Tax Gap: Actions That Could Improve Rental Real Estate Reporting Compliance
Published: 2008-08-28T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: As part of its most recent estimate of the tax gap, for tax year 2001, the Internal Revenue Service (IRS) estimated that individuals underreported taxes related to their rental real estate activities by as much as $13 billion. Given the magnitude of underreporting, even small improvements in taxpayer compliance could result in substantial revenue. GAO was asked to provide information on rental real estate reporting compliance. This report (1) provides information on the extent and primary types of taxpayer misreporting of rental real estate activities and (2) identifies challenges IRS faces in ensuring compliance and assesses options for increasing compliance. For estimates of taxpayer misreporting, GAO analyzed a probability sample of examination cases for tax year 2001 from IRS's most recent National Research Program (NRP) study of individual taxpayer compliance.
section_title: What GAO Found
paragraphs: At least an estimated 53 percent of individual taxpayers with rental real estate misreported their rental real estate activities for tax year 2001, resulting in an estimated $12.4 billion of net misreported income. This amount of misreporting is understated because IRS knows it does not detect all misreporting during its NRP examinations and adjusts the amount of misreporting it detects to estimate the tax gap. Also, the rate of misreporting of rental real estate activity was substantially higher than for some other sources of income, such as wages, a disparity that undermines the fairness of the tax system. Misreporting of rental real estate expenses was the most common type of rental real estate misreporting. Limited third-party information reporting for rental real estate activity is among the challenges IRS faces in ensuring compliance for rental real estate reporting. While information reporting, such as financial institutions sending information to IRS about taxpayers' mortgage interest payments, improves compliance, it is not practical to implement and enforce broad, new information reporting requirements for rental real estate activities. However, improving existing information reporting requirements is one of various options that could improve compliance. For example, based on current law, whether rental real estate property owners must file information returns for certain expenses they incur depends on whether the owners' rental activities are considered a trade or business, but the law does not define how to make this determination. Another approach to improving compliance is to require taxpayers to report additional detail about their rental real estate activities on tax returns. For example, requiring taxpayers to report complete property address information, which GAO found that some taxpayers did not report, could help IRS address misreporting. Requiring additional detail on tax returns could also compel paid tax return preparers, used by about 80 percent of individual taxpayers who report rental real estate activity, to obtain more accurate information from taxpayers. Enhanced IRS guidance, such as on required recordkeeping, and additional IRS outreach to paid preparers and others about rental real estate misreporting could also improve compliance.

section_title: Letter
paragraphs: The Internal Revenue Service (IRS) estimated that individual owners of  rental real estate underreported their taxes by as much as $13 billion for  tax year 2001. By misreporting their rental real estate activities, these  taxpayers contribute to the gross tax gap, most recently estimated at  around $345 billion for tax year 2001. The tax gap is the difference  between the taxes that taxpayers pay voluntarily and on time and the  amounts they should pay under the law.
We have noted in past reports and testimonies that the tax gap has  multiple causes, spans five types of taxes, and is spread over individuals  and different business types. For these reasons, addressing the tax gap  requires understanding the characteristics of specific types of  misreporting, such as for rental real estate, in order to develop potential  solutions for closing the gap. Given the magnitude of the estimated tax gap  from rental real estate misreporting, even small improvements in taxpayer  compliance could result in substantial revenue. Increasing compliance  could also improve the fairness of the tax system, as misreporting  taxpayers increase the burden of funding the nation’s commitments for  those taxpayers who voluntarily pay their taxes.
Given your long-standing concern about the tax gap, you asked us to  provide information on individual taxpayer compliance in reporting rental  real estate activity. In response, this report (1) provides information on the  extent and primary types of individual taxpayer misreporting of rental real  estate activities and (2) identifies challenges IRS faces in ensuring  compliance with rental real estate reporting and assesses options for  increasing compliance.
To provide information on the extent and primary types of individual  taxpayer misreporting of rental real estate activities, we selected a  probability sample of case files from a larger sample of individual tax  returns IRS examined through its National Research Program (NRP). We  reviewed case files for 1,000 returns that included rental real estate or  royalty activity and used the results of our case file review along with data  from IRS’s examinations of the tax returns from NRP to make estimates  for the entire population of individual taxpayers with rental real estate  activity. Since our estimates are based on a sample, we express our  confidence in the estimates as a 95 percent confidence interval, plus or  minus a margin of error. These intervals would contain the actual  population value for 95 percent of the samples we could have selected.  Unless otherwise noted, all percentage estimates have a margin of error of  less than 5 percentage points; value estimates have a margin of error of  less than 8 percent. To identify challenges IRS faces in ensuring rental real  estate reporting compliance and assess options for increasing compliance,  we reviewed IRS forms, publications, and other taxpayer guidance related  to reporting rental real estate activity and reviewed documents and data  from IRS’s enforcement programs. In addition, we interviewed officials  from IRS’s Small Business/Self-Employed; Wage and Investment; and  Research, Analysis, and Statistics divisions who have knowledge of rental  real estate compliance issues. We also interviewed representatives of the  tax return preparation, property management, and mortgage banking  industries. We conducted this performance audit from May 2007 through  August 2008 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Individuals report their rental real estate activities on their tax returns,  including for the rental of residential, vacation, and commercial  properties. Individuals own and manage a large amount of residential  properties in the United States. According to a study by the Department of  Housing and Urban Development and the U.S. Census Bureau (Census),  individuals owned an estimated 83 percent of the 15.7 million rental  housing properties with fewer than 50 units in 2001 (with the remainder  owned by partnerships or other entities). Individuals owned 13 percent of  the estimated 71,000 rental properties with 50 units or more.
Likewise, according to a Census study of rental property management  characteristics for 1995, an estimated 67 percent of rental housing  properties with fewer than 50 units were managed by their owners as  opposed to management companies or another type of manager. Owners  managed an estimated 5 percent of rental properties with 50 units or  more. According to IRS data, the estimated number of individual  taxpayers who reported rental real estate activity for properties they  owned directly was 8.7 million in 2001 and 9.1 million in 2005.
Individual taxpayers generally must report as income any rent they receive  from the use or occupation of real estate on Part I of Schedule E, which  they attach to the individual tax return—Form 1040. The amount of  income taxpayers must report includes rent payments and other amounts,  such as kept security deposits or the fair market value of services  taxpayers receive from tenants in lieu of rent. Taxpayers ordinarily are  allowed to deduct the expenses of renting property from their rental  income on Part I of Schedule E. However, the costs of property  improvements that add to the value of a property or extend its useful life,  such as a bathroom addition or new built-in appliances, must be  depreciated, meaning that taxpayers must deduct such costs on their tax  returns over multiple years. Likewise, taxpayers must depreciate the cost  of acquiring a rental property. The amount of depreciation that a taxpayer  can deduct for both property improvements and the cost of rental property  depends on the taxpayer’s basis in the property, among other factors. A  taxpayer’s basis in a rental property is generally the cost of the property  when it was acquired, excluding the cost of land, which is not depreciable  (in practice, taxpayers must determine what portion of the cost of their  properties is attributed to land versus actual structures in order to  determine their depreciable basis).
