Taxpayers have been allowed to deduct mortgage interest payments on their federal tax returns since Congress enacted the federal income tax in 1913. At that time, the deduction for home mortgage interest was part of the deduction allowed for any interest paid. The Tax Reform Act of 1986 limited deductions for nonbusiness interest. The 1986 act specifically disallowed deductions by individuals of personal interest but included a limited exception for qualified mortgage interest. The 1986 act was amended the next year to include dollar limits on the amount of home mortgage debt for which interest payments can be deducted. Taxpayers may deduct the interest they pay on loans secured by qualified homes—either their main home or their main home and a second home. These loans include first or second mortgages, home equity loans, and home equity lines of credit. Boats and recreational vehicles may qualify as homes if they have sleeping, cooking, and toilet facilities. As table 1 shows, two kinds of debt may qualify for the mortgage interest deduction. The first kind is acquisition debt, which is debt incurred in acquiring, constructing, or substantially improving a qualified home and that is secured by the home. Taxpayers may deduct all of the interest paid on acquisition debt incurred on or before October 13, 1987, known as grandfathered debt. Taxpayers’ interest deductions for debt on qualified homes purchased after October 13, 1987, is limited to the interest on $1 million of acquisition debt, reduced by any grandfathered debt. The second kind of qualified debt is home equity debt, which is any non- acquisition debt secured by the home. Its proceeds may be used for anything other than to buy, build, or substantially improve the home. For example, the proceeds may be used to pay off credit cards or finance cars or vacations. Home equity debt is limited to the home’s fair market value minus the acquisition debt and grandfathered debt, or to $100,000, whichever is less. Home equity debt for tax purposes should not be confused with what is commonly called a home equity loan. The latter may qualify as either acquisition debt or home equity debt depending on how the proceeds are used. Table 1 also summarizes the deductibility of points. A point is a term used to describe certain charges paid in connection with obtaining a mortgage and is calculated at 1 percent of a mortgage’s principal. Generally, points are considered prepaid interest, and, as such, the deduction is usually allocated over the life of the loan. However, if various conditions are met, the taxpayer may deduct the points in the year paid. Determining whether points are fully deductible in the year paid may require that taxpayers go through as many as 10 decision steps. Lending institutions and other entities engaged in a trade or business that receive $600 or more during the year in mortgage interest and certain points from an individual taxpayer are required to file a Form 1098, Mortgage Interest Statement. Form 1098 reports are sent both to the taxpayer and IRS to show how much mortgage interest was paid to the lender that year. Taxpayers report their deductible mortgage interest information to IRS on lines 10 through 13 of Schedule A, the schedule itemizing deductions for the Form 1040 individual income tax return (see app. II). Typically, the larger deductible amounts are reported on line 10, which shows home mortgage interest and points reported to taxpayers on Form 1098. Lines 11 and 12 of Schedule A are for claiming mortgage interest and points, respectively, not reported on Form 1098, and, starting in 2007, line 13 is used for deductible qualified mortgage insurance premiums. Some interest payments reported on Form 1098 may be deductible on other Form 1040 schedules, such as Schedule C for sole proprietorship businesses or Schedule F for farming. Changes in the housing market over the years may have affected the overall amount of home mortgage interest that taxpayers claimed. Table 2 shows the change in various indicators related to the mortgage interest deduction from 2001 to 2006. The rise in home prices and thus mortgage amounts, partly account for the large increases in mortgage interest deductions claimed by taxpayers in 2006 compared to 2001. In 2006, the median sales price for existing U.S. single-family homes was up from 2001. Median sales prices varied widely across metropolitan areas, with some locations exceeding $700,000. The home equity loan totals reported by the Federal Reserve Board also increased significantly from 2001 to 2006. According to the U.S. Census Bureau’s 2006 American Community Survey, about a fifth of owner-occupied housing units with a mortgage had a home equity loan. Also, according to the Joint Center for Housing Studies of Harvard University, 85 percent of homeowners who refinanced their mortgages in 2006 took cash out. Although IRS’s enforcement and research programs found some mortgage interest deduction compliance problems, the methods leave gaps in what is known about the extent and specific nature of noncompliance. The four main programs that IRS uses to enforce or research mortgage interest deduction compliance include the following. A computer matching program designed to identify taxpayers whose mortgage interest deduction exceeds amounts reported on Form 1098: Of the approximately 1.7 million