If you own a home, the interest you pay on your home mortgage provides one of the best tax breaks available. However, many believe that any interest paid on their home mortgage loan is deductible. Sadly, as the Defrancis’ discovered in a recent Tax Court opinion, that assumption is wrong. In DeFrancis v. Commissioner, the Tax Court held that the couple could not deduct as qualified residence interest the interest they paid on a loan from the wife's mother that was secured by an unrecorded mortgage. How can that be?
On October 31, 2001, Christopher and Jennifer Defrancis, a married couple, purchased a home in Northampton, MA. In January of 2003, they signed a document described as a "mortgage note," promising to pay Joan Gross, Jennifer's mother, $427,333 plus interest in return for a mortgage loan. The mortgage note provided that the couple would pay monthly interest and that the full principal amount of the mortgage note was due on January 1, 2033. Also in January of 2003, the couple signed another document entitled "Mortgage." This document provided they were indebted to Joan Gross in the principal sum of $427,333. The document further provided that the couple "hereby mortgage grant, convey and assign to... [Joan Gross] the property with an address of …" The couple and Joan Gross signed the mortgage document. The document was not notarized or recorded. During 2009, the couple paid Joan Gross $19,230. The couple treated the expenditure as a payment of home mortgage interest on their 2009 federal income tax return.
Sounds deductible right?
It used to be the case that pretty much all interest payments were deductible. Since 1986, however, deductibility has become very complicated. Personal interest is disallowed, but one kind of personal interest that remains deductible is qualified residence interest. Qualified residence interest is interest paid or accrued during the tax year on acquisition indebtedness or home equity indebtedness with respect to any qualified residence of the taxpayer.
The term "acquisition indebtedness" means any indebtedness incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by such residence.
Secured debt means a debt that is on the security of any instrument (such as a mortgage, deed of trust, or land contract):
- that makes the interest of the debtor in the qualified residence specific security of the payment of the debt,
- under which, in the event of default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated, and
- that is recorded, where permitted, or is otherwise perfected under applicable State law.
In this case, the Court held that the interest wasn't deductible because the debt did not meet two of the three requirements to be secured debt.
It’s all about HOW you do it.
Joan Gross's failure to record the mortgage exposed the mortgage to potential defeat by third parties who didn't have actual notice of the mortgage, who are protected by the Massachusetts recording statute. In other words, in Massachusetts, as is the case in most states including PA, NJ and NY, an unrecorded mortgage is invalid against third parties who do not have actual notice of it. If a default occurs, the unrecorded mortgage note would not subject the residence to the satisfaction of the debt with the same priority as a recorded mortgage because the unrecorded mortgage note is valid only against any third person having actual notice of it. Therefore, the Court said, the couple did not satisfy the second prong for being a secured debt under the regulations. The Court also noted that the taxpayers provided no evidence that they otherwise perfected the mortgage under Massachusetts law and therefore concluded that the taxpayers failed the third prong of the definition as well.
There are other provisions in the law that adds to the complexity of mortgage interest deductibility. You can't deduct the interest for acquisition debt greater than $1 million ($500,000 for married individuals filing separately). So, if you bought a $2 million house with a $1.5 million mortgage, only the interest you pay on the first $1 million in debt will be deductible. The rest will be considered personal interest.
Note also that the $1 million ceiling on deductible home mortgage debt includes both your primary residence and your second home combined. Many people assume they can deduct $1 million from each mortgage. If you have a $700,000 mortgage on your primary home and a $500,000 mortgage on your vacation home, you'll have to count the interest relating to the excess $200,000 as nondeductible personal interest.
The rules are different for home equity loans. Home equity debt is debt (other than acquisition debt) secured by your principal or second residence. Home equity debt is limited to the lesser of $100,000 ($50,000 if your filing status is married filing separately) or your equity in the home. The interest you pay on a qualifying home equity loan is generally deductible regardless of how you use the loan proceeds, except when the proceeds are used to purchase tax-exempt obligations.
This provision provides some real savings opportunities if you have equity in your home and also have other debts. Credit card debt is not deductible and usually carries a higher interest rate than home equity interest. By converting your nondeductible, higher-rate, credit card debt to home equity indebtedness (i.e., use the home equity loan to pay off your credit card balance), you could save both on taxes and on the interest rate differential. You should keep in mind that interest on a home equity loan isn't deductible for purposes of the alternative minimum tax (AMT), unless you use the loan to improve your home. This is an important consideration, since an increasing number of taxpayers are subject to the AMT.
The Tax Warriors® at Drucker & Scaccetti understand the nuances of the rules relating to deductibility of interest on various forms of indebtedness. We can review the rules with you and, depending on your facts, suggest other tax saving strategies. Use the button below to ask your questions or give us a call at (215) 665-3960 to discuss your particular situation.