If individual taxpayers use their properties for both rental and personal  purposes in a given tax year the expenses they can deduct may be limited.  Personal use of a property includes the use by the taxpayer or any other  person who has an interest in the property or use of the property by a  family member of either, even if the property is rented at a fair rental  price. Personal use also includes use by nonowners and non-family  members if the rental is at less than a fair rental price. However, in  general, renting property to a family member or another person is not  considered to be personal use if the property is rented at a fair rental price  and is used by the renter as his or her principal residence. Taxpayers who  use their properties for both rental and personal purposes, but whose  personal use is not enough for the property to be considered a residence,  must allocate their expenses between rental and personal use based on the  number of days used for each purpose.
To assist in filing their tax returns, individual taxpayers are expected, and  in some cases required, to keep records, including those for rent received  and expenses. Additionally, taxpayers must keep records to substantiate  items on their tax returns in case IRS has questions about the items.  Taxpayers who, upon IRS examination, cannot produce evidence to  support items they reported on their tax returns may be subject to  additional taxes and penalties. For example, taxpayers who cannot  substantiate their rental real estate expenses with appropriate records  may have their expenses disallowed, resulting in additional taxes owed.
Information reporting provides taxpayers, as well as IRS, with some  records of rent received and expenses from rental real estate. For  example, when an individual taxpayer receives rent of $600 or more  through a rental agent, such as a rental management company, the agent is  required to report the amount of rent received to the taxpayer and IRS on  a Form 1099-MISC. Payees of rent payments of $600 or more made in the  course of a trade or business, such as renting office space, are also  required to report those payments on Form 1099-MISC. Likewise,  financial institutions are required to report to taxpayers and IRS on Form  1098 the amount of interest taxpayers paid on mortgages they held on their  rental properties. A taxpayer whose rental real estate activity is a trade or  business is required to report service payments of $600 or more on Form  1099-MISC. However, according to IRS, whether a taxpayer’s rental real  estate activity is considered a trade or business is determined on a facts  and circumstances basis. Generally, taxpayers currently do not have to file  Form 1099-MISC for payments made to corporations.
IRS relies on both enforcement and taxpayer service programs to ensure  compliance by taxpayers with rental real estate activity. Two enforcement  programs IRS uses to ensure compliance are the Automated  Underreporter program (AUR) and examinations. Through AUR, IRS  matches information that taxpayers report on Schedule E for rent received  and mortgage interest to amounts that third parties report for these items  on Forms 1099-MISC and 1098, respectively. When mismatches arise  between amounts on tax returns and Forms 1099-MISC and 1098, IRS may  send notices asking taxpayers to explain the discrepancies or pay  additional taxes. Examinations may address any type of misreporting and  come in three forms. Correspondence examinations are conducted  through the mail and usually cover a narrow issue or two. Office  examinations are also limited in scope but involve taxpayers going to an  IRS office. For field examinations, IRS sends a revenue agent to a  taxpayer’s home or business to examine the misreporting that IRS  suspects it has identified. During examinations, IRS uses information from  third parties, taxpayers, and external sources, such as public records.
Through its taxpayer service programs, IRS provides publications, forms,  and instructions to help taxpayers understand and comply with their  rental real estate reporting requirements. IRS also disseminates relevant  information to tax professionals, such as tax return preparer associations,  and business organizations. For example, in July 2007, IRS released a fact  sheet on the requirements for reporting rental real estate activity. In  addition to publishing the fact sheet on its Web site, IRS disseminated the  information to the media and a wide network of tax professional and small  business organizations. IRS also provides assistance to taxpayers through  its toll-free telephone service where taxpayers can call and speak directly  with IRS staff about their tax issues.
IRS periodically measures taxpayer compliance and the tax gap that  results from misreporting, including those for individual taxpayers with  rental real estate activity. The portion of IRS’s 2001 tax gap estimate  caused by individual underreporting is based on NRP. Through NRP, IRS  conducted a review and examination of a representative sample of about  46,000 individual tax returns from tax year 2001. IRS generalized from the  NRP sample results to compute estimates of underreporting of income and  taxes for all individual tax returns. Because even the detailed NRP reviews  could not detect all misreporting, IRS adjusted the NRP results to account  for undetected misreporting when estimating the tax gap, as will be  discussed in the next section of this report.
section_title: About Half of Individual Taxpayers with Rental Real Estate Activities Misreported, Often Because of Overstated or Unsubstantiated Expenses
paragraphs: Based on the unadjusted NRP results, at least an estimated 53 percent of  taxpayers with rental real estate activity (about 4.8 million out of   8.9 million taxpayers) misreported their rental real estate activities for tax  year 2001. Individual taxpayers misreported their rental real estate  activities more frequently than some other types of income for tax year  2001. For example, we previously reported that an estimated 10 percent,  17 percent, and 22 percent of individual taxpayers with wage and salary,  dividend, and interest income, respectively, misreported their income from  these sources. This disparity in compliance undermines the fairness of  the tax system, because when some taxpayers fail to pay the amount of  taxes they should pay under the law, the burden of funding the nation’s  commitments falls more heavily on compliant taxpayers.
Individual taxpayers misreported an estimated $12.4 billion of net income  from rental real estate, before adjusting for tax gap purposes. The  unadjusted NRP results understate the amount of net misreported income  from rental real estate, as they represent only what IRS detected through  NRP examinations. IRS knows that it does not detect all misreporting  during its examinations. As such, it uses various methodologies and other  sources of data to adjust the aggregate NRP results for tax gap purposes to  estimate net misreporting for categories of income or activities, such as  rental real estate and royalties (total rental real estate income or loss is  reported on the same line of Schedule E). After these adjustments, IRS  estimated that the tax gap for rental real estate and royalty activities was  $13 billion for tax year 2001. Misreported rental real estate likely  accounted for most of the $13 billion because taxpayers misreported an  estimated $23.7 million of net income from royalties compared to the  $12.4 billion of net income from rental real estate that taxpayers  misreported.
Of the 4.8 million taxpayers who misreported their rental real estate  activities, an estimated 75 percent underreported their net income from  rental real estate (by either understating rent received or overstating  expenses or loss). For these taxpayers, a relatively small number  underreported $10,000 or more in net income from rental real estate, but  these taxpayers accounted for a large amount of misreported net income,  as shown in table 1. Conversely, nearly one-third of underreporting  taxpayers (about 1.2 million out of about 3.6 million underreporting  taxpayers) underreported less than $1,000. By comparison, an estimated  25 percent of taxpayers who misreported rental real estate activities  overreported their net income from rental real estate (by overstating rent  received or understating expenses or loss), although the amounts they  misreported were relatively small. For example, the estimated median  amount of net income that misreporting taxpayers overreported was  $518, about one-quarter of the median amount of net income of $1,981  that misreporting taxpayers underreported. Some taxpayers who  misreported did so in a way that may not have affected the amount of  income tax they owed but may have affected the amount of employment  tax they owed, as discussed later in this report.
