008).

  • The $345 billion tax gap consists of three types of non-compliance:

    • Non-filing ($27 billion)
    • Underpayment ($33 billion)
    • Underreporting ($285 billion)
  • The $285 billion of underreporting consists of:

    • Individual income tax ($197 billion)
    • Employment tax ($54 billion)
    • Corporate income tax ($30 billion)
    • Estate and excise taxes ($4 billion)
  • The $197 billion of underreporting for the individual income tax arises from the following areas. (GAO-07-423R (PDF))

Type

Tax Gap
(billions)

NMP**

Farm Income
$6
72
Sole proprietor
(non-farm)
$68
57
RRE, royalties
(Schedule E (PDF))*
$13
51
Passthrough entities
$22
18
Non-business income
$56
4
Credits
$17
26
Deductions
$14
5
Exemptions
$4
5
Adjustments
-$3
-21
Total
$197
18
* The IRS estimates that most of this gap is due to RRE rather than royalties.
** Net Misreporting Percentage (NMP) is the net amount misreported of the aggregate absolute values of what should have been reported for that category.

  • About 53 percent of the 8.9 million taxpayers with RRE contributed to the tax gap. In contrast, the percentage of individuals misreporting in the following categories was much lower: (GAO-08-956(PDF))

    • Wage income: 10 percent
    • Dividend income: 17 percent
    • Interest income: 22 percent
  • Improper reporting of RRE expenses represented the bulk of the RRE misreporting. Types of RRE misreporting for 2001: (GAO-08-956 (PDF))

Type of
misreporting

# of taxpayers
who misreported (millions)

Net misreported
income (billions)

Unsubstantiated expenses
2.1
$5.2
Underreporting of expenses
1.7
-$2.6
Depreciation error
1.0
***
Personal expenses deducted
1.0
$3.2
Expensed an asset
0.5
$1.7
Other expense misreporting
1.0
$1.9
Misreported rent received
1.3
***
Reported wrong place on return
0.5
***
Misreported loss
***
***
Other misreporting
0.4
***
All RRE misreporting
4.8
$12.4
*** unable to reliably estimate

  • For 2001, approximately 166,000 taxpayers failed to remove land from the depreciable basis of their RRE (GAO-08-956 (PDF)).
  • For 2005, 81 percent of individuals reporting RRE activity used a paid preparer. In contrast, among all individuals, 60 percent used a paid preparer. Despite the difference, professionally prepared returns were just as likely to have RRE misreporting as were taxpayer-prepared returns (GAO-08-956 (PDF)).

GAO Recommendations

The GAO report includes the following recommendations for the IRS.

  1. Require that mortgage interest statements (Form 1098) include the property address.
  2. Require individuals to separately list the basis of land and structure.
  3. Require taxpayers to show the exact address of RRE on Schedule E (PDF).
  4. Expand the Schedule E instructions to include:

    • a. When 1099-MISC reporting is required.
    • b. Resources to help taxpayers separate the basis of land and structure.
    • c. Information on recordkeeping requirements and the potential penalties for unsubstantiated deductions.

  5. Determine whether it would be cost-effective for the IRS to send information to some or all individuals reporting RRE activity.
  6. Expand outreach to preparers, tax return preparation software developers and industry groups to inform them of common RRE misreporting problems.

IRS Actions

The IRS agreed with all of the GAO recommendations other than the first two noted above. The IRS was concerned about the burden on third party reporters of requiring additional information on Form 1098. Also, the IRS did not think the land/structure basis information would be useful on Schedule E because depreciation is reported elsewhere. The IRS did agree to add information about land basis to the Schedule E instructions.

On its Web site the IRS already has RRE reporting information that specifically addresses tax gap problems. This website has reminders about the types of rental income that must be reported and deductible repairs versus capitalizable items. There is also some basic information about the need for additional calculations when RRE is also used for personal use. There is nothing about land being non-depreciable. No examples are provided although there is reference to IRS Publication 527, Residential Rental Property (PDF).

Looking Forward — Addressing Complexity

As many taxpayers and preparers know, the tax rules governing RRE activities are complicated. The GAO report does not mention that owners of RRE with some personal use must make annual determinations as to whether the loss limitation rules of §280A (property used as a residence) or §469 (passive activities) apply. It is also possible that the §183 hobby loss rule could apply (see "Rental of Residences," The Tax Adviser, September 1990). The rules become even more complicated if personal use ties to a "qualified rental period" under §280A(d)(4) or the property was used by a relative or use was donated to a charity. The GAO report (PDF) doesn't mention the need to keep records on losses that can be carried forward or the lack of complete guidance under §280A(d) where regulations have been in proposed form for over 20 years.

If both simplification and reducing the tax gap are agenda items for the 111th Congress, much progress could be made by revamping the rules for RRE and implementing changes to reduce the misreporting noted in the GAO's report. Consideration should be given to replacing the complex §280A(d) rental limitation with the less complicated §469 passive activity loss limitation. This change would also eliminate the harsher loss limitation of §280A(c)(5) which prevents a loss from one rental from being used against income from other rentals or passive activities.

In addition, the definition of personal use of a residence should be simplified such as by only treating days where the property is not rented at fair rental as personal use (even if the renter is a relative paying fair rent).

Further compliance simplification could be obtained by making the Schedule E more of a worksheet that requires entry of information noted by the GAO as causing misreporting. For example, the allocation of basis between land and structure could be maintained on the Schedule E worksheet. Also, a worksheet could be included that allocates expenses between personal use and rental days.

The advantage of incorporating worksheets into the Schedule E is twofold. First, as part of the schedule, they must be used. When worksheets or guidance are in instructions or publications, they are easily overlooked or ignored. Second, a worksheet provides additional details that aid the IRS in examinations and better encourages and facilitates proper reporting by taxpayers. When over half of individual taxpayers who own RRE misreport RRE income, the problem should not be viewed solely as a tax gap one, but must also be considered an area in dire need of simplification.

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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.