What. A. Year.
When tax geeks arose from their slumber on January 1, 2018, we were greeted by a strange and unfamiliar world. Gone were personal exemptions, Section 199, and 50% bonus depreciation. In their place were a doubled standard deduction, Section 199A, and 100% bonus depreciation. These changes, in addition to countless others, were the end result of a whirlwind legislative process that overhauled our beloved Internal Revenue Code in a mere seven weeks, an act of Congressional hubris that tax professionals will rue for years to come.
As a result of this sweeping new legislation, ever since the calendar turned to 2018, all of our attention has been focused on getting up to speed on the new law. But while we’ve been up to the strained waistline of our pleated Dockers in Opportunity Zones and interest limitations, the century worth of tax law that existed prior to the Tax Cuts and Jobs Act has been completely ignored. Thousands of provisions survived the recent round of reform, and throughout 2018, many of those provisions have found their way into the Tax Court, where disputes between taxpayers and the IRS have ended in all-important judicial precedent.
But anyone who claims to have kept up with the Tax Court in 2018 is flat-out lying. Save for the occasional Wesley Snipes appearance, most of the cases decided by the court in 2018 have gone largely unnoticed, lost to the piles of proposed regulations that have been published on the new law.
And that, quite frankly, is unacceptable. We can’t be like Homer, who once lamented that every time he learned something new, it pushed some old stuff out of his brain. We’ve got to do it all: get a grasp on the new law, while continuing to master the old. After all, Judge Holmes ain’t offering up that word play for no one to read it.
So let’s do this. Over the next twelve weeks, lets dissect one Tax Court case from each month of 2018. Keep in mind, these cases are not necessarily the most important decisions of each month, but rather the ones that I believe to be most useful to your humble workaday tax pro. If you disagree, write your own damn list.
For January’s case, we covered Conner v. Commissioner, T.C. Memo 2018-6, a case addressing whether the sale of real estate generated ordinary income or capital gain.
For February, check out Meruelo v. Commissioner, TC Memo 2018-16, in which we discussed the many ways shareholders in an S corporation screw up trying to obtain “debt basis.”
For March, we went through Simonsen v. Commissioner, 150 T.C. 8, and discovered that the tax treatment of short sales and foreclosures is anything but straightforward.
In April, we looked at Povolny Group, Inc. v. Commissioner, T.C. Memo 2018-37, and discovered that sometimes a loan isn’t a loan.
For May, we beat up Barker v. Commissioner, T.C. Memo 2018-67.
In June, it was Alterman v. Commissioner, TC Memo 2018-83, which took a look at the tax treatment of marijuana facilities.
For July, we covered Martin v. Commissioner, T.C. Memo 2019-109, and learned who qualifies as a real estate professional, or to put it more accurately, who doesn’t.
In August, we took a look at Lakner v. Commissioner, T.C. Memo 2018-127, a case that helped us understand when you can receive a legal settlement or judgment tax-free under Section 104.
We’ve reached September, and Frankel v. Commissioner, T.C. Summary Opinion 2018-45, a case that I chose because it highlights a trap for the unwary; specifically, just because you pay the mortgage interest on a residence does not necessarily mean you are entitled to deduct that interest. Let’s take a look.
What Makes It Special
If you’re preparing a Form 1040, when you turn to Schedule A, you’ll notice that you are allowed a deduction for any mortgage interest expense you paid during the year. This is where you’ll draw a deep breath and revel, ever so briefly, in the fact that at least part of the tax preparation process is simple. You’ll add up the interest expense you paid, drop it on the form, and move on to the next challenge.
Your moment of relaxation, however, is misplaced. Deducting mortgage interest expense, like the majority of the tax law, is even more complicated than it reads. And that’s saying something.
Facts in Frankel
In 2005, Moshe Frankel purchased a home. Although married, he was the only spouse listed on the deed. The residence was to be used by Moshe, his wife Chevy, and their children as a second home.
Moshe took out a mortgage on the home, and then entered into a written contract with his wife. The agreement provided that Chevy Frankel would have an “equal interest” in the house, but would assume full responsibility for the mortgage. She would pay the principal and interest, as well as the property taxes, insurance, and any repairs and maintenance. Finally, the agreement stated that because only Chevy would be paying the mortgage, only she would be entitled to deduct the mortgage interest on her tax return.
Chevy would make mortgage payments from an account that was in her name only, but into which both she and her husband deposited their salaries. After 2011, however, no mortgage payments were made.