In terms of income levels, the distribution of taxpayers who misreported  rental real estate activity did not vary greatly from the income levels for all  taxpayers who reported rental real estate activity for tax year 2001, as  shown in table 2. However, taxpayers who reported—and misreported— rental real estate activity were generally of higher income levels than all  individual taxpayers. Most of the misreporting, in dollar terms, was  attributed to taxpayers with more than $50,000 of adjusted gross income.
subsections: section_title: Misreporting of Rental Real Estate Expenses Was the Most Common Type of Misreporting We Found That IRS Detected during NRP Examinations
paragraphs: As shown in table 3, misreporting of rental real estate expenses was the  most common type of misreporting that we found through our file review  that IRS detected through the NRP examinations of taxpayers with rental  real estate activity. The figures in table 3 do not include additional  misreporting that IRS assumes to have taken place, which it takes into  account when estimating the tax gap. Following table 3 we discuss the  specific types of misreporting that we found IRS to have detected through  NRP.
The most common reason why taxpayers misreported their rental real  estate expenses was because they lacked documentation to substantiate  some of the expenses they deducted, as shown in table 4.
For taxpayers who did not substantiate expenses, some may have incurred  the expenses they could not document while other taxpayers may simply  have made up expenses. Generally, we could not discern from our case file  review why taxpayers did not substantiate reported expenses.
We found two scenarios for taxpayers who did not report or fully report all  allowable expenses. During the course of IRS’s examinations, some  taxpayers discovered additional expenses for properties that they reported  on their tax returns. For other taxpayers, unreported expenses were  related to properties for which they received rent that they did not report  on their tax returns—and that IRS subsequently identified. For these  properties, IRS required the taxpayers to report the rent that they received  and allowed them to deduct related expenses that they could document.  We could not estimate the frequency of these scenarios because we could  not always determine whether the unreported expenses were related to  unreported rent.
Taxpayers misreported depreciation expenses in a variety of ways. We  estimate that about 166,000 taxpayers included the value of their land  within the depreciable basis of their properties. Other types of  misreported depreciation included taxpayers deducting depreciation for  properties that they had already fully depreciated or miscalculating  depreciation by using an incorrect length of time (useful life) over which  to depreciate property.
Additional ways in which taxpayers misreported rental real estate  expenses included the following:    Deducting expenses in full that should have been depreciated. For  example, taxpayers deducted expenses related to improving a property  or deducted the full expense of buying an item, such as a washing  machine, instead of depreciating these costs.  Improperly deducting personal expenses. Some taxpayers deducted  expenses that were completely personal in nature while others made  errors in how they divided expenses that were for both personal and  rental real estate purposes.
Other types of misreporting of expenses. These included taxpayers  deducting unallowable expenses, such as penalties or interest related  to real estate taxes, or making mathematical errors on their tax returns.
subsections: section_title: Misreported Rent Received
paragraphs: We identified three scenarios for taxpayers who misreported rent  received.
Taxpayers who did not report any rental activity.    Taxpayers who reported receiving rent for some properties but not for  others.
Taxpayers who reported receiving rent for all of their properties but  reported incorrect rent amounts. Some examples of misreporting rent  in this manner included taxpayers failing to count certain items as rent,  such as expenses paid by tenants or kept security deposits, or having  inadequate records.
We could not estimate the frequency of these scenarios because we could  not always determine the exact nature of the misreported rent.
section_title: Reported Activity on an Incorrect Part of the Individual Tax Return
paragraphs: This type of misreporting includes taxpayers who reported income or  expenses as rental real estate activity on Part I of Schedule E that they  should have reported elsewhere on their tax returns and taxpayers who  reported an activity elsewhere on their tax returns that they should have  reported on Part I of Schedule E. For example, some taxpayers reported  business activities as rental real estate activities on Part I of Schedule E  that IRS determined should have been reported on the schedule to the  individual tax return for profit and loss from business (Schedule C). We  also found taxpayers who reported income or expenses on Schedule C  that should have been reported as rental real estate activity on Part I of  Schedule E. This type of misreporting may not have affected the  calculation of the amount of income tax owed. However, reporting  activities on the wrong schedule could have affected the amount of self- employment tax these taxpayers owed, as net income from a trade or  business is subject to self-employment tax whereas net income from rental  real estate reported on Schedule E generally is not. IRS estimated that  underreported self-employment tax accounted for $39 billion of the 2001  tax gap.
section_title: Misreported Loss from Rental Real Estate
paragraphs: The most common reason why taxpayers misreported loss from their  rental real estate activities was because they also used their rental  property as a residence—including taxpayers who rented their properties  at less than a fair rental price—and claimed a loss to which they were not  entitled. Other reasons why taxpayers misreported loss were because they  were not actively participating in their rental real estate activities or  exceeded applicable income limitations for deducting a loss from rental  real estate.
section_title: Limited Information Reporting and Complexity Hinder Compliance, and Various Options Exist for Improving Compliance
paragraphs: Limited information reporting, complexity, and the number of taxpayers  misreporting are challenges IRS faces in ensuring compliance with rental  real estate reporting. IRS receives information returns for a relatively  small number of taxpayers with rental real estate activity. For tax year  2001, for example, IRS received Forms 1099-MISC reporting rent received  for about 327,000 taxpayers who reported rent on their tax returns. By  comparison, there were about 8.2 million taxpayers who reported rent on  their tax returns for whom IRS did not receive a corresponding Form 1099- MISC from a third party reporting the rent. For taxpayers who deduct  rental real estate expenses, IRS generally receives information returns  from third parties only for mortgage interest that taxpayers pay. For tax  year 2001, about 55 percent of taxpayers who reported rental real estate  activity deducted mortgage interest, accounting for about 36 percent of the  total amount of all rental expenses, including depreciation, that taxpayers  deducted for that year. As a result, about 64 percent of the total amount of  all rental real estate expenses taxpayers reported may not have been  subject to information reporting.
IRS enforcement officials cited limited information reporting as a major  challenge in ensuring compliance for the reporting of rental real estate  activities because without third-party information reporting it is difficult  for IRS to systematically detect taxpayers who fail to report any rent or  determine whether the rent and expense amounts taxpayers report are  accurate. The officials also told us that because third parties are not  required to include on Form 1098 the address of the property for which  they are reporting mortgage interest, IRS is less able to determine if the  interest is for a property used for rental or personal purposes.
In addition, limited information reporting on rental real estate activities  results in lower levels of taxpayer voluntary compliance in reporting rental  real estate activities when compared to other types of income or activities  covered by more extensive information reporting. Taxpayers tend to more  accurately report income that third parties report on information  returns—such as Forms 1099-MISC and 1098—because the income is  transparent to taxpayers as well as to IRS. As shown in figure 1, individual  taxpayers misreport receiving rent to a greater extent than they misreport  income subject to more extensive information reporting.
Although information reporting tends to lead to high rates of compliance,  requiring all individuals who pay rent to report to IRS the annual amount  of rent they pay to property owners or their intermediaries is not practical.  Officials at IRS and representatives from the tax return preparation  industry told us that although such a requirement would likely improve  compliance, it would place a substantial burden on taxpayers, who may  not have any incentive to comply. Likewise, the requirement would be very  difficult for IRS to enforce given the large number of potential information  return filers.
IRS compliance officials and representatives of the paid tax return  preparer industry told us that the complexity involved in reporting rental  real estate activities also hampers compliance. For example, the rules  surrounding whether to file Forms 1099-MISC or how to accurately  depreciate property may be challenging for some taxpayers to understand.