mismatches the program identified above a certain threshold in 2005, the latest year available, IRS followed up on about 135,000 and changed tax assessments or refunds for about 53,000. Tax assessments totaled about $216 million, much more than in previous years, and averaged about $4,300. IRS’s National Research Program (NRP), the main ongoing study of taxpayer compliance based on examinations of a random sample of tax returns: IRS found that between 12 and 14 percent of individual taxpayers who claimed home mortgage interest on line 10 of Schedule A misreported the amount. The misreporting was split about evenly between taxpayers underreporting the deduction and taxpayers overreporting it. Routine examinations done by correspondence, in an IRS office, or on site: IRS does not maintain separate examination results solely on line 10 issues. Most of the approximately 33,000 examinations done in fiscal year 2008 by IRS revenue agents and tax compliance officers that included a review of line 10 resulted in increases to the line 10 deduction (i.e., the deduction increased) or in no recommended change. For cases involving line 10 where examiners recommended greater tax amounts, the median tax owed for all issues examined including line 10 was $4,612, according to our analysis of IRS records. For cases closed in fiscal year 2008 in which examiners decreased the line 10 amounts and lowered taxpayers’ deductions, the median decrease in the line 10 mortgage interest deduction was $6,430. Other results are listed in appendix III. Two special compliance initiative projects (CIP) primarily examining acquisition debt for a limited segment of individual taxpayers with high mortgage interest deductions or high adjusted gross incomes: About 9,000 examinations were closed in fiscal year 2008 for both projects. IRS recommended about $95 million in tax changes for cases closed in fiscal years 2006 through 2008. Examiners decreased line 10 deductions for most cases closed in fiscal year 2008. The median decreases were about $29,000 for the first project and $28,000 for the second. For cases in which examiners increased the tax owed, the median increases in tax were about $8,000 in both projects. IRS examiners attributed the changes to taxpayers and paid tax return preparers not knowing or ignoring the mortgage interest deduction rules and to problematic tax preparation software. Appendix III also presents results from CIP exams. Table 3 shows, for these four main programs, that gaps exist in what IRS can measure or enforce concerning taxpayers’ mortgage interest deductions. Of the four main programs, only NRP projects the amount of mortgage interest deduction misreporting to the population of individual taxpayers. However, because NRP automatically excluded any Schedule A deduction where the Form 1098 amounts matched the Schedule A amounts, it may have underestimated mortgage interest deduction misreporting relating to the home equity and acquisition debt limits. The mortgage interest deduction rules create compliance problems for taxpayers, reflecting the deduction’s complexity. The effects of the problems, however, are uneven. Although many taxpayers might encounter few problems, others could face many more. Problems cited by tax practitioners and in our review of articles on deducting home mortgage interest included the following: Taxpayers need to distinguish between acquisition and home equity debt but did not always do so. Taxpayers deducted interest on loans exceeding the limitations, including the acquisition, home equity, and two-home limits. Taxpayers who were subject to the AMT and thus not eligible to deduct home equity interest claimed it nonetheless. Tax practitioners also missed the limitations and did not comply with the AMT rules. Depending on the circumstances, some taxpayers and practitioners faced extensive recordkeeping and calculations related to such matters as refinancing, the AMT, business use of the home, other uses of loan proceeds, and the periodic use and repayment of home equity lines of credit. One practitioner told us that completing worksheets was the quick and easy part of work related to the mortgage interest deduction; the most difficult and most time-consuming part was getting taxpayers to locate and provide the proper information on what kind of debt was involved and how loan proceeds were used. Typically, taxpayers provided records piecemeal over time and after many phone calls. Taxpayers may have been unaware that they might need documentation on matters such as how proceeds of home equity loans are spent to properly determine the amount of the mortgage interest deduction on their tax returns. Mortgage interest deduction limits based on debt amounts are not directly comparable with the information on Form 1098, which lists interest paid. If taxpayers’ debts exceed the limits, taxpayers must calculate how much interest they can deduct. The complexity of the laws that govern the mortgage interest deduction are evident in the guidance IRS has published. Figure 1 is the flowchart in IRS’s 16-page instructions to taxpayers—Publication 936: Home Mortgage Interest Deduction—that help taxpayers determine if their mortgage interest is fully deductible. It leads taxpayers through as many as seven decision points and still sometimes requires them to consult another part of the publication.