Moshe declared bankruptcy in 2009, I presume by loudly proclaiming it at his place of business. In 2013, the home was sold for $82,000 at a time when Moshe still owed $204,000 on the mortgage. That amount, which included $37,000 of accrued but unpaid interest, was forgiven by the bank, and then subsequently excluded from Moshe’s taxable income pursuant to the bankruptcy exception of Section 108(a)(1)(A) as discussed in this article.
On her 2013 tax return that she filed separately from Moshe, Chevy deducted the $37,000 of mortgage interest that was forgiven as part the bankruptcy. The IRS denied the deduction. Let’s find out why…
General Rule, Deduction for Mortgage Interest
As a general rule, you must satisfy five requirements –which can best be phrased as questions — before deducting mortgage interest. The requirements, as laid out in Section 163 of the Code, are as follows:
1. Who paid the mortgage? Because individuals are cash basis taxpayers, you can only deduct mortgage interest if you actually pay it. Makes sense.
2. Who is listed as the borrower on the mortgage? In general, you can only deduct interest on debt for which you are legally obligated. In other words, you can’t deduct interest you pay on a debt that’s not yours.
3. Who has legal title to the house? Treas. Reg. §1.163-1(b) provides an exception to the general rule found in #2. Pursuant to the regulations, even if you’re not directly liable on the mortgage, you can deduct any interest you pay on the debt as long as you are the legal owner of the house (e.g., a deed holder).
4. Is the home secured by the residence? The statute defines qualified residence interest as any interest paid or accrued during the taxable year on acquisition indebtedness that is secured by the qualified residence of the taxpayer. Acquisition debt, in turn, is debt taken out in order to acquire, construct, or substantially improve a residence. Prior to 2018, you were also permitted to deduct the interest on up to $100,000 of home equity debt, but that rule was removed from the law from 2018-2026 as part of the Tax Cuts and Jobs Act (TCJA).
5. What are the limits on deducting personal mortgage interest? Here’s another one that changed under the TCJA. Under old Section 163(h), you could deduct interest related to the first $1,000,000 of acquisition debt. The TCJA drew a line in the sand, however; for mortgages taken out prior to December 15, 2017, the $1,000,000 limit remains. For mortgages taken out AFTER December 15, 2017, however — other than refinances of grandfathered mortgages — the limit drops to $750,000.
On the surface, these requirements seem simple enough. As evidenced below, however, subtleties in your living arrangement may mean that determining your mortgage interest deduction might be anything but easy, and that’s exactly what happened in Frankel. Let’s take a look at an increasingly common scenario, and then take what we’ve learned from the relevant case history and apply it to the facts in Frankel.
Scenario: Mom and Dad buy the house for you, but you pay the mortgage.
The lending market ain’t what it used to be. The free-wheeling days of the early part of the millennium — when banks were handing out cash faster than Jeff Bezos wooing a married woman — are long gone. The subsequent housing market crash has forced lenders to tighten their purse strings, leaving many hopeful homebuyers – read: you — unable to secure a mortgage.
Faced with the ultimate indignity of running back to mom and dad, you might decide to get creative. So instead of living with your parents, you just beg them to use their solid credit to purchase a house, which you’ll then live in and pay the mortgage on. And when tax time comes, you’ll take the deduction for the mortgage interest that you paid, as permitted by the tax law. Right?
Not so fast.
If you run through our list of requirements for deducting mortgage interest, the problem should reveal itself fairly quickly. While you satisfy #1 above as the person actually paying the mortgage, things then start to go wrong. Because you’re not listed as a borrower on the mortgage, the debt you are servicing every month does not legally belong to you, and thus under the general rule, you may not deduct the mortgage interest you paid.
As seen in requirement #3, however, there is an exception to this general rule. Even if you are not listed on the mortgage, you can deduct the interest if you are listed on the deed as the legal owner of the property. Because mom and dad bought the house, however, this leeway does you no good.
So then do mom and dad get to deduct the mortgage interest? Of course not, because they haven’t actually paid the interest, and thus fail to satisfy requirement #1. Then is nobody entitled to deduct the mortgage interest?
Maybe. But maybe not. The regulations also allow a taxpayer who is an “equitable” owner of the house to deduct the mortgage interest he pays, even if he is not listed on the mortgage as a co-borrower.
What constitutes an “equitable” owner of a house? The Tax Court (see Blanche v. Commissioner, T.C. Memo 2001-63) has typically defined an equitable owner as one who:
- Has a right to possess the property and to enjoy the use, rents or profits thereof;
- Has a duty to maintain the property;
- Is responsible for insuring the property;
- Bears the property’s risk of loss;
- Is obligated to pay the property’s taxes, assessments or charges;
- Has the right to improve the property without the owner’s consent; and
- Has the right to obtain legal title at any time by paying the balance of the purchase price.
