Monday, February 13, 2023
Lesson From The Tax Court: Mortgage Interest Deductions When The Payor Is Not The Borrower
Families can be complicated. Tax law can be complicated. Put those complications together and you get today’s lesson: family obligations to pay interest on a mortgage don’t support the §163 deduction even though they might, informally, be as binding as legal obligations.
In Hrach Shilgevorkyan v. Commissioner, T. C. Memo. 2023-12 (Jan. 23, 2023) (Judge Ashford), the taxpayer paid half the interest due on a mortgage, but he was not the borrower. The loan had been obtained by his brothers. And while the complex rules for §163 allow interest deductions in some circumstances when the payor is not also the borrower, this taxpayer was unable to show how the complexities of his particular family arrangement fit into the complexities of the statute. Details below the fold.
Law: Some Complexities of §163
Section 163 used to be simpler. Subsection (a) permits a deduction for “all interest paid or accrued within the taxable year on indebtedness.” (emphasis supplied). Readers of a certain age will recall fondly that until 1986 that broad language included interest on personal indebtedness, such as credit card debt.
In 1986 Congress killed the joy and made §163 more complicated by adding §163(h). See Tax Reform Act of 1986, 100 Stat. 2085 at 2246. Section 163(h)(1) now generally disallows deduction for any item of “personal interest.” However, §163(h)(2) adds complexity by excluding six types of interest from the definition of “personal interest.” The one relevant today is “any qualified residence interest (within the meaning of paragraph (3).”
What constitutes qualified residence interest has its own complexity. Section 163(h)(3) tells us that qualified residential interest comes in two flavors: acquisition indebtedness and home equity indebtedness. Today’s lesson involves the former, so we don’t have to worry about the latter, which has been suspended anyway until 2026 per §163(h)(3)(F).
Acquisition indebtedness arises from a loan that is used to buy, build, or substantially improve a qualified residence of the taxpayer and the loan is secured by that same residence. §163(h)(3). The deduction permitted by the statute is capped by the size of the qualifying indebtedness. For the tax years at issue in today’s case, taxpayers could deduct interest on qualifying indebtedness of up to $1m. Interest attributable to loan balances exceeding $1m were not deductible. Again, we don’t need to worry about the current cap of $750,000 on qualifying indebtedness or whether that goes away in 2026.
So that’s the statute. It’s complex enough. But life is complicated and both the Tax Court and IRS have found it necessary to complexify the mortgage interest deduction analysis in at least three ways relevant to today’s lesson.
Complexity 1: Relationship of taxpayer to loan.
The first complexity is determining whether the taxpayer seeking the deduction has a sufficient obligation to pay the loan. This requires looking at the relationship between the taxpayer and the loan. As a general rule, the indebtedness must be the obligation of the taxpayer and not another. See Golder v. Commissioner, 604 F.2d 34 (9th Cir.1979) (taxpayers’ status as guarantors of loan acquired by their closely held corporation was insufficient to support §163 interest deduction, even though they had mortgaged their own property to secure the guaranty).
But the regulations explicitly contemplate that taxpayers who are not directly responsible for the loan might still have an obligation that supports the mortgage interest deduction. Treas. Reg. 1.163-1(b) has long provided that “Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness.”
The most typical situation is also the simplest: the taxpayer is the borrower and the loan is recourse. But it can get complicated. The original point of the regulation was to permit taxpayers who are paying interest on a non-recourse loan to take a deduction. See Golder, supra, at 35 (explaining history of the regulation). However, the Tax Court has expanded on this to permit interest deductions when the taxpayer has a sufficiently enforceable agreement with the original borrower to pay off the loan. See e.g. Amundson v. Commissioner, T.C. Memo. 1990-337 (finding taxpayer’s agreement to make mortgage payments on loan obtained by sister in exchange for half-interest in the residence created "enforceable interest-bearing debt" to taxpayer's sister).
