More than half of Spain’s landlords are dodging taxes as the rental market expands, depriving the financially strapped government of more revenue each year.

Owners are asking for payment in cash from tenants to avoid tax on 2.5 billion euros ($3.5 billion) of earnings annually, the Gestha union of tax inspectors estimates. An increase in rental properties nationwide hasn’t generated any more tax revenue.

The Spanish government, seeking to pull the country out of its deepest recession in 60 years, needs all the money it can get right now. The slump was triggered by a crash in the housing market and has left Spain with the highest budget deficit since at least 1980. Taxes go unpaid on income equal to about a quarter of gross domestic product, Gestha estimates.

“The deep economic crisis in which the country is submerged is once again making the hidden economy flourish,” said Juan Jose Figares, chief analyst at Link Securities in Madrid. “The government will be compelled to clamp down on rent fraud.”

A drop in house prices starting in the second quarter of 2008 has forced many people who bought homes as investments to seek tenants for their properties rather than selling at a loss. At the same time, more Spaniards are trying to lease homes after they were priced out of the market in the years before the crash, making it easier for landlords to strike deals that don’t involve the taxman.

The number of properties for rent increased 18 percent to 2.2 million units in 2008, according to data from Spain’s Housing Ministry. Rental income declared by landlords rose by just 0.1 percent over the same period, a report on the Web site of Spain’s tax office shows.

Room to Grow

The rental market has a lot of room to grow. At 13 percent, the proportion of renters to homeowners in Spain is still low compared with other European countries, where 40 percent to 60 percent of housing is rented, according to Madrid-based property consultant Aguirre Newman. Around 65 percent of Spaniards aged 25 to 29 live with their parents, compared with about 22 percent in France and the U.K., economic research institute Fedea estimates.

“During the housing boom, the state was earning so much from home sales that it wasn’t worth chasing the odd landlord,” said Fernando Encinar, co-founder of Idealista.com, Spain’s largest real estate Web site. “Now, with the economic crisis, the government really does need the money and will make efforts to prosecute tax dodgers.”

Easy to Dodge

Encinar, whose company lists 360,000 properties for rent and purchase, said Gestha’s estimate that 54 percent of landlords are ducking taxes “falls short of the true figure, which is set to grow further.”

The penalty for avoiding tax on rent is a fine equivalent to 150 percent of the unpaid amount, according to the Spanish tax office. The tax also must be repaid. There is no punishment for the tenant.

The penalty is almost never applied because tax dodgers are not being investigated, Gestha General Secretary Jose Maria Mollinedo said.

“As both the landlord and the tenant make an agreement not to declare tax or their residency, there is absolutely no way to prove that tax fraud is taking place and therefore no non- declaring landlords are brought to book,” Mollinedo said.

A tax break adopted in 2008 accounts for part of the difference between rising rentals and the lack of tax revenue growth. It gives landlords a 100 percent tax break if they rent to tenants who are under 35, according to a spokesman for Spain’s tax office who declined to be identified by name, citing government policy. He didn’t provide information on how many landlords claimed the tax break.

Read more here: BusinessWeek.