In Uslu v. Commissioner, T.C. Memo 1997-551, the taxpayers lived in a home purchased on his behalf by his brother, who was able to obtain the financing the taxpayer wasn’t. The taxpayers and their children were the sole occupants of the property since the time of its purchase. They made each and every mortgage payment on the property and paid all expenses for real property taxes, insurance, repairs, maintenance, and improvement from their own income. Furthermore, the taxpayer’s brother and his wife made no payments on behalf of the property, and since the time of purchase, hadn’t acted in any manner that would be consistent with an ownership interest in the property.
Based on these facts, the Tax Court concluded that the taxpayers were the equitable owners of the home, and could thus deduct the mortgage interest.
In 2013, the Tax Court examined a similar situation in Puentes v. Commissioner, T.C. Memo 2013-277, and reached a different conclusion. In Puentes, the taxpayer moved into a home owned by her brother. Her brother was the sole holder of legal title to the property, and the only obligor listed on the mortgage. Taxpayer, however, made the mortgage payments.
Because the taxpayer was not legally obligated to make the mortgage payments or pay any real estate taxes, had no duty to maintain or insure the property, and had no right to improve or purchase the property, the court concluded that she failed to establish that she was an equitable owner. As a result, her mortgage interest deduction was denied.
As you can see, if you want to be treated as the equitable owner of a home, you’re going to have to earn it. Pay for as much of the down payment out of your own pocket as you can so that you have some “skin in the game.” Pay all mortgage costs, real estate taxes, and repair, insurance and maintenance expenses. Act like you own the place, and the IRS may just treat you as doing so.
Applying the Facts to Frankel
In Frankel, the husband (Moshe) was the sole spouse listed on the deed, as well as the sole obligor on the mortgage. Chevy, however, lived in the home, and (allegedly) paid the mortgage interest prior to the house being sold in 2013. When the house was sold as part of her husband’s bankruptcy proceedings, she deducted the $37,000 of interest that was forgiven as part of the sale.
The problem is obvious. Like the child in our scenario above, while Chevy paid the mortgage, she was not the legal owner of the house, nor was she listed on the mortgage. As a result, the IRS denied her deduction. As we’ve learned, however, there is still hope for a taxpayer in this scenario, but that hope hinges on whether Chevy Frankel was the “equitable owner” of the house.
The court began by noting that while Moshe and Chevy had entered into a written agreement governing Chevy’s use of the home, the agreement did not address factors 1, 6, and 7 listed above. It then noted that Chevy did not bear the risk of loss, because when the house was eventually sold as part of Moshe’s bankruptcy, the forgiveness of the mortgage had no impact on Chevy’s separately filed tax return, as it was all reported by Moshe.
In addition, while the court conceded that the agreement gave Chevy the burden of factors 2, 3, and 5, neither Chevy nor Moshe could credibly testify as to who actually paid the mortgage principal, interest, property taxes, and other expenses of the home. In addition, because Chevy used an account that contained the earnings of both she and her husband, the court found it unclear whether she had actually paid the ongoing operating expenses of the home.
In her defense, Chevy cited the Uslu decision, but the court made a few key distinctions, most notably, that in that piece of precedent, the taxpayer clearly paid all of the expenses of the home, including the mortgage interest. In the immediate case, however, after the house went into foreclosure in 2009, neither Chevy nor Moshe made ANY payments on the mortgage.
As a last gasp attempt, Chevy argued that because she was married to Moshe, she should be treated as owning half the legal title to the house, but the court rightly conclude that New York state law does not give a spouse a half-interest in property owned by the other spouse. As a result, the Tax Court determined that Chevy was NOT the equitable owner of the house, and thus was not permitted to deduct the $37,000 of mortgage interest.
Other Complicating Factors
As you can see, you can pay the mortgage interest on a home and still not get the deduction, if you are not either 1) the legal owner, 2) listed on the mortgage, or 3) the equitable owner. But there are plenty of OTHER scenarios where you can go wrong as well. Let’s take a look at just a few…
Scenario 2: Mom and Dad loan you the money, and you buy the house directly.