This is not easy to establish as you can see by the many cases where the Tax Court has denied the interest deduction for lack of a proper relationship between the taxpayer and the loan. See e.g. Loria v. Commissioner, T.C. Memo.1995–420 (loan taken out by a sibling of the taxpayer and informal agreement for taxpayer to pay mortgage was insufficient); Song v. Commissioner, T.C. Memo.1995–446 (same, even though agreement for taxpayer to pay the sibling’s loan was put in writing).
Complexity 2: Taxpayer’s relationship to the property.
The second complexity arises because the Tax Court generally favors economic substance over legal forms. What that means is that it has expanded the reach of Treas. Reg. 1.162-1(b) to cover situations beyond non-recourse loans. Focusing on the regulation’s “legal or equitable owner” language, the Tax Court has permitted taxpayers to take the mortgage interest deduction when they can show they were the legal or equitable owner of the property and were making the interest payments in order to preserve their legal relationship to the property. Put another way, if the taxpayer’s relationship to the property is strong enough, that can trump the fact that the taxpayer lacks the proper relationship to the loan.
As befits this substance-over-form approach, the Tax Court looks a number of factors to decide (under relevant state law) whether the taxpayer as a sufficient legal or equitable interest in the property to fall within this expansive reading of the Treas. Reg. The Court will look to see whether the taxpayer (1) had the right to possess the property and to enjoy its use, rents, and profits; (2) had the unilateral right to improve the property; (3) had the right to obtain legal title in situations where a seller was holding title as security; (4) bore the risk of loss of the property; (5) had the duty to maintain the property; (6) was responsible for insuring the property; and (7) was obligated to pay taxes, assessments, and charges against the property. See Blanche v. Commissioner, T.C. Memo. 2001-63.
Using those factors, the Tax Court has sometimes held that taxpayers who do not hold legal title to property nonetheless established they had a sufficient rights in the property such that their loan payments were necessary to preserve their rights, even though the loan had been taken out by another person. See e.g. Njenge v. Commissioner, T.C. Summ. Op. 2008-84; Uslu v. Commissioner, T.C. Memo. 1997-551.
Using the same factors, the Tax Court has also found that taxpayers did not establish equitable ownership, see: Frankel v. Commissioner, T.C. Summ. Op. 2018-45; Adams v. Commissioner, T.C. Memo. 2010-72. Nair v. Commissioner, T.C. Summ. Op. 2007-116. Daya v. Commissioner, T.C. Memo. 2000-360 (2000).
Complexity 3: Taxpayers qualifying use of property.
The first two complications generally apply to all mortgage interest deductions, including mortgages on business property. This third one, however, applies only to home mortgages.
The statute permits deduction of home mortgage interest only for a “qualified residence.” Each taxpayer can have up to two qualified residences. The first one is the taxpayer’s principal residence. The second one can be any other residence the taxpayer designates so long as the taxpayer actually makes personal use of it for the greater of 14 days or 10% of the days it’s rented out. §163(h)(4)(A), x-ref. to §280A(d)(1). But the taxpayer must specifically designate the residence. That second residence is not an issue in today’s case. So that’s one complexity we can ignore.
What qualifies as a taxpayer’s principal residence can be complex. No surprise there. Treas. Reg. 1.163-10T(p)(2) says that “the term “principal residence” means the taxpayer's principal residence within the meaning of section 1034.” Well, gosh, that just shows you how old this Temp. Reg. is! Congress nuked §1034 in 1997 when it created current rules for §121 home sale exclusion. See Lesson From The Tax Court: The Unforeseen Circumstances Rule For §121 Home Sale Exclusions, TaxProf Blog (Ap. 25, 2022). So as Judge Ashford tells us, the cross-reference is really to the definition of “principal residence” for §121 purposes. Op. at 8. And, as Treas. Reg. 1.121-2(b)(2) puts it: “whether property is used by the taxpayer as the taxpayer's principal residence depends upon all the facts and circumstances.” See e.g. Guinan v. U.S., No. CV 02-0261-PHX-PGR (D. Ariz. Apr. 9, 2003) (TPs who had owned and used three homes could not establish that the one they sold was their principal residence). Close enough.
