The mortgage interest deduction seems simple enough. The Code provides a deduction for mortgage interest that is paid during the year.
It starts with a broad grant:
There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.
Then these 18 words in a single sentence are followed by approximately 7,500 words that limit the benefit. That is about 30 pages of rules using single spacing and 12 point font. The Treasury has also added several pages of regulations that explain and further limit the deduction. It has also summarized the rules in various publications, which add nuances that also have to be considered.
IRS statistics show that taxpayers spend an average of 4 to 5 hours filling out their entire tax return each year. This suggests that most taxpayers spend just a few minutes each year to report their mortgage interest deduction. This might not be enough time to comply with the 30+ pages of rules for this deduction.
Those who are audited by the IRS found to have not complied with the rules may view the broad-grant-plus-takeaway a form of entrapment. An “I got you” arrangement. If not entrapment, those who read the rules may find the length annoying at best. Those who plan for the tax rules may find that the rules can be used to help reduce the amount of tax owed.
The recent McCarthy v. Commissioner, T.C. Memo. 2020-74 provides an opportunity to consider these mortgage interest rules. It addresses the primary vs. other residence election for the mortgage interest deduction.
Facts & Procedural History
This case involves a taxpayer who relocated to several states. He had an interest in the following properties:
- 1999-2003 – Rented house in California from a friend
- 2004-2014 – Purchased and resided in a New York property
- 2015 – Rented a property in Minnesota
In 2010, the taxpayer purchased a 32 percent interest in the California property from his friend. He then used the property for vacations, etc. It also appears that this 32 percent interest may have been for a separately accessible unit in the property.
In 2015, the taxpayer rented out the New York property. He apparently sold it one year later.
This case involves the 2015 tax year. For 2015, the taxpayer deducted on Schedule A, as itemized deductions, interest for the New York and California properties.
The IRS moved the interest deduction for the New York property to the Schedule E for rental properties. This loss was suspended due to the passive activity loss rules. The IRS disallowed the interest deduction for the California property in full.
Litigation ensued. The U.S. Tax Court had to decide whether the interest deductions were allowable.
The Home Mortgage Interest Deduction
Section 163 provides a deduction for mortgage interest paid during the year. This can include interest paid on debt incurred to:
- acquire the taxpayer’s qualified residence or
- refinance the taxpayer’s qualified residence.
The term “qualified residence” means:
- The taxpayer’s principal residence and
- One additional residence elected by the taxpayer which was used by the taxpayer as a residence
The rules go on to say that married taxpayers are treated as one taxpayer. Thus, married taxpayers who do not file a joint tax return can choose which property to count as their residence. They can also agree in writing as to which property they treat as the principal residence and which to treat as the other residence.
The court noted that there is no prescribed method for a taxpayer to elect which property is their primary and their other residence. This is unusual with elections. The IRS has prescribed methods for making most elections. It has not yet done so with this election.
Taxpayers who have more than one residence usually just deduct the mortgage interest for both properties on the Schedule A. The court allowed the taxpayer to make this election by telling the court which property was the primary address.
The choice has to be considered carefully. As this court case shows, it might not be best to just pick the property with the largest interest expense.
The Primary Residence Election
The principal residence has to satisfy the additional requirements set out in Section 121. The regulations for Section 121 provide several factors for determining whether a residence is a “principal residence.” These factors consider:
- the proximity of the taxpayer to the taxpayer’s place of employment and the principal place of abode of the taxpayer’s family members;
- the address listed on the taxpayer’s Federal and State tax returns, driver’s license, automobile registration, and voter registration card and the taxpayer’s mailing address for bills and correspondence;
- the location of the taxpayer’s banks; and
- the location of religious organizations and recreational clubs with which the taxpayer is affiliated.
In the present case, the court considered the New York property as the primary residence. In doing so, the court concluded that the property was not the taxpayer’s primary residence as it appeared that the taxpayer was actually living and working in Minnesota in 2015.
The court concluded that the property was not the taxpayer’s primary residence. This resulted in a full disallowance of the mortgage interest deduction for the New York property.
The Other Residence Election
The other residence has to satisfy the personal use rules in Section 280A(d)(1). These rules say that a residence has to be used by the taxpayer for “personal purposes” for more than the greater of: (1) 14 days or (2) 10% of the number of days during the taxable year that the unit is rented at a fair rental value.
The term “personal purposes” is not defined. It is generally understood to include most personal use, including actual use. It may even include below-market rents charged to parents or other family members.
The taxpayer has to be able to show 14 days or 10% of rental days. This requires some records to establish the personal use.
In this case, the court noted that the owner of the property rented the property to his secretary and he reported $96,000 of rental income on his personal tax return for this rental activity. The court did not believe that this amount was paid for just one room in the property. The court also noted the absence of any records showing that the taxpayer used the property for 14 days in 2015. It did not accept the taxpayer’s testimony that the property had been used for more than 14 days in 2015.
The court concluded that the property was not an other residence. This resulted in a full disallowance of the mortgage interest deduction for the California property.
The nuances in this case are instructive. Those who are married and filing separately should have something in writing specifying which property is the primary residence.
The taxpayer should document factors for to show which property is their primary residence. This may include picking the property with the largest expense, and documenting the factors in support of that property being the primary residence.
For the other residence, the taxpayer should document the 14 days of personal use. There is no set method for doing this, but travel records and/or a contemporaneous log might suffice.
While the amount of the interest deduction was recently limited by the Tax Cuts and Jobs Act, the deduction remains one of the largest itemized deductions for many taxpayers. An experienced real estate tax attorney can help navigate these rules.