Report to the Honorable Dick Armey,

Majority Leader, House of

Representatives

United States General Accounting Office

GAO

April 2001 TAX DEDUCTIONS

Estimates of

Taxpayers Who May

Have Overpaid

Federal Taxes by Not

Itemizing

GAO-01-529
Page 1 GAO-01-529 Tax Deductions

April 12, 2001

The Honorable Dick Armey

Majority Leader

House of Representatives

Dear Mr. Armey:

When computing their federal taxes, taxpayers either claim a standard

deduction or itemize deductions. These deductions are subtracted from

adjusted gross income in determining taxable income. Taxpayers in

general claim the type of deduction that is larger because that minimizes

their taxable income. In recent years, approximately 70 percent of

taxpayers have claimed the standard deduction, while the remaining 30

percent have itemized.

This report is our initial response to your request for an estimate of the

number of taxpayers who may have overpaid their taxes by claiming the

standard deduction instead of itemizing their deductions, as well as the

amount of taxes they may have overpaid. For this report, we estimated the

number of returns where taxpayers who claimed the standard deduction

may have had deductible mortgage interest expense in excess of their

standard deduction. We developed our estimate by matching data from

different Internal Revenue Service (IRS) databases.

We limited our estimate to itemizable mortgage interest because that was

the only type of itemizable expense for which data were readily available.

Not all mortgage interest payments can be claimed as itemized deductions.

When the data allowed, we excluded certain categories of mortgage

interest payments, such as interest on business mortgages, that may have

been nonitemizable. Because of data limitations, we had to exclude some

mortgage payments that likely were itemizable—to that extent our

estimates are understated. We attempted to identify and exclude the most

common nonitemizable mortgage interest payments. However, we could

not exclude all cases of nonitemizable mortgage interest—to that extent

our estimates are overstated. In a future report, we plan to do further

estimates regarding the number of taxpayers who had a broader range of

United States General Accounting Office

Washington, DC 20548
Page 2 GAO-01-529 Tax Deductions

itemizable expenses, not just mortgage interest.1 This will increase the size

of our estimate.

As agreed with your office, we did not attempt to determine the reasons

why taxpayers claimed the standard deduction when they might have paid

less tax had they itemized deductions.

We estimate that on about 510,000 tax year 1998 individual tax returns,

taxpayers did not itemize their deductions yet had mortgage interest

payments that exceeded the standard deduction amount for their tax filing

status.2

 We estimate these taxpayers may have overpaid their taxes by

about $311 million. The average overpayment amount was $610 and about

35 percent of the taxpayers3

 had overpaid their taxes by more than $500. In

oral comments on this report, IRS officials stated that our methodology for

developing our estimates was reasonable.

The tax code allows taxpayers to subtract from gross income either a

standard deduction or certain itemized deductions. The standard

deduction is the sum of two components, the basic standard deduction

and the additional standard deduction for taxpayers that are age 65 or over

and/or blind. Both the basic and additional standard deductions vary in

amount, depending on filing status. Basic and additional standard

deduction amounts are set by Congress and are adjusted annually for

inflation.

Itemized deductions are specified personal and other expenses that

Congress has chosen to allow as deductions in arriving at taxable income.

Deductible personal expenses include certain of the taxpayer’s interest

payments, such as mortgage interest and points, which are charges paid,

or treated as paid, by a borrower to obtain a home mortgage; certain

 1

For example, other key itemizable deductions include state and local taxes, property taxes

and charitable contributions.

2

The five filing statuses are single, married filing jointly, qualified widow(er) with

dependent child, head of household, and married filing separately. The standard deduction

amounts vary by filing status. For tax year 1998, the basic standard deduction was $4,250

for filing single, $7,100 for married filing jointly or as a qualified widow(er), $6,250 for head

of household, and $3,550 for married filing separately.

3

95-percent confidence level: 30 to 40 percent.

Results in Brief

Background
Page 3 GAO-01-529 Tax Deductions

nonfederal taxes, such as state and local income taxes, real estate taxes,

and personal property taxes; gifts to charity; medical and dental expenses;

and casualty and theft losses. Other deductible expenses include certain

payments related to the production or collection of income and expenses

related to the management of property held for the production of income.

Generally, a taxpayer is allowed to deduct the greater of itemized

deductions or the standard deduction. To minimize their tax liability,

taxpayers could compare their total standard deduction (the sum of their

basic standard deduction and any additional standard deductions) to their

total itemized deductions. If itemized deductions are less than their

standard deduction, taxpayers would compute taxable income using the

standard deduction. If their itemized deductions exceed the standard

deduction, taxpayers would compute taxable income by itemizing.