Due to limited information reporting and the complexity of reporting for  rental real estate activity, IRS primarily addresses rental real estate  misreporting through field and office examinations. IRS supplements  examination coverage for rental real estate misreporting through AUR, to  a limited extent, based on rental income amounts reported on Form 1099- MISC or mortgage interest reported on Form 1098.
Given the limited extent of information reporting, it can be difficult for IRS  to identify misreporting taxpayers. Also, field examinations are resource  intensive and on average address relatively large amounts of misreporting  compared to the misreported amounts for most taxpayers who  misreported rental real estate activity. For example, for fiscal year 2006,  the average tax assessment IRS recommended for field examinations of  individual taxpayers was about $18,000 per taxpayer. We found that  taxpayers who underreported their net income from rental real estate  misreported an average of $4,055. As a consequence, field examinations  may not be a cost-effective tool for targeting most rental real estate  misreporting. Further, the number of individual taxpayers misreporting  rental real estate activity (4.8 million) is large relative to the approximately  300,000 field examinations of individual taxpayers IRS conducted in fiscal  year 2006. According to IRS’s examination program, relatively small  amounts of misreporting are more likely to be addressed through  correspondence examinations.
subsections: section_title: Various Options Exist for Improving Rental Real Estate Reporting Compliance
paragraphs: Although as previously discussed, implementing broad, new third-party  information reporting requirements for rental real estate activities is not  practical, changing existing requirements is one of various options that  could improve rental real estate reporting compliance. One change to  current information reporting requirements that could improve rental real  estate income reporting compliance is to require third parties to include  mortgaged property addresses when reporting taxpayers’ mortgage  interest payments on Form 1098. As previously noted, not having property  addresses on Form 1098 hinders IRS’s efforts to enforce rental real estate  reporting compliance. IRS officials told us that having third parties  consistently report property addresses on Form 1098 would help them in  their enforcement efforts, for example, by allowing them to better  distinguish between owner-occupied and rental properties. Also, taxpayers  who receive Forms 1098 that include the addresses of their rental  properties could be deterred from failing to report activity for their  properties. Representatives of the mortgage banking industry told us that  it would be feasible to report property address information on Form 1098  because mortgage lenders maintain this information. The representatives  also told us that reporting this information would involve costs because  lenders would have to change their reporting systems. They said that such  costs would be lessened if lenders were only required to send property  address information to IRS, which they would send electronically, and not  to taxpayers, for whom the lenders may send Forms 1098 on paper, as  changing systems for electronic submissions is less costly than changing  systems for printed forms. However, excluding property address  information from Forms 1098 sent to taxpayers might eliminate any  deterrent effect.
Another potential change to existing information reporting requirements is  to expand the requirement for taxpayers to file Forms 1099-MISC for  certain payments they deduct as expenses, for example, when taxpayers  pay contractors to perform repair work on their rental properties. Existing  law on whether taxpayers must file information returns on selected rental  real estate expenses they incur requires a case-by-case analysis that  depends on the facts and circumstances for each taxpayer. Currently, only  taxpayers whose rental real estate activity is considered a trade or  business are required to report payments on Form 1099-MISC. However,  the law for filing information returns does not clearly spell out how to  determine whether taxpayers’ rental real estate activity should be  considered a trade or business, and IRS must make this determination on a  case-by-case basis. Without concrete statutory language, it may be difficult  for taxpayers who report rental real estate activity to determine if they are  required to file Forms 1099-MISC for certain expense payments they make.  As a result, it is possible that some taxpayers who should file Forms 1099- MISC for payments they make in the course of renting out real estate may  not file the forms. IRS does not have data on the number of taxpayers who  file Form 1099-MISC reporting expense payments from rental real estate  activities. Taxpayers are not required to indicate on Form 1099-MISC the  type of activity for which they are filing the form (e.g., business activity on  Schedule C versus rental real estate activity on Schedule E). Therefore,  under current statutory and regulatory guidance, it is not possible for IRS  to determine the activities for which Forms 1099-MISC are filed.
Although it would be a departure from the trade or business requirement,  making all taxpayers with rental real estate activity subject to the Form  1099-MISC filing requirement would provide clear guidance for who must  file Forms 1099-MISC. Such clarity could benefit both IRS and taxpayers.  Taxpayers would have clear direction on whether they had to file the form.  As previously discussed, we found through our file review that a large  amount of misreported net income from rental real estate was from  taxpayers for whom IRS disallowed expenses that the taxpayers could not  substantiate. It is likely that some of these taxpayers reported on their tax  returns expenses that they did not incur. Requiring taxpayers to file  information returns for certain rental real estate expense payments could  deter these taxpayers from reporting expenses they did not incur because  IRS would have a record of expenses it could use as part of an  enforcement action. Given the magnitude of misreporting for taxpayers  who could not substantiate some rental real estate expenses they  deducted, even small improvements in compliance could yield substantial  revenue.
Also, a change to the Form 1099-MISC filing requirement would put  taxpayers reporting rental real estate on par with other individual  taxpayers, such as sole proprietors of other types of trades or businesses,  who are generally required to file Forms 1099-MISC. Currently taxpayers  reporting rental real estate expenses whose activities are not considered a  trade or business and sole proprietors of other types of business who  generate similar amounts of gross income from their activities are treated  differently based on the information return statutes. For example, a  taxpayer with rental real estate activities not considered a trade or  business would not have to file an information return reporting a payment  made to an individual contractor for repair services whereas a sole  proprietor engaged in a trade or business would have to file for a similar  service, assuming the payments exceeded the minimum reportable amount  threshold. It is questionable whether, without additional statutory  authority, IRS can require all taxpayers with rental real estate activities to  report expense payments on Forms 1099-MISC regardless of whether their  activities are trades or businesses.
An expansion of the Form 1099-MISC filing requirement could have the  added benefit of improving compliance among payment recipients, such as  contractors who are sole proprietors, because additional payments would  be transparent to IRS and the payment recipients. IRS estimated that sole  proprietors misreport at a relatively high rate and accounted for a  significant portion—$68 billion—of the tax gap for tax year 2001.
Extending the Form 1099-MISC filing requirement to additional taxpayers  who report rental real estate involves costs and burdens for taxpayers.  Many taxpayers who were not required to file in the past or were unaware  of the filing requirement would have to learn the reporting rules and file  Form 1099-MISC. However, not all individual taxpayers with rental activity  would have to file Form 1099-MISC because not all will have paid $600 or  more to a single individual during the tax year, which is the threshold for  the reporting requirement. One way to further limit the number of  taxpayers with rental real estate activity that would be required to file  Form 1099-MISC would be to increase the exemption amount for  payments to a single person. The $600 or more threshold for reporting  payments made in the course of a trade or business has not been updated  since the 1950s, and as such a greater percentage of payments are likely  subject to reporting than when the requirement was first put in place  because of inflation.
One obstacle for taxpayers in determining if they are required to file Form  1099-MISC is that generally taxpayers do not have to file the forms for  payments made to corporations. As such, taxpayers must figure out  whether the persons or businesses to which they make payments are  incorporated to determine whether they need to file Form 1099-MISC. A  way to remove this obstacle is to expand information reporting to include  payments made to corporations. In the past, we have identified requiring  information reporting on payments made to corporations as a way to  improve compliance. Also, the administration in its fiscal year 2009  budget proposed requiring information reporting on payments to  corporations.
