Mortgage Interest – Personal vs. Business Expense

Posted on Thu, Sep 11, 2014 ©2021 Drucker & Scaccetti

Michael Hume and Dorsaye Dilani, TC Memo 2014-135

 

 

Recently, the Tax Court held that a divorced couple could not deduct mortgage interest as a business expense on a property they intended to rent to third parties because they never started a rental business and the former spouse resided in the property. The Court allowed interest on $1.1 million of the debt to be deducted as qualified residence interest.

 

The Case 

Michael Hume and his wife, Dorsaye Dilani (Taxpayers) owned two single-family homes. The second house (“property”) was purchased intending to rent it out for weekly vacations and for events. At the time of purchase and thereafter, they had no pre-existing arrangement to rent or sell the house to any third party. The property had many structural and aesthetic problems, and Taxpayers could never get the property into suitable shape for tenants.

 

During 2008 and 2009 (the years at issue), Taxpayers did not rent nor did they advertise the property. Despite their problems in carrying out the alleged rental plan during 2008 and 2009, they did not attempt to sell the property. During 2008 and 2009, Michael lived at the property when he was not traveling for work.

 

On their original 2008 and 2009 tax returns, Taxpayers deducted the mortgage interest for both homes on their Schedule A. The aggregate debt for both properties was more than $3 million. The IRS disallowed the mortgage interest and home equity interest deductions Taxpayers claimed if the interest related to loan principal, which exceeded the aggregate $1.1 million cap applicable to the qualified residence interest deduction.

 

Taxpayers filed Form 1040X for the 2008 and 2009 tax year and moved the interest deduction from their Schedule A to Schedule C, claiming the interest deduction associated with the second property was a business expense. The IRS disallowed the mortgage interest as a business expense.

 

The Background

You are allowed a deduction for all ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business.

 

Personal interest is nondeductible, but qualified residence interest, which includes interest paid or accrued on acquisition indebtedness and home equity indebtedness, is deductible. Acquisition indebtedness is indebtedness incurred to buy, build, or substantially improve an individual's qualified residence secured by the residence. The total amount treated as acquisition debt cannot exceed $1 million for any period ($500,000 for a married individual filing separately).  Home equity indebtedness is indebtedness (other than acquisition indebtedness) secured by taxpayer's qualified residence, to the extent the aggregate debt doesn't exceed the fair market value (FMV) of the residence, as reduced by the acquisition indebtedness on it.  The total amount treated as home equity indebtedness for any period can't exceed $100,000 ($50,000 for a married individual filing separately).  

 

The Tax Court Decision

The Tax Court concluded that the Taxpayers did not start actively engaging in their proposed rental activity in the 2008 or 2009 tax years and therefore the mortgage interest on the second property was not a business expense deductible on their Schedule C. The Court found that the IRS properly disallowed mortgage interest paid regarding loan amounts above $1.1 million.

 

In their analysis the Court noted that Michael derived no income from and did not rent out the property in either of the two years . In addition, Michael was living in the property during 2008 and 2009. His course of conduct contradicted that of a person who believed he was renting or able to rent out the property during 2008 or 2009.

 

The Tax Warrior’s Perspective

This case demonstrates that your actions must match your intent for a rental property. You must actively engage in your rental business to deduct the ordinary and necessary expenses associated with that activity.

 

While it wasn’t mentioned in the case, it’s surprising the Taxpayers didn’t argue that the second property was an investment property, which may have allowed the mortgage interest paid to be deducted as investment interest expense up to the amount of investment income each year, with the remainder carried forwarded.

 

The Tax Warriors® at Drucker & Scaccetti have extensive experience in representing individuals who own multiple properties. Contact us via the “Ask A Tax Warrior” button below if you have any questions about the properties you own and how to ensure the most tax-efficient strategy for deducting interest on debt relating to those properties.  We are always prepared to help you with this or any other tax matter.

Topics: real estate, Rental property, expense, peronal, mortgage deduction, Form 1040X, tax court, IRS, business

Read & Submit A Comment