The IRS will likely start taking a closer look at mortgage interest deductions and payments in an effort to identify tax cheats who are underreporting their income or not filing at all.

A new government audit found that large numbers of homeowners are paying significant amounts of mortgage interest but who are either not filing tax returns or whose returns indicate they do not have enough income to cover their mortgage payments and meet basic living expenses. The audit, by a U.S. Treasury inspector general, recommends making greater use of data reported on mortgage interest statements to identify and catch tax cheats.

The report focuses on data reported for IRS Form 1098, which is the form taxpayers use to report their mortgage interest payments for use in preparing their tax returns. Mortgage lenders and servicers keep track of borrower's mortgage principal and interest payments throughout the year and report the data to both individual taxpayers and the IRS using Form 1098.

Audit finds large numbers of suspicious returns

A random sampling of homeowners whose Form 1098 reports indicated they had paid at least $20,000 in mortgage interest in 2005 concluded that a full review of all such filers would yield approximately $1.4 billion in taxes, interest and penalties is owed by nonfilers and those who underreported their income. The IRS agreed with the report's conclusions and said it would take a closer look at making greater use of Form 1098 reporting to catch tax cheats.

"A large number of individuals are paying a significant amount of mortgage interest and either are not filing tax returns or are filing tax returns indicating their income is not sufficient to cover their mortgage obligations and basic living expenses," the report read. "The considerable difference between expenditures and income raises very serious questions about whether these taxpayers have additional sources of income that should have been reported on their tax returns."

The report drew criticism from at least one member of Congress, who said the proposal could end up harming homeowners who have lost their jobs or seen business declines but continue making mortgage payments out of savings or other assets.

"We shouldn't presume that these struggling families are tax cheats just because they continue to make their mortgage payments despite losing their income," said Rep. Charles Boustany (R., La.), the ranking minority member on the House Oversight Subcommittee.

Not everyone required to file

The report acknowledges that many homeowners are struggling to maintain mortgage payments in the current economy and that it is not clear whether nonfilers identified in the review were actually required to file tax returns. It says an IRS examination would be needed to determine whether a nonfiler or potential underreporter actually owed any additional taxes, penalties and interest.

The audit took a look at two randomly selected groups of 100 homeowners whose Form 1098 reports indicated they had paid more than $20,000 in mortgage interest in 2005. The first group consisted of 100 homeowners who appeared to have filed no federal tax return for 2005; the second consisted of 100 homeowners whose tax returns indicated they did not have enough income to cover their mortgage payments and basic living expenses that year.

Of the 100 homeowners who did not appear to have filed a tax return, 21 were identified who appeared to owe a total of $177,715 in delinquent taxes and $107,209 in penalties and interest. Of the 100 whose returns showed insufficient income, 37 were identified who appeared to owe a total of $265,018 in additional taxes and $61,233 in penalties and interest.

Based on Form 1098 data, the audit identified nearly 220,000 potential nonfilers and 245,000 individuals who appeared to have underreported their income. Based on the random samples above, the audit that an approximately $625 million in delinquent taxes, penalties and interest may be owed by nonfilers for FY2005, and approximately $800 million may be due from those who underreported their incomes on their federal tax returns that year.