Additionally, IRS would need to inform taxpayers and others of the  expanded Form 1099-MISC filing requirement. Communicating the  requirement could be complicated by the different deadlines for filing  Form 1099-MISC and the individual tax return. Taxpayers must send Form  1099-MISC to payment recipients by January 31, whereas the deadline to  file tax returns is April 15. Filing Form 1099-MISC past the deadline may  result in a penalty. Taxpayers who are newly required to file Form 1099- MISC may not learn of the requirement until they begin to prepare their  tax returns, which some may not begin to do until after the January 31  Form 1099-MISC filing deadline. IRS compliance officials told us that  taxpayers who realize that they are late in filing required Forms 1099-MISC  may choose not to file them rather than run the risk of incurring penalties  from filing late. One way to lessen the impact of potential penalties on  taxpayers who are newly required to file Form 1099-MISC would be to  waive penalties for late filers the first year they are required to file.
We are examining issues involved with filing Form 1099-MISC in a  forthcoming report. As such, we did not examine in depth some of the  issues involved with filing Form 1099-MISC that we highlighted in this  report, such as increasing the reporting threshold, requiring reporting for  payments made to corporations, and penalties.
subsections: section_title: Requiring Taxpayers to Report Additional Information on Tax Returns for Rental Real Estate Activity Could Improve Rental Real Estate Reporting Compliance
paragraphs: Requiring taxpayers to report additional information on their tax returns  for their rental real estate activity could improve rental real estate  reporting compliance by eliciting more accurate information from  taxpayers and providing IRS with additional information to detect  misreporting. As previously discussed, the requirements for reporting  rental real estate activities are complex. Such complexity may be why  individual taxpayers reporting this activity use paid preparers more  frequently than other individual taxpayers. For example, for tax year 2001,  an estimated 77 percent of individual taxpayers reporting rental real estate  activity used a paid tax return preparer. By comparison, an estimated 56  percent of all individual taxpayers used a paid preparer for that tax  year.As we have said in past reports, paid preparers are a critical quality- control checkpoint for the tax system and the quality of service they  provide is important. However, taxpayers with rental real estate activity  who used a paid preparer were statistically as likely to have misreported  as taxpayers with rental real estate activity who prepared their returns  themselves.
One of the challenges that paid preparers encounter when preparing  returns for taxpayers with rental real estate activity is that the preparers  do not always receive complete or accurate information from taxpayers.  Requiring preparers to verify taxpayers’ documentation of rental real  estate expenses or perform increased due diligence of taxpayers’ rental  real estate activities could improve the accuracy of what taxpayers report.  However, both of these requirements would involve substantial costs and  burdens for paid preparers, taxpayers, and IRS that could outweigh any  related compliance benefits.
Requiring taxpayers to report additional information for their rental real  estate activities on their tax returns is an alternative way to elicit more  accurate and complete information from taxpayers who use paid  preparers—as well as taxpayers who self-prepare. These additions would  add a level of due diligence because paid preparers would have to obtain  additional information on taxpayers’ income and expenses in order to  complete the taxpayers’ returns. For example, requiring taxpayers to  report on Part I of Schedule E if they filed a Form 1099-MISC for one or  more deducted expenses, such as through a check-the-box question, could  increase taxpayer awareness of the requirement and prompt paid  preparers to ask taxpayers questions about the nature of their clients’  expenses, which could improve the accuracy of the expenses taxpayers  report. IRS compliance officials were uncertain if having this information  for use in its enforcement efforts would provide additional compliance  benefits. As we are examining issues involved with filing Form 1099-MISC  in a forthcoming report, we did not examine whether requiring taxpayers  to indicate on their tax returns if they filed a Form 1099-MISC would be a  cost-effective way to improve compliance.
As previously mentioned, about 166,000 taxpayers improperly included the  value of land when depreciating their rental properties. Requiring  taxpayers to report on their tax returns the basis amount attributed to land  versus structure when depreciating rental property could further improve  compliance. With such a requirement, IRS could identify taxpayers who  depreciated land or may have undervalued their land when calculating  depreciation. This requirement would not be unprecedented, as IRS  currently requires taxpayers to report the value of their land when  determining the amount of depreciation to deduct for the business use of  their homes.
Also, through our file review, we found that taxpayers do not always  report on their tax returns the type of property they rented out. The  instructions to Schedule E currently provide the example of “townhouse”  as the type of information taxpayers should report on property type on  Part I of Schedule E. The instructions do not ask the taxpayer to report if  the house was rented for residential, vacation, commercial, or other  purposes, for example. If IRS is to use information on property type in its  enforcement efforts, it needs to receive consistent information, such as  that which taxpayers could provide by answering a check-the-box question  that included the various types of properties taxpayers might rent out.
Although such a check-the-box question would provide IRS with more  consistent information on property type, including such a question on Part  I of Schedule E would involve challenges. For example, IRS would need to  clearly define the different types of properties taxpayers might report, and  some rental properties could be used for multiple purposes. Also, IRS  compliance officials were uncertain to what extent IRS could use this  information in its enforcement efforts.
Finally, we found that about 36 percent of taxpayers reporting rental real  estate activity did not include the complete address of their rental  properties on their tax returns for tax year 2001. Although the instructions  to Schedule E direct taxpayers to report the street address, city or town,  and state for their properties (the instructions state that taxpayers do not  have to report zip codes), the language on the actual form directs  taxpayers to list the “location” of their rental real estate properties.  Specifically directing taxpayers to report complete property addresses  could increase the number of taxpayers reporting addresses, rather than  general location information. According to IRS examination officials,  having complete address information would allow IRS examiners to use  commercially available data sources on property values to help determine  fair rental prices for taxpayers whose returns are selected for  examination. Whether having complete address information could also  cost effectively enhance IRS’s examination selection process is less clear,  according to the officials.
section_title: Providing Taxpayers with Additional Guidance on Rental Real Estate Reporting Requirements Could Improve Compliance, Although to What Extent Is Difficult to Measure
paragraphs: Another way to help taxpayers to more accurately report their rental real  estate activities is by providing them with additional guidance to help  them complete their tax returns. The impact on the tax gap from providing  additional guidance may be difficult to measure, as IRS researchers have  found it difficult to determine the extent to which taxpayer services, such  as tax form instructions, improve compliance among taxpayers who want  to comply. Likewise, providing taxpayers with additional guidance does  not guarantee that the taxpayers will actually read the guidance, especially  those who use paid preparers, and would not affect taxpayers who  willfully misreported. Regardless, providing taxpayers with additional  guidance could produce compliance benefits among taxpayers who want  to comply that exceed the related implementation costs, which may be low  relative to other actions IRS could take to improve compliance, such as  increased enforcement efforts. Providing additional guidance could be  particularly helpful for taxpayers who use tax return preparation software  to prepare their returns if the software included or is based on the  guidance.
For example, regardless of whether the requirement for who must file a  Form 1099-MISC changes in the future, at least some taxpayers who  reported rental real estate activity are currently required to file. However,  the instructions to Schedule E do not discuss this requirement. Including  guidance on the Form 1099-MISC filing requirement in the instructions to  Schedule E could inform taxpayers of the requirement and could result in  more taxpayers filing the form.