To estimate the number of taxpayers who potentially overpaid their taxes

by claiming the standard deduction instead of itemizing and the amount of

taxes they may have overpaid, we used IRS’ Statistics of Income (SOI)

data for tax year 1998 (the most recent year for which data were

available). The SOI data consist of a random sample of about 164,000

individual returns filed in 1999, which is statistically representative of the

124.8 million tax year 1998 individual returns filed. To the sampled returns,

we matched data from IRS’ Information Returns Master File, which

contains data from the various information returns, such as form 1098 for

mortgage interest and form W-2 for wages. We used this matched file to

obtain mortgage interest payment amounts for taxpayers in the sample

who did not itemize their deductions.

We first identified the returns of all taxpayers in the SOI sample that did

not itemize their deductions but whose mortgage interest exceeded the

standard deduction available to them. We included only those taxpayers

whose mortgage interest alone exceeded their standard deduction because

the Information Returns Master File did not contain any data on taxpayers’

itemizable deductions other than mortgage interest payments. Thus, we

could not incorporate any of the other itemizable deductions—such as

state and local income taxes, real estate and personal property taxes, and

gifts to charities—in our estimates. Other taxpayers may also have

overpaid their taxes because their total deductible expenses may have

exceeded their standard deductions, but the data on expenses other than

mortgage interest were unavailable.

Scope and

Methodology
Page 4 GAO-01-529 Tax Deductions

We attempted to identify and exclude from our sample the most common

situations in which mortgage interest could not be claimed as an itemized

deduction. We excluded:

• Returns with no tax liability. Because these filers had no tax liability,

there was no potential gain to them from itemizing deductions.

• Returns where the filing status was “married, filing separately.”

Taxpayers in this filing status are required to use the same type of

deductions as their spouse (i.e., if one spouse claimed the standard

deduction, the other must also). Some of these taxpayers may have

been required to claim the standard deduction because their spouse did

so. We did not have data on the filing status of their spouse, so we

excluded these taxpayers from our analysis.

• Returns where taxpayers reported mortgage interest on either their

Schedule C: Profit or Loss From Business, Schedule E: Supplemental

Income and Loss, or Schedule F: Profit or Loss From Farming. We

assumed that all the mortgage interest payments shown on these

taxpayers’ forms 1098 were for business purposes and not for personal

expenses. Thus our estimates of the number of taxpayers who may

have overpaid their taxes may be understated to the extent that the

mortgage interest payments were actually personal expenses.

• Returns of taxpayers that were in the phase-out range for itemizing

deductions and who would not have lowered their taxes by itemizing.

Certain itemized deductions are subject to being phased out beginning

at certain levels of adjusted gross income. The income levels are

$124,500 for filing single; married, filing jointly; qualified widow(er)

with dependent child; and head of household; and $62,250 for married,

filing separately, for tax year 1998. The itemized deductions subject to

phase-out are home mortgage interest, including points; state and local

income taxes; real estate and personal property taxes; gifts to charities;

unreimbursed employee expenses; and some other itemizable

expenses.

• Returns that later were amended by taxpayers. Because these

taxpayers may have itemized their deductions when they filed their

amended return and we did not have data to indicate which taxpayers

did later itemize deductions, we eliminated all returns that later were

amended. Thus our estimates of the number of taxpayers who may

have overpaid their taxes may be understated to the extent that
Page 5 GAO-01-529 Tax Deductions

taxpayers who filed amended returns did not later itemize their

deductions.

In certain cases we were unable to exclude mortgage interest that may not

have been itemizable. To the extent that these cases included

nonitemizable mortgage interest payments, our estimates are overstated.

Home mortgage interest payments that we identified as not being fully

itemizable, but could not exclude from our estimates are:

• Interest payments on mortgage balances over $1 million, where the

mortgage(s) were used to acquire (that is, buy, build, or improve) the

residence(s). Although we could not exclude them, it is unlikely that

our sample included many such large mortgages. Less than one percent

of the returns that we projected to have overpaid taxes had associated

mortgage interest payments of $50,000 or more, which would be the

interest payment on a $1 million mortgage at an interest rate of 5

percent.

• Interest payments on home equity debt, where the mortgage totaled

over the lesser of $100,000 or the fair market value of the home,

reduced by acquisition indebtedness. The amount of such interest

could be limited by lending institutions.

• Interest payments on a third home. Taxpayers who meet this

nondeductible category generally would have to have three nonincome-producing homes. If any of the three homes were used for

business purposes, including rental property, the mortgage interest

payments would have been reported on the taxpayers’ Schedules C, E,

or F. If so, they were already excluded from our sample.

Our estimates may be affected by the accuracy of the form 1098 data we

used. We assumed that the data were accurate for both the amount of the

mortgage interest payments and the taxpayer that made the interest

payments. If there are any errors in the data, our estimates are overstated

to the extent that the mortgage interest amounts were overstated.

