From the Walls Street Journal

Eva Rosenberg | MarketWatch

The mortgage-interest deduction claimed by millions of homeowners every year may prove to be a useful window for the IRS to peek into taxpayers’ income situation — and potentially reap millions of dollars in unpaid taxes.

First, some history. Each year, your lender sends you a Form 1098, known as the mortgage-interest statement. The IRS gets a copy, too. It shows the total interest you paid as part of your monthly mortgage payment.

Historically, the IRS computers have been matching the totals on those Forms 1098 to ensure that you didn’t deduct more mortgage-interest expense than the lender reported. When deductions are higher than the total amounts on all Forms 1098 with your Social Security number and that of your spouse, the IRS sends you a letter. They ask you to identify the lender whose interest you are deducting.

The goal is twofold: To ensure you don’t deduct interest you didn’t pay, and to ensure that the person you paid reported the interest income. This makes perfect sense.

New use for 1098s

But there’s an interesting way to use those 1098 forms to catch non-filers and tax cheats, according to a new report by J. Russell George, the Treasury Inspector General for Taxpayer Administration, also known as TIGTA.

According to the TIGTA report, the IRS had their computer match up filed tax returns with Form 1098s from 2004 and 2005 showing residential mortgage interest paid by individuals. There were hundreds of thousands of 1098s that had no corresponding tax return on file. After some filtering, IRS sent notices to 227,019 non-filers asking that they either file their tax returns or explain why they do not need to file. (Many people were living on savings or tax-free income.)

As a result, nearly 70,000 new tax returns were filed for those two years by the non-filers. For 2005, about 28,000 of those tax returns generated $276 million in assessments. TIGTA estimates that in a given year, this type of audit system will generate between $352 million and $900 million per year in additional tax assessments.

Of course, simply assessing taxes does not guarantee they can be collected. Remember, many people who earned a great deal of money last year or the year before are nearly broke now.

What’s the likelihood that this money will be collected? George and his staff don’t deal in that kind of information. And the IRS doesn’t publish statistics that track collections by these criteria. But look at this population logically:

• The Form 1098 shows mortgage interest actually paid, not just assessed.
• These people are paying mortgage interest of $10,000 or more (the TIGTA study considered Forms 1098 with interest of $20,000 or more). People wouldn’t waste that kind of money without equity in the home.
• Therefore, even if they don’t pay the taxes, when the IRS or a state files a lien, there’s apt to be enough equity in the house to force the taxpayer to pay the tax bill if they refinance or sell.

This is a brilliant collection tactic, don’t you think?

Expect to see more of this from IRS

In response to TIGTA’s recommendations, the IRS said it will expand an existing local audit project on the mortgage-interest deduction to a Nationwide Compliance Initiative Project. IRS’s Small Business/Self-Employed Division will study existing processes to ensure that mortgage interest is appropriately considered when selecting non-filer cases for further examination.

Don’t expect to see this implemented within the next year or so, according to Eric Smith, an IRS spokesman. Who will be targeted? Smith says it’s premature to speculate on the contours of any possible program. So, you can take a deep breath — for now.

But will a similar program be coming soon to a state near you?

California started a pilot program in 2007, says John Barrett, a spokesman for the California Franchise Tax Board. The FTB sent out 56,000 notices to folks with mortgage interest of $10,000 or more. The state collected about $40 million dollars.

To select the winners of this mortgage lottery, California runs a screening process, eliminating folks whose records show indications of savings or other non-taxable sources of funds. After all, as long as worldwide income is less than $14,845 in 2008, there is no need to file a California tax return.

With these IRS and California pilot programs showing such rich results, you can expect your state to implement this kind of scavenger hunt, too. Get ready!

How will this affect you?

When you get a notice, there are two ways to respond. The right way and the wrong way. Consider the following two examples.

In West Hills, Calif., tax attorney Bruce Drooks has a client who received a notice from the California Franchise Tax Board asking how he pays his mortgage. His client responded to the notice on his own, before contacting Drooks, saying the source of the mortgage money was gifts from family.

California thanked the gentleman and promptly requested proof, including copies of the checks or wire transfers used to give him the money, the names and Social Security numbers of the people making his mortgage payments, and the first two pages of their tax returns! In fact, the FTB wants this information for any other years they’ve been paying his mortgage. This could get ugly.

Although Drooks’ client is undoubtedly truthful, this is going to be a major inconvenience to the family members helping him out.

Across the country, Laurence Rubin, a certified public accountant and a partner at Aronson & Company in Rockville, Md., has a client whose letter from the IRS arrived a couple of months ago. This fellow’s Form 1098 mortgage interest showed $45,000, and he had not filed a tax return. They guy didn’t respond to the IRS himself. He brought the notice to Rubin, who responded for him.

Rubin has a philosophy when it comes to the IRS and state tax-agency correspondence. He aims to settle the matter at once, rather than letting it turn into some agent’s career project. Rubin’s response included proof of the source of the funds — the relevant page of a divorce agreement showing a very generous settlement. Since he knew the IRS would ultimately ask for it anyway, Rubin included a copy of the bank statement showing that money in the bank account, and how little interest it was earning.

