BETA
This is a BETA experience. You may opt-out by clicking here

More From Forbes

Edit Story

Five Traps To Avoid When Deducting Mortgage Interest

This article is more than 9 years old.

The New Year is upon us. This means that the time for preparing your 2014 tax return draws near. Soon you'll don your tinted visor, dust off your ten-key, and get to work filling in your Form 1040. Minutes later, as you struggle to make sense of the tangle of forms and schedules before you, you'll be painfully reminded that the tax law is damn complicated.

As you flip to Schedule A, you'll notice that you are permitted 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 Line 10, 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.

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, only the taxpayer who actually pays the mortgage is entitled to a deduction.

2. Who is listed as the borrower on the mortgage? In general, a taxpayer can only deduct interest on debt for which he is legally obligation. He cannot deduct interest he pays on a debt that isn’t his.

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 or home equity indebtedness that is secured by the qualified residence of the taxpayer.

5. What are the limits on deducting personal mortgage interest? Section 163(h) provides that a taxpayer can deduct interest related to the first $1,000,000 of acquisition debt and the first $100,000 of home equity debt.

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. The remainder of this column covers five scenarios where determining your deduction for mortgage interest expense requires more thought than you might have realized, and the end result may be no deduction at all!

Scenario 1: 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 Stephen Hawking at a strip club — 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 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.

Scenario 2: Mom and Dad loan you the money, and you buy the house directly.

Maybe things are even worse for you. Maybe you've got neither credit nor cash; at least for the moment. 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 persons 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, issued just last week, 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, Section 163(h)(3) allows 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 is limited to the amount applicable to only the first $1,100,000 worth of debt.

Now assume for a moment that Ace and Gary -- an unmarried couple -- build their dream house, owning the home as joint tenants. And assume the total mortgage debt — including a home equity loan of $200,000 –is $2,200,000, with each owner paying interest on only their $1,100,000 share of the total debt.

Are both Ace and Gary both entitled to a full mortgage deduction — since each paid interest on only $1,100,000 of debt, the maximum allowable under Section 163 — or is their mortgage deduction limited because the total debt on the house exceeds the $1,100,000 statutory limitation?

In Sophy, this issue was surprisingly addressed for the first time in the courts (it had previously been addressed with a similar conclusion 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 $1,100,000 debt limitation to be applied on a per-residence basis:

Qualified residence interest is defined as “any interest which is paid or accrued during the taxable year on acquisition indebtedness with respect to any qualified residence of the taxpayer, or home equity indebtedness with respect to any qualified residence of the taxpayer.” Sec. 163(h)(3)(A) (emphasis added).

The definitions of the terms “acquisition indebtedness” and “home equity indebtedness” establish that the indebtedness must be related to a qualified residence, and the repeated use of the phrases “with respect to a qualified residence” and “with respect to such residence” in the provisions discussed above focuses on the residence rather than the taxpayer.

Thus, in the above example, even though Ace and Gary each paid mortgage interest on only the maximum allowable $1,100,000 of debt, each owner’s mortgage interest deduction is limited because according to the Tax Court, the maximum amount of qualified residence debt on the house — regardless of the number of owners — is limited to $1,100,000. Assuming Ace and Gary each paid $70,000 in interest, each owner’s limitation would be determined as follows:

$70,000 *  $1,100,000 (statutory limitation) / $2,200,000 (total mortgage balance)  = $35,000

In summary, each taxpayer loses 50% of their mortgage interest deduction based on a curious drafting of the statute.

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 were to flip to Section 163 in your Code, you’d find that the language of the statute governing the $1,100,000 limitation 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.

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.

follow along on twitter @nittigrittytax