Family Mortgages Come Under IRS Scrutiny

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The IRS insists that i’s must be dotted and t’s crossed before the IRS will allow taxpayers to deduct mortgage interest on a “qualified residence.”  If the formalities are not observed, the debtor may be denied a deduction while the creditor must nonetheless report the interest payments as interest income.  This adverse tax situation is, perhaps, most likely to arise in the context of a family loan, typically, where a parent extends mortgage credit to a son or daughter.  Here is one recent case [1]

On October 31, 2001, a married couple (“the taxpayers”) purchased real property in Northampton, Massachusetts (“the Property”) for $365,000.  In January 2003, the taxpayers signed a Mortgage Note promising to pay Ms. Jones[2], the mother of one of the taxpayers, $427,333 plus interest (4.5% annually) in return for a mortgage loan.  The taxpayers also signed a Mortgage which provided that the taxpayers were indebted to Ms. Jones the principal sum of $427,333.  The Mortgage further provided that the taxpayers “hereby mortgage grant, convey and assign to * * * [Ms. Jones] the Property…”  The taxpayers and Ms. Jones signed the mortgage document, but the document was not notarized nor was it recorded.

In September 2008, the taxpayers signed a document entitled “Open End Mortgage” with TD Bank, N.A. (“TD Bank mortgage”).  The taxpayers did not disclose the existence of their indebtedness to Ms. Jones when they applied for the TD Bank mortgage.  The $200,000 TD Bank mortgage was secured by the Property, and the mortgage was recorded with the Hampshire County Registry of Deeds in September 2008.

During 2009 the taxpayers paid Ms. Jones a total of $19,230, and the taxpayers also paid interest on the TD Bank mortgage of $1,138.  The taxpayers claimed a home mortgage interest deduction of $20,368 ($19,230 + $1,138) on their 2009 Schedule A, Itemized Deductions.

The IRS disallowed $19,230 of taxpayers’ $20,368 claimed home mortgage interest deduction.  The IRS asserted that taxpayers were not entitled to deduct the $19,230 under IRC Section 163(h).  The $1,138 of home mortgage interest paid to TD Bank, N.A. and reported on Form 1098 is not in dispute.

A taxpayer may claim a deduction for qualified residence interest paid or accrued during the taxable year on acquisition indebtedness or home equity indebtedness secured by the qualified residence.[3]  Acquisition indebtedness is “any indebtedness which is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by such residence.”  IRC Section 163(h)(3)(B)(i).  Secured debt is debt on any instrument

(i)                 “That makes the interest of the debtor in the qualified residence specific security of the payment of debt,

(ii)               Under which, in the event of default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage…, and

(iii)             That is recorded, where permitted, or is otherwise perfected in accordance with applicable State law.”  Section 1.163-10(T)(o)(1), Temporary Income Tax Regs.

The first element of secured debt was satisfied by the wording in the Mortgage.  The second element was not satisfied because the Mortgage was not recorded therefore exposed the Mortgage to potential defeat by third parties because a third party, such as TD Bank, did not have actual notice of the Mortgage.  The Mortgage would not be subject to the same priority as the TD Bank mortgage which was recorded.  The third element was not satisfied according to the Court.  The Mortgage was not recorded and the taxpayers did not establish that the Mortgage was otherwise perfected under Massachusetts law.  The Court held that the interest was not deductible because the debt to Ms. Jones did not meet 2 of the 3 requirements for secured debt.

[1] United States Tax Court, T.C Summary Opinion 2013-88

[2] The names involved with this case have been redacted or changed.

[3] An individual taxpayer is prohibited from claiming a deduction for personal interest paid or accrued during the taxable year under IRC Section 163(h).  Qualified residence interest is one of the limited exceptions.  See IRC Section 163(h)(3)(A).