Today’s case illustrates all three of those complexities. Let’s take a look.
The tax year at issue here is 2012. On his return for that year Mr. Hrach Shilgevorkyan claimed a mortgage interest deduction for over $66,000 for interest he paid to Wells Fargo on a loan secured by a house in Paradise Valley, AZ. The IRS disallowed the deduction and that’s the dispute in Tax Court.
The facts in this case are a bit tangled, much like the myriad relationships one sometimes finds in families. Basically it’s the story of three brothers: Artur, Edvard, and Hrach. The three brothers were strongly entrepreneurial, operating “a number of auto shops, a jewelry store, and a restaurant” through various business entities. Op. at 2. But they were not strongly tax compliant. An undescribed check-cashing scheme resulted in criminal tax penalties against Edvard and civil tax fraud penalties against Hrach. Id.
The brothers were also involved in the purchase and construction of a 5,300 sq. ft. home and associated 1,700 guest house in Paradise Valley, AZ in the mid-2000’s. Whether this was a personal purchase or a business move is unclear. The property was purchased in 2005 by Edvard and his wife Lusine. The opinion does not say when the house and guest house were completed but I infer it was 2008. In 2010, Edvard put the property on the market. It did not sell. He tried again in 2013. The opinion is silent on the results of that effort.
The loan documents suggest that the lender was also unclear about the purpose of the purchase. Was it to build a home to live in or to flip? The first loan was to buy the land, obtained by Edvard and Lusine. Then Artur joined them in securing a second loan to build the structures. While Artur was a cosigner, he never actually made any payments. Op. at 8. By 2008, the three borrowers had consolidated and re-financed the loans into a single $2m loan from Wells Fargo Bank. The loan documents required that the borrowers “occupy, establish, and use” the property as their principal residence within 60 days after the refinancing and would remain their principal residence for at least one year unless Wells Fargo agreed to release them or unless there were extenuating circumstances that forced them out. Op. at 3. So that suggests that the structures were not completed by 2008. Readers of a certain age might recall the economic situation that year. Younger readers can Google “Great Recession.”
Hrach, the taxpayer in today’s case, was not listed as an obligor on the Wells Fargo loan. In fact, the loan documents provided that if any of the three borrowers (Edvard, Lusine, and Artur remember) transferred their interest in the property, it would trigger a default and Wells Fargo could require immediate payment of the full loan balance from the three borrowers. Op. at 3.
Well ... Artur never lived at the Paradise Valley property at all! In 2010 (the same year Edvard put the property up for sale for the first time), Artur executed a quitclaim deed in favor of Hrach. No one told the Bank. In 2010 Hrach seems to have started living in the guest house at least part time. But he also maintained a residence in Mountain Park Condominiums, where he and his brothers owned and rented out units. Op. at 4. And he did not list the Paradise Valley property as an asset in a home loan application he made in February 2013. Instead on that application he represented that he was a renter at that property. Hrach got the 2013 loan and used it to buy a house. He moved there in 2013.
During 2012 Hrach paid his brother Edvard an amount equal to half of the mortgage payments for that year. Wells Fargo issued a Form 1098 to Edvard and Lusine. Hrach claimed a deduction for some $66,000, representing half of the interest reported on that 1098.
In Tax Court Hrach argued that he should be allowed to deduct the $66k because a side agreement he had with Edvard made it an enforceable obligation. He had the right relationship with the loan to justify the deduction. Alternatively, Hrach argued that he had the right relationship with the property. Invoking Treas. Reg. 1.163-1(b), he argued that he was a half-owner of the property and so his payments were necessary to protect his legal interest. Judge Ashford rejected both arguments and then threw in a third reason for disallowing the deduction: the Paradise Valley guest house was not his principal residence. Let’s take a look at each lesson.
