Case — Allocation of Interest Expense

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TL Case Summ

THE QUESTION

Can a taxpayer deduct as investment interest certain amounts of mortgage interest that do not constitute qualified residence interest?

THE DISPUTE

Taxpayer Says: The amount paid for property should be allocated between a home and investment property. Interest on the mortgage for the home portion is deductible as qualified personal residence interest, and interest on the remainder of the debt is deductible as qualified investment interest.

Internal Revenue Service Says: The taxpayer may deduct part of the interest as qualified residence interest, but is not entitled to deduct any additional amounts of interest paid on the mortgage.

THE LAW

From Internal Revenue Code Section 163(h): As a general rule, individuals may not deduct personal interest. Limited exceptions to this general rule permit individuals to deduct investment interest and qualified residence interest.

From Internal Revenue Code Section 163(d): For noncorporate taxpayers, investment interest is deductible only to the extent of the taxpayer’s net investment income for the taxable year. Investment interest generally means “any interest * * * which is paid or accrued on indebtedness properly allocable to property held for investment.” Investment interest excludes qualified residence interest.

THE CAUSE OF THE DISPUTE

You can claim an itemized deduction for interest you pay on debt used to buy, construct, or improve your home, as well as interest you pay on home equity debt. In general, the deduction is limited to interest paid on up to $1 million of acquisition debt, and $100,000 of home equity debt.

In addition, you can deduct interest you pay on money you borrow to purchase property for investment purposes, such as non-business property that will produce a gain (or loss). The investment interest deduction is limited to the amount of your investment income, and is not allowed for interest paid on investments that produce tax-exempt income.

If you borrow money for more than one purpose you have to divide the interest expense into the applicable category for deduction.

In this case, the taxpayer purchased two properties for $1.8 million, with the intention of living in an existing home on one property, and subdividing the other. The final purchase agreement made no allocation of the purchase price between subparcels.

The taxpayer financed the acquisition with a single credit line secured by the home. Later refinancing was also secured by the home. After the purchase, the taxpayer had a feasibility study performed, talked to a developer about subdividing the property, contracted to perform a boundary check of the property, plot a subdivision creating two parcels, and set pipes for the new lots as needed. The taxpayer also hired a company to conduct an environmental study with respect to the proposed development of the properties. The taxpayer had not subdivided the property by the time the case came before the tax court.

On their 2006 return, the taxpayer allocated $1 million of debt to the home, and $800,000 to the second parcel as investment property, and claimed a deduction for home mortgage interest on the $1 million, and a deduction for investment interest on the $800,000. The allocation was based on the original offer made for the residence ($1 million), and the additional amount paid for the adjoining property ($800,000).

The IRS agrees the taxpayer used the existing home as a personal residence, and can deduct qualified residence interest on $1 million of indebtedness (plus an additional $100,000 because some of the debt was used to renovate the home). However, the IRS argues the taxpayer is not entitled to deduct any other amounts of interest paid.

The IRS says that the taxpayer did not substantiate the allocation because the purchase agreement for the property makes no allocation of the purchase price between subparcels, and the parties to the transaction never discussed any such allocation when they entered into the purchase agreement.

In addition, while the taxpayer intended to subdivide a significant portion of the property at some future date, he cannot allocate any part of the mortgage to investment property because he did not actually subdivide the property or use it for any business purpose provided for in the Internal Revenue code.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 39KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
For the IRS. The taxpayers failed to account for the fact that the property was financed with a single credit line. The final purchase agreement does not support the taxpayer’s allocation, and contained terms and restrictions not necessarily contemplated in the initial conversations about the purchase (upon which the taxpayer made the allocation). (Editorial note: This case hinges on the lack of evidence regarding the allocation made by the taxpayer, and the court did not decide the issue of whether the taxpayer was precluded from allocating part of the mortgage to investment property because he did not actually subdivide the property or use it for any business purpose enumerated under code section 280A.)
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