Keith Codron's Law Blog

Tuesday, May 4, 2010

Whose Mortgage Deduction Is It, Anyway?


As a general rule, in order for interest payments on a home mortgage loan to be deductible, the indebtedness must be the taxpayer's own obligation and not that of another person.  Section 1.163-1(b) of the federal income tax regulations states: "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."  Where the taxpayer acquires real property "subject to" a mortgage and is thus not personally liable for repayment of the indebtedness, a deduction is still allowable as long as the taxpayer can establish a legal or equitable ownership interest in the encumbered property.  Legal or equitable ownership rests, in turn, on whether one has assumed the "benefits and burdens" of property ownership.

In a recent memorandum decision of the United States Tax Court, Anthony J. Adams v. Commissioner (4/13/2010), TC Memo 2010-72, 99 T.C.M. 1305, a taxpayer was found to have assumed the benefits and burdens of ownership of real property held in the name of an irrevocable, short-term trust created by unrelated third-party trustors for the benefit of taxpayer and others as part of a promotional easy-financing and asset protection arrangement.  Accordingly, taxpayer was entitled to deduct home loan interest payments made by the trustee with respect to the trustors' mortgage obligation.


In 2003, sellers, Michael and Zina Gedz, conveyed their residence to an irrevocable 5-year trust, assigning beneficial interests therein to the taxpayer and certain others.  Trustors named an independent corporate trustee to hold legal title to the property, along with the proceeds and profits therefrom, for the use, possession and enjoyment of taxpayer and the other beneficiaries. The trust agreement provided that the beneficiaries' interests were to consist solely of the following: (1) a power of direction to authorize the trustee to deal with the trust property; (2) the right to receive or direct the disposition of proceeds from the property, such as from rents, mortgage refinancings or sales; (3) the right to purchase, lease, manage and control the property; and (4) the obligation to pay for expenses and disbursements relating to the property, including homeowners' insurance.  All earnings, gains, proceeds and expenses of the trust were to be allocated among the beneficiaries in accordance with their respective percentages of beneficial interests.

The trust agreement further provided that the beneficiaries' rights to the proceeds from the trust property were to be deemed personal property, and that the beneficiaries would not possess any right, title or interest in or to the real property itself, neither legal nor equitable. However, the beneficiaries did have a right of first refusal to purchase the real property, a right which taxpayers did not exercise due to a decline in the property's market value. Furthermore, no beneficiary could assign its beneficial interest in the trust without the consent of a majority of the beneficiaries.  

This arrangement was promoted to the taxpayer as a way to realize the benefits of home ownership without having to qualify for a bank loan and without the property's being subject to creditors' claims.  An upfront payment of $320,000 was required from taxpayer for the purchase of a 50% beneficial interest in the trust.  Taxpayer occupied the residence pursuant to an occupancy agreement which required him to pay monthly rent to the trustee of $2,900, an amount equal to the sum of principal and income payments owing monthly on the property's mortgage.  By contrast, the fair rental value of the residence was only between $1,500 and $1,600 per month during this time.  While living at the home, taxpayer made substantial repairs and improvements to the property, which he paid for out of his own pocket, including landscaping, replacing the home's cedar deck, and installing a new garage door opener and glass block windows.

The escrow account statements from which the mortgage payments were made showed the trustors, Mr. & Mrs. Gedz, as the mortgagees (borrowers) on the loan, and so did the annual tax statement for Mortgage Interest Paid, IRS Form 1098.  Nevertheless, for the years of his occupancy, taxpayer claimed the mortgage interest deduction for the portion of his "rental" payments to the trustee attributable to the mortgage interest paid by the trust to the bank.  On audit, IRS, relying on the above-cited income tax regulation, disallowed taxpayer's mortgage interest deduction based on the fact that the loan giving rise to the interest payment was not the legal or equitable obligation of the taxpayer's, but rather that of the trustors.


The Tax Court disagreed with IRS, holding that, on balance, taxpayer had indeed assumed the benefits and burdens of ownership with respect to the real property owned by the trust.  The Tax Court based its decision on the following findings: (1) taxpayer had a duty to repair or maintain the property; (2) taxpayer was responsible for keeping the property adequately insured; (3) taxpayer had a duty to pay taxes, assessments and other charges levied on the property; (4) taxpayer had a right to the property's proceeds from rents, refinancings and sales; (5) taxpayer had a right to obtain legal title at any time by paying the balance of the purchase price; (6) taxpayer bore some risk of loss if the property declined in value, which it did; and (7) taxpayer agreed to pay the mortgage's principal and interest under the occupancy and beneficiary agreements entered into with the trustee.  The Court reasoned that these 7 factors outweighed the factors against establishing taxpayer's benefits and burdens of ownership, which included the following: (1) taxpayer could elect not to exercise his right of first refusal to purchase the property, choosing instead to simply walk away from the property at the end of the 5-year trust term; (2) taxpayer had to enter into an occupancy agreement with the trustee in order to use, possess or enjoy the property; and (3) under the terms of the beneficiary and occupancy agreements, taxpayer was prohibited from making any material alterations or improvements to the property without first obtaining certain consents.


For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com.  Mr. Codron welcomes your inquiries and comments.


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