Likewise, IRS’s publication on residential rental property discusses that  land cannot be depreciated and provides guidance on how taxpayers can  determine the value of their land. Although the instructions to Schedule E  also state that land cannot be depreciated, they do not provide guidance  on how to determine the value of land. Representatives from the tax return  preparation industry told us that taxpayers are more likely to review tax  form instructions than IRS publications. As such, providing guidance on  resources available to taxpayers for determining how to distinguish  between the cost of land versus the cost of structures in the instructions to  Schedule E could help taxpayers more accurately determine the value of  their land, which could help them more accurately report depreciation.
With regard to recordkeeping, IRS produces a publication with general  guidance for individual taxpayers. However, recordkeeping requirements  for expense deductions are only discussed in the instructions to Part I of  Schedule E with regard to deducting mortgage or other interest. Providing  general guidance on recordkeeping requirements in the instructions to  Part I of Schedule E could encourage taxpayers to keep better records,  which could lead to more accurate reporting. The instructions could also  include language similar to that in IRS’s publication on recordkeeping,  explaining that taxpayers who, upon IRS examination, cannot produce  records to substantiate items they report on their tax returns may be  subject to additional taxes and penalties. Including this language could  increase voluntary compliance by deterring taxpayers from reporting  expenses they did not incur.
section_title: Outreach to Taxpayers and Other Stakeholders Could Improve Understanding of Reporting Requirements and Common Types of Misreporting
paragraphs: Given that some taxpayers may not read IRS’s guidance, an additional way  to inform taxpayers of the reporting requirements is to send them notices  covering key requirements and common mistakes taxpayers make with  regard to reporting rental real estate activity. In addition to making  taxpayers aware of the reporting requirements, such notices could serve  as a reminder to taxpayers that IRS is aware that they have rental real  estate activity, which in turn could serve as a deterrent to intentional  misreporting. These notices could be sent to some taxpayers, such as  taxpayers reporting rental real estate for the first time, or all taxpayers  who report rental real estate activity. Sending these notices to taxpayers  could also help inform paid preparers of the requirements and common  types of misreporting given that taxpayers who received such notices  would likely share them with their paid preparers, according to  representatives of the tax return preparation industry.
However, the cost-effectiveness of sending notices like these is not clear.  IRS would have to dedicate resources to take calls from taxpayers who  receive the notices and have questions, which would be a likely scenario  according to IRS communications officials and representatives of the tax  return preparation industry. Producing and sending the notices would also  involve costs. Also, IRS would not necessarily be able to target taxpayers  who potentially misreported their rental real estate activities when  sending the notices. Given these limitations, it would be important for IRS  to test the effectiveness of sending notices to taxpayers to determine if  they can increase compliance in a cost-effective manner.
A way to indirectly inform taxpayers of the reporting requirements and  common types of misreporting for rental real estate is for IRS to enhance  its focus on rental real estate in its outreach efforts to paid preparers and  other external stakeholders. Outreach to paid preparers could be  particularly important given that about 80 percent of individual taxpayers  who report rental real estate use a paid preparer, but these taxpayers  were as likely to have misreported as taxpayers who self-prepared their  tax returns. As previously discussed, IRS produced and disseminated a  fact sheet on the requirements for reporting rental real estate activity,  although the fact sheet did not include information on common types of  misreporting. Providing additional information on the common types of  misreporting, such as those we found that IRS identified through NRP  examinations, in outreach efforts could help paid preparers assist  individual taxpayers to comply with the reporting requirements.
An IRS examination official told us that outreach, such as contacting  national paid preparer groups or providing information at IRS Nationwide  Tax Forums and other conferences that paid preparers attend to fulfill  their continuing professional education requirements, could be a good  approach to improving paid preparer due diligence. An IRS official  involved with outreach to external stakeholders told us that although in  the past IRS had targeted its outreach efforts primarily to individual paid  preparers, IRS is starting to reach out to tax return preparation companies  and tax preparation software vendors as well. These outreach efforts  could include providing information on common types of rental real estate  misreporting. Likewise, IRS compliance and stakeholder liaison officials  suggested including property managers within IRS outreach efforts for this  area of compliance.
section_title: Conclusions
paragraphs: The disparity in individual taxpayer reporting compliance between net  income from sources subject to minimal information reporting, such as  rental real estate, and income that is subject to extensive information  reporting, such as wages, results in substantial revenue loss and  undermines the fairness of our tax system. However, significant obstacles  stand in the way of improving tax compliance by owners of rental real  estate. There are few practical opportunities for additional third-party  information reporting. Some taxpayers may not fully understand the  complex rules governing the reporting of rental real estate activity, in part  because their heavy reliance on paid preparers means that many taxpayers  may not read IRS guidance. Detecting misreporting often requires face-to- face examinations, which are costly to IRS and reach relatively few  individual taxpayers.
Nevertheless, opportunities exist to improve compliance by individual  taxpayers who own rental real estate. First, existing information reporting  requirements could be improved. For example, under current law, only  taxpayers whose rental real estate activity is considered a trade or  business are required to report expense payments on Form 1099-MISC, but  the law for filing the form does not clearly spell out how to determine  whether taxpayers’ rental real estate activity should be considered a trade  or business. To hold taxpayers with rental real estate to the same  requirements for filing Form 1099-MISC as taxpayers whose activities are  considered a trade or business would provide clarity about who is required  to file. Likewise, requiring property addresses on Forms 1098 that report  mortgage interest could provide IRS with additional information to  identify taxpayers who may not have reported rental real estate activity  and could deter taxpayers from failing to report. Second, requiring  taxpayers to report additional information on their tax returns for their  rental real estate activities could force taxpayers to pay more attention to  IRS guidance or seek advice from paid preparers, act as a deterrent to  intentional misreporting, and compel paid preparers to obtain more  accurate income and expense information from taxpayers. Third, although  it is unclear the extent to which individual taxpayers read guidance on  reporting requirements, especially taxpayers who use paid preparers,  enhancements to IRS’s guidance on rental real estate reporting  requirements could reduce unintentional misreporting. Such  enhancements might also be useful to paid preparers and could be  reflected in tax preparation software. Fourth, improving outreach efforts  could also improve compliance. Given the uncertainty about whether  individual taxpayers read IRS guidance, researching the effectiveness of  outreach to taxpayers could be beneficial. Also, given the heavy reliance  on paid preparers by owners of rental real estate, additional outreach to  paid preparers, among others, could be an effective way to indirectly reach  large numbers of taxpayers.
section_title: Matter for Congressional Consideration
paragraphs: To provide clarity for which taxpayers with rental real estate activity must  report expense payments on information returns and to provide greater  information reporting, Congress should consider amending the Internal  Revenue Code to make all taxpayers with rental real estate activity subject  to the same information reporting requirements as other taxpayers  operating a trade or business.
section_title: Recommendations for Executive Action
paragraphs: We are making nine recommendations to the Commissioner of Internal  Revenue.
To help IRS identify taxpayers who may have misreported their rental real  estate activity, we recommend that the Commissioner of Internal Revenue  require third parties to report mortgaged property addresses on Form 1098  mortgage interest statements.
