The article reports that - “the Internal Revenue Service will expand a program designed to catch tax cheats that searches for inconsistencies between mortgage payments and income”.
It also tell us – “The data could also be used to target for audits individuals who don't file tax returns, or who report less income than they paid in mortgage interest, according to a letter released Monday by the Treasury inspector general for tax administration”.
A recent TIGTA report found that, “tens of thousands of homeowners who paid more than $20,000 in mortgage interest in 2005 either didn't file a tax return or reported income that appears insufficient to cover their mortgage interest and basic living expenses”.
This is something that first occurred to me over 20 years ago. I had seen several returns where the combination of the mortgage interest, real estate tax and personal exemption deductions was more than the total income reported on the 1040, which generally consisted of a W-2 and some interest. I remember one return in particular for a full-time waiter at a Chinese restaurant who was married with children.
If I thought this odd I wondered why the IRS did not also. Yet in 37 years I have never come across an IRS audit in such a situation.
During an audit of a doctor client many, many years ago I asked the IRS auditor why the return was selected for review. I was told that it was the policy of that IRS office to audit returns of self-employed professionals with high income. Hey, I thought at the time (and still do), you should actually be auditing the returns of self-employed professionals with low incomes! I do believe the audit of my doctor client resulted in “no change”.
The IRS uses income reported on 1099s and W-2s to catch non-filers, so why not also use deductions reported on 1098s.
I realize that there could be several scenarios where the mortgage interest reported on a Form 1098 could be more than the taxable income reported on the 1040. One is income from tax-exempt investments (i.e. muni bonds or muni bond funds). But this income, while not taxed, is still reported on the Form 1040 on Line 8b. The sale of an investment or other asset for substantial gross proceeds (which are not reinvested) could produce a reported capital loss or minor capital gain. The gross proceed information would, however, be reported on Schedule D.
The article suggests another scenario – “Highly paid former employees of investment banks who lost their jobs in the financial crisis but who, thanks to their savings, are still making their mortgage payments”. And, then. the mortgagees could also be getting help from parents or other relatives.
Obviously claiming mortgage and real estate tax deductions in excess of taxable income does not automatically mean that there is unreported income. Perhaps the first contact from the IRS in such a situation could be a letter of inquiry, requesting that the taxpayer explain and document the source of funds used to make the mortgage payments. Those who do not respond, or who do not provide sufficient documentation, could then be subject to a full-blown office audit.