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. 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.