To elicit more accurate information from taxpayers on their rental real  estate activities, we recommend that the Commissioner of Internal  Revenue  require taxpayers to report on the individual tax return the basis  amount attributed to land versus structure when depreciating rental  real estate;    determine if IRS uses property type information that taxpayers  currently report on Schedule E in its efforts to enforce rental real  estate reporting compliance, and  if it is determined that IRS uses the information, the Commissioner  should require taxpayers to provide specific information on Part I of  Schedule E about the type of properties for which they are  reporting activity, for example by answering a check-the-box  question, and  if it is determined that IRS does not use the information, the  Commissioner should not require taxpayers to report any property  type information; and  require taxpayers to report the exact “address” of their rental real  estate properties on Part I Schedule E instead of property “location,” as  currently worded, and require taxpayers to report property zip codes.
To help taxpayers understand the requirements related to certain aspects  of reporting rental real estate activities, we recommend that the  Commissioner of Internal Revenue include guidance within the  instructions to Part I of Schedule E on the requirement for some taxpayers with rental real estate activity to  report on Form 1099-MISC certain payments made in the course of  renting out real estate;  resources available to taxpayers for determining how to distinguish  between the cost of land versus the cost of structures; and  recordkeeping requirements and the potential for disallowed expenses  and penalties if taxpayers cannot produce documentation for reported  expenses upon examination by IRS.
To enhance IRS’s outreach efforts, we recommend that the Commissioner  of Internal Revenue    evaluate whether sending notices to some or all taxpayers who report  rental real estate activity would be a cost-effective way to reduce  misreporting of some types of rental real estate activity and    expand outreach efforts to external stakeholders, such as paid tax  return preparers, tax return preparation software providers, and  industry groups related to rental real estate, to include common types  of misreporting for rental real estate activity, such as those identified in  this report.
section_title: Agency Comments and Our Evaluation
paragraphs: In written comments on a draft of this report, which are reprinted in  appendix II, IRS agreed with seven of our nine recommendations.  However, IRS agreed only to consider implementing our recommendation  to require third parties to report mortgaged property addresses on Form  1098 mortgage interest statements citing the burden the requirement could  place on third parties. Although it is important to take third-party burden  into account when considering whether to require information reporting,  representatives of the mortgage banking industry told us that it would be  feasible to report property address information on Form 1098 because  mortgage lenders already maintain this information. Also, IRS disagreed  with our recommendation to require taxpayers to report on the individual  tax return the basis amount attributed to land versus structure when  depreciating rental real estate properties. Specifically, IRS stated that  taxpayers report depreciation on Form 4562 and not on Schedule E to the  individual tax return, and that the basis of land is not used in calculating  depreciation. However, taxpayers are not required to report the basis  amount attributable to land on Form 4562. Further, we did not specifically  recommend on which form or schedule taxpayers should be required to  report the value of their land for properties they depreciate. Also, we  believe that, in effect, the basis of land is used in calculating depreciation  because taxpayers must subtract the value of land from the overall basis of  their properties. We found that for tax year 2001, about 166,000 individual  taxpayers included the value of land when calculating depreciation for  their rental properties. We believe that requiring taxpayers to report the  value of land in conjunction with reporting depreciation calculations— whether on Form 4562, Schedule E, or elsewhere—would serve to reduce  the number of taxpayers who improperly include the value of land when  calculating depreciation for their rental properties. We agree with IRS that  more guidance to taxpayers is needed about allocating basis to land.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days from its  issue date. At that time, we will send copies to the Chairman and Ranking  Member, House Committee on Ways and Means; the Secretary of the  Treasury; the Commissioner of Internal Revenue; and other interested  parties. Copies will be made available to others upon request. This report  will also be available at no charge on GAO’s Web site at  http://www.gao.gov.
If you or your staff have any questions, please contact me at (202) 512-9110  or whitej@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this report.  Key contributors to this report are listed in appendix III.
section_title: Appendix I: Scope and Methodology
paragraphs: To provide information on the extent and primary types of individual  taxpayer misreporting of rental real estate activities, we relied on data and  examination case files from the Internal Revenue Service’s (IRS) most  recent National Research Program (NRP) study of individual taxpayers.  Through NRP, IRS selected and reviewed a stratified random sample of  45,925 individual income tax returns from tax year 2001. We selected a  sample of cases that included taxpayers with rental real estate activity  from this NRP sample. The NRP sample is divided across 30 strata by the  type of individual tax return filed and income levels. IRS accepted as filed  some of the NRP returns, accepted others with minor adjustments, and  examined the remainder of returns either through correspondence or face- to-face meetings with taxpayers. If IRS examiners determined that  taxpayers misreported any aspect of the selected tax returns, they  adjusted the taxpayers’ income accordingly and assessed additional taxes.
IRS captured data from tax returns and examination results in the NRP  database, including data for rental real estate activities. However, because  taxpayers report expenses from both rental real estate and royalty  activities on the same lines of Part I of Schedule E, it is not possible to  determine with certainty whether adjustments examiners made in the NRP  database to these expense lines were for rental real estate or royalty  activities. Likewise, the data do not include detailed information on why  examiners made adjustments to rental real estate activities. Therefore, to  distinguish between misreporting for rental real estate versus royalty  expenses and to identify the primary types of misreporting of rental real  estate activities, we selected a statistical sample of NRP examination case  files to review.
We selected a sample of 1,202 cases from the tax returns IRS examined  from its NRP sample. We selected tax returns for taxpayers who reported  rental real estate or royalty activity on Part I of Schedule E. Our sample  was made up of four groups: (1) taxpayers for whom IRS made  adjustments to rental real estate activity, (2) taxpayers who reported  rental real estate activity for whom IRS did not make adjustments to rental  real estate activity, (3) taxpayers for whom IRS made adjustments to  royalty activity, and (4) taxpayers who reported royalty activity for whom  IRS did not make adjustments to royalty activity. We included cases for  taxpayers who accurately reported rental real estate activity in order to  make comparisons between taxpayers for whom IRS did and did not make  adjustments to rental real estate activity. We selected cases with royalty  activity to estimate misreporting from royalties, which IRS combines with  misreporting from rental real estate to estimate the tax gap for these two  activities.
The first group of cases consisted of 752 cases of taxpayers for whom IRS  made an adjustment to rents received, expenses, or loss reported on Part I  of Schedule E. Within this group we included, where possible, the 10 cases  in each stratum for which the adjustments examiners made had the largest  impact on the total amount of these adjustments for all taxpayers when  weighted for the entire population of individual taxpayers (a total of 204  cases). We focused on cases with the largest adjustments, in weighted  terms, because including these cases would improve the level of  confidence of any estimates of the total amount of adjustments to  taxpayers’ rental real estate activities. We selected the remaining 548 cases  in this first group of cases at random and in proportion to the number of  NRP returns for which IRS made adjustments to taxpayers’ rent, expenses,  or loss reported on Part I of Schedule E. Because our sample is a  subsample of the NRP sample and is subject to sampling error, we added  cases, where applicable, to ensure that each stratum contained a minimum  of 5 randomly selected cases.