Conversely, our estimates are understated to the extent that the mortgage

interest amounts are understated. Also, if there are any taxpayers whose

names and Social Security numbers appear on the forms 1098 who were

not the persons legally entitled to claim a mortgage interest deduction, our

estimates may be overstated.

All sample results in this report have been weighted to reflect the entire

population and are subject to sampling error. Unless otherwise indicated,
Page 6 GAO-01-529 Tax Deductions

all estimates are surrounded by a 95-percent confidence interval. The

confidence interval ranges are shown in tables 1 and 2. We did our work in

March and April of 2001 in accordance with generally accepted

government auditing standards.

We requested and received oral comments from the Director of SOI and

other SOI staff on a draft of this report. They stated that the methodology

we used for developing our estimates was reasonable.

For tax year 1998, taxpayers filed over 124 million tax returns. On almost

86 million, or about 70 percent of these returns, taxpayers claimed the

standard deduction. On the remaining 38 million, or about 30 percent, they

itemized their deductions. Of the 86 million returns claiming the standard

deduction, we estimate that on about 510,000 returns, taxpayers may have

reduced their taxes if they had itemized deductions, as shown in table 1.

Mortgage Interest

Payments Exceeded

the Standard

Deduction for Some

Taxpayers Who Did

Not Itemize
Page 7 GAO-01-529 Tax Deductions

Table 1: Estimated Number of Returns Where Taxpayers May Have Overpaid Their Taxes Because Their Mortgage Interest

Payments Exceeded the Standard Deduction, Tax Year 1998

Returns

Return category

Estimated

number

Percent of

total

95-percent

confidence interval

Total returns 124,770,662 100.0

Returns where taxpayer claimed the standard deduction (i.e., did not

itemize)

85,576,463 68.6 85,257,168 to 85,895,758

Returns claiming standard deduction and mortgage interest exceeded the

standard deduction

1,533,346 1.2 1,467,546 to 1,601,308

 excluding returns without a positive tax liability 1,153,643 1.0 1,096,581 to 1,212,883

 excluding returns with filing status “married, filing separately” 1,009,963 0.9 956,590 to 1,065,519

 excluding returns where taxpayers reported mortgage interest on their

 Schedule C, E, or F

543,416 0.5 504,387 to 584,653

 excluding returns where taxpayers in the phase-out range for itemizing

 deductions could not have lowered their taxes by itemizing

529,526 0.4 491,000 to 570,262

 excluding returns later amended by the taxpayer equals estimated

 number of returns where taxpayers may have overpaid their taxes

510,072 0.4 472,274 to 550,081

Source: GAO analysis of SOI and other IRS data.

We estimated that these taxpayers may have overpaid their 1998 taxes by

about $311 million. The average overpaid tax amount is $610. On about 35

percent of returns, taxpayers may have overpaid their taxes by more than

$500, as shown in table 2.

Table 2: Distribution of Returns Where Taxpayers May Have Overpaid Their Taxes

Because Their Mortgage Interest Payments Exceeded the Standard Deduction, Tax

Year 1998

Returns

Distribution of overpaid tax

Estimated

number

Percent

of total

95-percent

 confidence interval

$1 to $100 97,986 19.2 80,791 to 117,065

$101 to $250 113,149 22.2 94,904 to 133,065

$251 to $500 120,385 23.6 101,691 to 140,676

$501 to $1,000 109,535 21.5 91,523 to 129,248

$1,001 to $5,000 63,083 12.4 49,002 to 79,513

Over $5,000 5,934 1.2 2,059 to 13,106

Total 510,072 100.0 472,274 to 550,081

Note: Totals may not sum because of rounding.

Source: GAO analysis of SOI and other IRS data.
Page 8 GAO-01-529 Tax Deductions

As agreed with your office, unless you publicly announce its contents

earlier, we plan no further distribution of this report until 30 days from the

date of this letter. At that time, we will send copies to Representative

William Thomas, Chairman, and Representative Charles B. Rangel,

Ranking Minority Member, House Committee on Ways and Means; Senator

Charles E. Grassley, Chairman, and Senator Max Baucus, Ranking

Member, Senate Finance Committee; Representative Amo Houghton,

Chairman, and Representative William J. Coyne, Ranking Minority

Member, Subcommittee on Oversight, House Committee on Ways and

Means; and the Honorable Charles O. Rossotti, Commissioner of Internal

Revenue. We will also make copies available to others upon request.

If you have any questions regarding this report, please contact me at (202)

512-9110 or Ralph Block at (415) 904-2150. The major contributors to this

report were John Mingus and Anne Stevens.

Sincerely yours,

James R. White

Director, Tax Issues

(440031)
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