Lesson 1: Family Obligation Is Not Sufficient Legal Obligation To Support Deduction
Hrach and Edvard both testified that they had a handshake agreement that if Hrach would pay half the mortgage, Edvard would split the profits from the sale of the Paradise Valley property with him. It appears they were trying to fit their circumstances under Amundson, supra.
Judge Ashford did not believe them, writing “We need not accept a taxpayer’s self-serving testimony when the taxpayer fails to present credible, corroborative, documentary evidence.” Op. at 7. Here, Hrach had no other evidence of the brothers’ agreement, much less evidence that it was enforceable outside of the family. Heck, Hrach did not even have evidence of his payments! He made no payments directly to Wells Fargo. All the payments to Wells Fargo came from Edvard and Lusine. Instead, the story was that Hrach paid half of those amounts directly to Edvard but Hrach apparently was unable to even introduce evidence of that. Id.
Lesson 2: Quitclaim Deed Cannot Create Something Out of Nothing
Recall that even if the taxpayer is not primarily liable for the loan, Treas. Reg. 1.163-1(b) permits taxpayers who have a sufficient legal or equitable interest in the property to deduct interest payments. Determining whether a taxpayer has a sufficient legal or equitable interest in the property to meet the requirement of requires a facts and circumstances examination of the taxpayer’s relationship with the property, using state law.
Hrach tried to argue he was a half-owner of the Paradise Valley property because Artur had executed a Quitclaim deed in his favor. However, the relevant state law, Arizona, provided that Artur never had an ownership interest in the property. He was simply a co-debtor. Writes Judge Ashford: “Under Arizona law, Artur was an accommodation party and had no ownership interest in the property.” Op. at 8. Therefore, Hrach could not use the quitclaim deed to establish legal ownership because a “quitclaim deed cannot convey greater rights to property than those that the grantor possessed.” Id.
So Hrach had no legal interest. What about equitable interest? It does not appear Hrach even tried. Judge Ashford writes that Hrach “did not provide credible evidence that he paid expenses associated with the property or that he bore any benefits or burdens of the property.” Id. To the contrary, his claim of ownership before the Tax Court was directly contradicted by contemporaneous documents. Hrach had put in his February 2013 loan application that he rented the guest house and he did not list the Paradise Valley property as an asset.
Lesson 3: Ya Gotta Have A Qualified Residence
Finally, Judge Ashford notes that even if Hrach had been able to actually show he made mortgage interest payments, and had done so to protect a legal or equitable ownership interest, he still would not be entitled to a §163 deduction because he could not show that the Paradise Valley guest house was his primary residence in 2012. Hrach “had his mail sent to multiple addresses,” and was unable to even show how much time during 2012 he spent at the Paradise Valley residence instead of the Mountain Park Condos. Op. at 9. In contrast to Paradise Valley, the electric utilities at Mountain Park were under his name and Hrach paid those bills by personal checks. Judge Ashford notes that on none of those checks, nor any bank statement, did Hrach even list the Paradise Valley address as his residence.
In sum, “petitioner has not met his burden of proving that the Paradise Valley property was his qualified residence for 2012.” Op. at 9.
Bottom line: Yes, taxpayers who pay interest on a home mortgage can sometimes be entitled to the §162 interest deduction even if they are not the borrower (if the home is their qualified residence). But one must always be careful to fit the complexities of each taxpayer’s situation with the complexities of the law.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf blog for another Lesson From The Tax Court.
I can't prove it, but I think this is the kind of case that should have been brought to District Court, where I think a judge or jury would have been more sympathetic to the taxpayer. Of course, the taxpayer would had to have the means to front the tax payment for which he would sue for a refund.
Posted by: Tu Phat | Feb 13, 2023 5:54:14 PM