The real estate sector has been identified as an area conducive to money laundering and tax fraud. This is a persistent problem in various countries, but there are no official data or statistics on its true scale. In this sense, price manipulation when carrying out a mortgage transaction is one of the methods most commonly used to commit tax fraud.

The researchers created a model based on the behaviour of the mortgagor to predict tax evasion on real estate transfers.

José García Montalvo, full professor of Applied Economics at UPF; Amedeo Piolatto, Ramón y Cajal researcher at the UAB, both linked to the Barcelona GSE, together with Josep M. Raya, a professor of the Tecnocampus-UPF ESCSET School of Business and Social Sciences and of the Department of Economics and Business at UPF, have created a model based on the behaviour of the mortgagor to predict tax evasion on real estate transfers.

The model is included in a study published last March in the journal Regional Science and Urban Economics, which examines the extent to which appraisals may be used as a tool to ascertain the probability of tax evasion on mortgage transfers: it provides an observable measure of overvaluation, inversely related to tax evasion: “Our model unequivocally suggests a negative correlation between overvaluation and evasion carried out by means of liquidity”, the authors affirm.

A model based on essential information from 1,400 real estate transactions

The researchers develop a theoretical model and combine it with an empirical analysis of a unique dataset in Spain from 2005 to 2011, including information on the sale value declared to the tax authority, the amount actually paid and the appraised value of some 1,400 real estate transactions.

Taking these data, they build an index of observed overvaluation, which is the ratio between the appraisal and the declared sale value, and they study how overvaluation varies with tax evasion.

Almost half of the sample transactions include an undeclared amount of money.

Almost half of the sample transactions include an undeclared amount of money, accounting for an average of 7.64%, which is equivalent to 13,847 euros of the total. Depending on the fraudulent behaviour, this percentage rises to 15.1% (27,409 euros).

The model reveals that low appraisals usually correspond to a buyer that has available cash and, as opposed to a buyer with restricted cash, who can afford to make a side payment (illegal) to reduce the sales value and, therefore, the payment of taxes, without resorting to a high mortgage.

 “The use of overvaluation to increase the amount of the appraisal continues to be the final resort for a buyer, used only if there are no other alternatives. Hence, overvaluation is a sign of liquidity constraints and it is unlikely to occur in people who have savings that can be used for illegal side payments”, the authors assure.

A study that may help improve the effectiveness of the tax authorities

From the results of their study, the authors conclude that the tax authorities should concentrate their auditing efforts on lower-appraisal transactions (compared to the sale price) to better identify those that are potentially fraudulent.

“As declared overvaluation is much easier to evaluate and observe than access to liquid savings or fraud, it should be used as an indicator of the likelihood of fraud. In particular, the tax authorities should focus their attention on transactions where the appraisal is relatively low”, they assert.

According to the researchers, a good choice of the transactions for auditing (via the “red flags system”) is crucial to efficiently manage the resources of the tax authorities: “A good ‘red flag’ should be easy to notice and present a high probability of identifying fraud, and our study can help greatly in this respect”, they explain.

The importance of personal characteristics and of the local environment

After combining their data with indicators of the local environment, such as corruption, quality of governance, the shadow economy and social capital, the authors argue that some of the variation in the probability of committing fraud and its magnitude is determined by the immediate environment.

In addition, people’s individual characteristics also explain some of the observed heterogeneity when committing tax evasion: “As we have had access to the individual characteristics of a third of the sample, we have been able to document that a high level of education is a good predictor of low levels of evasion”, they confirm.

Reference work: José G. Montalvo, Amedeo Piolatto, Josep M. Raya (March 2020). “Transaction-tax evasion in the housing market”. Regional Science and Urban Economics, Vol.61, 103526, 10.1016/j.regsciurbeco.2020.103526