Taxing Lessons From Court Decisions

Decisions — Perfection

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You know personal interest is not deductible. You probably also know that “qualified residence interest” is an exception to the general rule, and that “qualified residence interest” is 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.

But what is “secured” debt?

That’s the question in T.C. Summary Opinion 2014-4 (Dong/Weng), and it’s worth a deduction of $26,442 for 2007 and $26,162 for 2008.

Image source: OpenClipArt.org
Image source: OpenClipArt.org

The taxpayers paid the interest to their parents, who issued a loan agreement and a deed of trust. The loan agreement provides that the taxpayers’ home is specific security for the payment of the debt. However, neither the loan agreement nor the deed was recorded in any jurisdiction, including New York, where the taxpayers lived.

The tax court looked at the three elements of secured debt: ownership in the home is security for payment of the debt; in the case of default, the home can satisfy the debt; and the debt instrument is recorded or otherwise perfected under state or local law.

Under New York law, the tax court was unaware of any way of perfecting the debt besides recording the debt instrument. Since that didn’t happen, the IRS said the interest was not deductible, and the court agreed.

Taxing Lesson: Sometimes it pays to seek perfection.

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