With all the relevant back-up documents, Rubin outlined the situation, proving the client’s income is too low to require filing a tax return. Rubin’s client got a thank-you letter from the IRS saying the file was closed.

See, that’s how you do it. Don’t equivocate or be vague. Give the agency useful information straight off and you won’t get the kind of terrifying letter Drooks’ client got from California.

Review your tax return before filing it

Read Page 14 of the TIGTA report. It includes an example of how the IRS works backwards from your tax return or the data they have on file from W-2s, 1099s, 1098s, etc. to compute how much money you need to live on in the area where you live. See the report.

Use this concept to review your own tax return before filing it. If the bottom line on your tax return does not support your living expenses, consider adding a statement to your tax return explaining how you’re paying your living expenses. Is it non-taxable income from state bonds, or draws from partnerships? Are you drawing down savings? Are you a trust-fund baby, where the trust is paying all the taxes? The IRS doesn’t know any of this until you tell them.

A word of warning: Did you know that if you don’t file a tax return, the IRS and your state can audit that year forever? Yes indeed! If the government is really desperate for money and finds that you owe them money and have the funds to pay the taxes, beware. If you have not filed tax returns for years, file them now and close the statute of limitations for audits and collections. Otherwise the un-filed years are always in jeopardy.

One last tip, file a tax return for yourself or your senior relatives, even if you have no filing obligation. It locks up that statute of limitations and protects you from intrusive inquiries years later, when tax authorities are trying to raise money.

Eva Rosenberg is the founder of TaxMama.com and an enrolled agent licensed to represent taxpayers before the IRS. She is the author of the new e-book “The 100% Home-Based Business Tax Solution.” Reach her at taxwatch@gmail.com.

Fron the Wall Street Journal

Banks under pressure to meet revenue goals are taking away this perk.

By KELLI B. GRANT

Free checking is going the way of the free lunch.

Once a common benefit at most commercial banks, free checking is becoming more of a hassle than a perk. Getting your checking fees waived increasingly requires meeting so many conditions and wading through so much fine print that, for many customers, it’s hardly worth the trouble.

“Banks, just like airlines and local governments, need to fill the revenue gap,” says Greg McBride, the senior analyst for Bankrate.com. “They’re looking to fee increases to do that.”

Banks are experimenting with a variety of tactics to increase revenue. In May, Fifth Third Bank rolled out its Secure Checking Account program, which costs $8 per month and includes identity theft alerts, discounts on a safety deposit box and a connected emergency fund savings account. And regional bank BBVA Compass offers a program called Built-to-Order Checking, a free no-frills account that offers add-on features for $2 a piece, including interest accrual, free use of other banks’ ATMs and one overdraft fee pardon per year. Last year, Chase renamed its Chase Free Checking program Chase Checking; it is free only for accountholders who use direct deposit or make at least five debit card purchases per statement period — otherwise, users pay $6 a month.

Changes to federal regulations have triggered the cascade of new fees. Already cash-strapped banks anticipate declining revenue from credit cards as rules from the CARD Act take effect, says Hank Israel, director of Novantas, a financial services consulting firm in New York. The Federal Reserve has also said it plans to address overdraft fees, which are projected to bring in $38.5 billion in 2009, according to industry consultant Moebs Services, which has studied overdraft fee strategies. That means fewer profits to subsidize free accounts and the costs of maintaining branches.

Expect a slow transition away from free checking as banks test what changes will bring in revenue without alienating customers, Israel says. “It comes down to, what’s more important: convenience or price?” he says. Consumers who value local branch services will need to pay for that convenience while cost-conscious accountholders are likely to be steered toward online-only accounts, which cost less in overhead but offer less accessibility.

Banks are also likely to add more strings, such as requiring regular checking account use to avoid fees or obtain better deals on other products, McBride says. For example, Wells Fargo requires an account to apply for its credit cards. Chase’s new Mortgage Cash Back program offers 1% back on their monthly Chase mortgage payment when you make automatic payments from a Chase checking account.

“For most people, the answer is still to find a free checking account,” McBride says. Look for free-account conditions you can easily meet, as well as policies and features that can help you avoid other fees (for example, lots of local ATMs and low-cost overdraft protection). Your employer can also help you score free checking. Many companies offer access to credit unions or have special relationships with big banks that yield higher-tier accounts without the regular fee.

Here are five options for free checking accounts at national banks:

Big-Bank Requirements for Free Accounts

Bank of America My Access Checking Account

Requirements: Customers who open an account online will have the monthly maintenance fee of $8.95 waived.

Chase Checking

Requirements: Accountholders who use direct deposit or make five debit transactions per month can avoid the $6 monthly service fee.

Citibank EZ Checking

Requirements: Customers who use direct deposit, make two monthly bill payments or maintain a combined $1,500 balance will pay no fees. Otherwise, they’ll pay a monthly maintenance fee of $7.50 to $9.50 as well as 50 cents to $1 per check (varies by state).

SunTrust Free Checking

Requirements: None.

Wachovia Free Checking

Requirements: None.

*Data from individual banks.