You’re back living with mom and dad. And as miserable as that makes you, it makes them FAR more miserable. They’ve been cleaning up after you for 25 years, and after you left for college, they had no intention of every doing it again. Desperate to liberate themselves from your presence, your parents loan you hundreds of thousands of dollars so that you can pay cash for your new home. The money isn’t free, however, and you promise to pay your parents back, with interest, just as if you had borrowed from the bank. And each year, like the dutiful, diligent son or daughter than you are, you pay your parents back. So of course, you deduct the interest portion of your “mortgage” payments on your tax return.
But should you? Are you the legal owner of the house? Check. Are you the legal obligor on the debt? Check. Are you actually paying the debt? Check. So what’s the problem?
Take a glance at requirement #4 above. The statute requires that the home be secured by the residence. In Weng v. Commissioner, T.C. Summary Opinion, 2014-4, we found out that the IRS takes this requirement very seriously.
In Weng, when the taxpayer borrowed from his parents in order to pay cash for a home, mom and dad never bothered to formally record or perfect the loan to their son under state law, because, you know…they were his mom and dad.
The court, however, noted that this failure to record the loan meant that the loan was not “secured by the residence” as required by the regulations, and thus Weng — despite being the payor on a mortgage on which he was the obligor, of a residence on which he was the legal owner — was not entitled to a mortgage interest deduction for the amounts paid to his parents.
The lesson? Thank mom and dad for their gratitude, but encourage them to follow the necessary formalities.
Scenario 3: You and your roommate own a house together, pay the mortgage out of joint or separate bank accounts
As stated in #2 in our list of requirements, in general, a deduction for interest is available only to those who are primarily liable on the underlying debt. Where, however, two or more people are jointly and severally liable for a debt, each is primarily liable for that debt, and each is entitled to a deduction for the interest on that debt that he or she pays.
Thus, where more than one taxpayer is liable on a home mortgage obligation, questions arise as to which taxpayer is entitled to the interest deduction. The answer, of course, is driven by who paid the interest, which is not always clear when payment is made from a joint account.
For example, assume a same-sex couple that has not legally married buys a home together and are jointly and severally liable on the mortgage. They also open a joint bank account together, and pay the mortgage from that account. Come tax time, the bank either issues a Form 1098 under only one social security number, or under both.
In CCA 201451027, the IRS concludes that funds paid from a joint account with two equal owners are presumed to be paid equally by each owner, in the absence of evidence showing that that is not the case. It also says that a person who is jointly and severally liable on a home mortgage debt is entitled to deduct all the otherwise allowable interest on that debt, provided that person actually pays all the interest.
Thus, in our example, because both taxpayers are liable on the mortgage, both are entitled to claim the mortgage interest deduction to the extent of the mortgage interest paid by either taxpayer. If the mortgage interest is paid from a joint bank account in which each has an equal interest, it would be presumed that each has paid an equal amount absent evidence to the contrary.
If, however, the mortgage interest is paid from separate (rather than joint) funds, each taxpayer may claim the mortgage interest deduction paid from each one’s separate funds.
See Scenario 4, however, for a situation where each owner’s share of the deduction may be limited.
Scenario 4: You and your roommate own a very expensive house together.
In Sophy v. Commissioner, 138 T.C. 8 (2012), the Tax Court dealt a blow to wealthy unmarried couples and same-sex couples who have not married under state law, holding that the $1,100,000 limitation on mortgage debt must be applied on a per-residence, rather than a per-taxpayer basis.
As mentioned in #5 of our requirements above, prior to 2018, Section 163(h)(3) allowed a deduction for qualified residence interest on up to $1,000,000 of acquisition indebtedness and $100,000 of home equity indebtedness. Should the mortgage balance (or balances, since the mortgage interest deduction is permitted on up to two homes) exceed the statutory limitations, the related interest deduction was limited to the amount applicable to only the first $1,100,000 worth of debt.
Now assume for a moment that A and B — an unmarried couple — built their dream house in 2012, owning the home as joint tenants. And assume the total mortgage debt is $2,000,000, with each owner paying interest on only their $1,000,000 share of the total debt.
Are both A and G entitled to a full mortgage deduction — since each paid interest on only $1,000,000 of debt, the maximum allowable under Section 163 — or is their mortgage deduction limited because the total debt on the house exceeds the $1,000,000 statutory limitation?
In Sophy, this issue was surprisingly addressed for the first time in the courts (it had previously been addressed in CCA 200911007), with the Tax Court concluding, after examining the structure of the statute, that the plain language of Section 163 requires the applicable $1,000,000 debt limitation to be applied on a per-residence basis. Thus, according to the Tax Court, A and B had to split the maximum $1,000,000 limitation.