For the second group of cases we selected 248 cases for taxpayers who  reported rents received, expenses, or loss on Part I of Schedule E that IRS  did not adjust. We selected these cases at random and in proportion to the  NRP sample through an iterative process ensuring, where possible, that a  minimum of 5 cases was included in each stratum.
The third group of cases included 102 cases where IRS made an  adjustment to taxpayers’ royalties received. The aggregate of these 102  cases and 30 cases with adjustments to royalties received selected as part  of the first group of cases account for all 132 cases in the NRP database  where examiners made adjustments to taxpayers’ royalties received. The  fourth group consisted of 100 cases, selected at random and in proportion  to the NRP sample, for taxpayers who did not report rents received and  reported royalties received that IRS did not adjust. We ensured, where  possible, that a minimum of 5 cases were included in each stratum.
Of the 1,202 cases we selected for our sample, we reviewed 1,000 cases.  We did not review the remaining 202 cases because either IRS did not  provide the files in time to include in our review (185 cases) or the files did  not contain examination workpapers essential to determine if or why  examiners made adjustments to taxpayers’ rental real estate activities (17  cases). We requested the cases at two points, in late-May 2007 and late- June 2007, and periodically checked on the status of our requests with IRS.  We were only able to review cases that arrived by January 11, 2008, in  order to meet our agreed-upon issue date for the report.
We recorded information from the case files using a data collection  instrument (DCI) that we developed. To ensure that our data collection  efforts conformed to GAO’s data quality standards, each DCI entry that a  GAO analyst completed was reviewed by another GAO analyst. The  reviewers compared the data recorded within the DCI entry to the data in  the corresponding case file to determine whether they agreed on how the  data were recorded. When the analysts’ views on how the data were  recorded differed, they met to reconcile any differences.
The estimates we included in this report were based on the NRP database  and the data we collected through our file review and were generated  using statistical software. All computer programming for the resulting  statistical analyses were checked by a second, independent analyst. Our  final sample size was large enough to generalize the results of our review  for the entire population of individual taxpayers with rental real estate  activity or had margins of error small enough to produce meaningful  estimates, unless otherwise noted in the report.
Because we followed a probability procedure based on random selection,  our sample is only one of a large number of samples that we might have  selected. Since each sample could have resulted in different estimates, we  express our confidence in the precision of our particular sample’s results  as a 95 percent confidence interval, plus or minus the margin of error.  These intervals would contain the actual population value for 95 percent  of the samples we could have selected. Unless otherwise noted, all  percentage estimates have a margin of error of less than 5 percentage  points; value estimates have a margin of error of less than 8 percent.
We assessed whether the examination results and data contained in the  NRP database were sufficiently reliable for the purposes of our review.
For this assessment, we interviewed IRS officials about the data, collected  and reviewed documentation about the data and the system used to  capture the data, and compared the information we collected through our  case file review to corresponding information in the NRP database to  identify inconsistencies. Based on our assessment, we determined that the  NRP database was sufficiently reliable for the purposes of our review.
We also used IRS’s Statistics of Income (SOI) file for individual taxpayers  from tax years 2001 through 2005, which relies on a stratified probability  sample of individual income tax returns, to develop estimates on  characteristics for taxpayers who reported rental real estate activity.  Where possible, we compared our analyses against published IRS data to  determine that the SOI database was sufficiently reliable for the purposes  of our review.
To identify challenges IRS faces in ensuring rental real estate reporting  compliance and to assess options for increasing compliance, we reviewed  IRS forms, publications, and other taxpayer guidance related to reporting  rental real estate activity and documents from IRS’s enforcement  programs. We also reviewed data from the Automated Underreporter  program and published data on examinations to determine the extent of  IRS’s enforcement efforts. We also examined data on individual taxpayers  from SOI to determine the extent to which (1) individual taxpayers use  paid tax return preparers and (2) third parties report information on rental  real estate activity on Form 1099-MISC. In addition, we interviewed  officials from IRS’s Small Business/Self-Employed; Wage and Investment;  and Research, Analysis, and Statistics divisions who have knowledge of  rental real estate compliance issues. We also spoke with representatives of  the American Institute of Certified Public Accountants, National  Association of Enrolled Agents, National Association of Residential  Property Managers, and Mortgage Bankers Association to get their  perspectives on issues related to rental real estate reporting compliance.
We conducted this performance audit from May 2007 through August 2008  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Appendix II: Comments from the Internal Revenue Service
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Acknowledgments
paragraphs: In addition to the contact named above, Charlie Daniel, Assistant Director;  Jeff Arkin; Ellen Grady; Laura Henry; Shirley Jones; Winchee Lin; John  Mingus; Karen O’Conor; Ellen Rominger; Jeff Schmerling; Andrew  Stephens; and Elwood White made key contributions to this report.
section_title: Related GAO Products
paragraphs: Highlights of the Joint Forum on Tax Compliance: Options for  Improvement and Their Budgetary Potential. GAO-08-703SP.  Washington, D.C.: June 2008.
Tax Administration: The Internal Revenue Service Can Improve Its  Management of Paper Case Files. GAO-07-1160. Washington, D.C.:  September 28, 2007.
Tax Gap: A Strategy for Reducing the Gap Should Include Options for  Addressing Sole Proprietor Noncompliance. GAO-07-1014. Washington,  D.C.: July 13, 2007.
Using Data from the Internal Revenue Service’s National Research  Program to Identify Potential Opportunities to Reduce the Tax Gap.  GAO-07-423R. Washington, D.C.: March 15, 2007.
Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax  Gap. GAO-07-488T. Washington, D.C.: February 16, 2007.
Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax  Gap. GAO-07-391T. Washington, D.C.: January 23, 2007.
Tax Compliance: Opportunities Exist to Reduce the Tax Gap Using a  Variety of Approaches. GAO-06-1000T. Washington, D.C.: July 26, 2006.
Tax Compliance: Challenges to Corporate Tax Enforcement and Options  to Improve Securities Basis Reporting. GAO-06-851T. Washington, D.C.:  June 13, 2006.
Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost  Basis Would Improve Compliance if Related Challenges Are Addressed.  GAO-06-603. Washington, D.C.: June 13, 2006.
Tax Gap: Making Significant Progress in Improving Tax Compliance  Rests on Enhancing Current IRS Techniques and Adopting New  Legislative Actions. GAO-06-453T. Washington, D.C.: February 15, 2006.
Tax Gap: Multiple Strategies, Better Compliance Data, and Long-Term  Goals Are Needed to Improve Taxpayer Compliance. GAO-06-208T.  Washington, D.C.: October 26, 2005.
Tax Compliance: Better Compliance Data and Long-term Goals Would  Support a More Strategic IRS Approach to Reducing the Tax Gap. GAO- 05-753. Washington, D.C.: July 18, 2005.
Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal  Sustainability but Will Require a Variety of Strategies. GAO-05-527T.  Washington, D.C.: April 14, 2005.
Tax Administration: IRS Is Implementing the National Research  Program as Planned. GAO-03-614. Washington, D.C.: June 16, 2003.
Tax Administration: New Compliance Research Effort Is on Track, but  Important Work Remains. GAO-02-769. Washington, D.C.: June 27, 2002.
Tax Administration: Status of IRS’ Efforts to Develop Measures of  Voluntary Compliance. GAO-01-535. Washington, D.C.: June 18, 2001.