The decision was later reversed by the Ninth Circuit, however, based on a fascinating application of the law. There is a premise — as crazy as it sounds — that every word in the Code is intended to have weight. No sentence is to be thought of as superfluous. Why does this matter?
If you flip open Section 163(h), you will note that (prior to 2018) it explicitly states that the limit on acquisition debt is $1,000,000, but is reduced to $500,000 in the case of a taxpayers married filing separately. And this is critical, because in the eyes of the Ninth Circuit, if two unmarried taxpayers who shared a house were required to cap the TOTAL limit at $1,000,000, there would be no reason for the Code to explicitly apply a $500,000 limit to a taxpayer who files separately from their spouse. That would just be the way it is. Stated in another way, if the $1,000,000 limit truly applied on a per-residence basis, as the Tax Court concluded, then the rule limiting two spouses who file separately to deducting the interest on $500,000 each would be totally unnecessary. And again, that’s not how the law is interpreted; every sentence is presumed to matter.
Thus, in the above example, where A and B each paid mortgage interest on only the maximum allowable $1,000,000 of debt, each owner’s mortgage interest deduction was allowed up to the full $1,000,000, because they were NOT married taxpayers filing separately. The IRS later acquiesced on the Ninth Circuit’s decision in Sophy.
Scenario 5: You and you spouse own the house together, but file Married Filing Separately
After the Supreme Court struck down the Defense of Marriage Act at the tail end of 2013, same-sex couples that were legally married in a state that respects their union must file their tax returns as married filing jointly or married filing separately; they no longer have the opportunity to file as single taxpayers. If they choose to file separately, however, it opens up another trap for the unwary when deducting mortgage interest expense.
Consider the following facts: you and your spouse (whether same-sex or otherwise) purchase a home for $1,300,000, taking out a $1,000,000 mortgage to finance the purchase price.
During the year, you pay the full interest expense on the $1,000,000 loan, amounting to $50,000 for the year. Your spouse pays nothing.
You and your spouse then choose to file your tax return as Married Filing Separately. On your separate return, you claim the full $50,000 interest deduction related to the home. Because you paid the interest and are listed on the deed and mortgage, and because the debt is secured by the residence, you see no reason why you wouldn’t be entitled to the deduction.
This is exactly what the taxpayer did in Bronstein v. Commissioner, 138 T.C. 21 (2012). Let’s see where she went wrong.
For starters, if you again flip to Section 163 in your Code, you’d find that the language of the statute governing the $1,100,000 limitation that existed prior to 2018 (and as discussed in #5 of our requirements) provides that:
· The aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return).
· The aggregate amount treated as home equity indebtedness for any period shall not exceed $100,000 ($50,000 in the case of a separate return by a married individual).
The IRS, using a plain interpretation of the statute, disallowed half of Bronstein’s interest deduction, arguing that because her filing status was “married filing separately,” she was limited to deducting the interest paid on only $500,000 of acquisition debt and $50,000 of home equity debt.
In her defense, Bronstein argued that the intent of the statute in cutting the limitations in half for married filing separately taxpayers was to accommodate situations where the husband and wife jointly paid mortgage interest but chose to file separate returns. In this case, each spouse would be permitted to take interest deductions on half of the full limitation amounts. In a situation where one spouse pays all the interest expense — as Bornstein did in the immediate case — she argued that she should be entitled to deduct interest on the full debt amounts of $1,000,000 and $100,000.
The Tax Court disagreed, requiring a strict adherence to the statutory language:
We believe section 163(h)(3)(B)(ii) clearly states that a married individual filing a separate return is limited to a deduction for interest paid on $500,000 of home acquisition indebtedness. Similarly, we believe section 163(h)(3)(C)(ii) clearly states that a married individual filing a separate return is limited to a deduction for interest paid on $50,000 of home equity indebtedness. Petitioner has not offered any unequivocal evidence of legislative purpose which would allow us to override the plain language of section 163(h)(3)(B)(ii) and (C)(ii). As a result, we agree with respondent that petitioner is not entitled to a deduction for the interest paid on the entire $1 million of acquisition indebtedness incurred in purchasing the property. Rather, petitioner is entitled to deduct interest paid on only $550,000 of the mortgage indebtedness.
Conclusion
The moral of these five scenarios should be obvious: when it comes to tax law, nothing is as simple as it seems. And in today’s real estate market, with many taxpayers resorting to non-traditional forms of home ownership and lending arrangements — taxpayers and their advisors must be aware of the various requirements and limitations when deducting mortgage interest.