Taxes in Your Practice: Qualified residence interest deductions denied
Vol. 76, No. 4 / July - August 2020
Scott E. Vincent
Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.
In a case that may be timely for those considering or using a second residence, the Tax Court recently addressed interest deductions with respect to a taxpayer with two real estate properties. In McCarthy v. Commissioner, T.C. Memo. 2020-74 (McCarthy), the court upheld the Internal Revenue Service disallowance of qualified residence interest deductions based on the taxpayer’s ownership and use of the properties.
The petitioner and taxpayer in McCarthy is a certified public accountant who engaged in a variety of rental and recreational activities with a longtime friend, attorney, and CPA (Rodgers). For several years, the taxpayer rented a beach house in California (California property) from Rodgers. In 2005, the taxpayer moved to New York and later bought a co-op unit there (New York property), where he resided until 2014 when he moved to Minnesota following a job change. The taxpayer did not live at the New York property in 2015.
After his 2005 move to New York, the taxpayer occasionally visited California and stayed at the California property. The taxpayer testified that he purchased 32.5% of the California property from Rodgers in 2010, financed by an interest bearing loan from Rodgers. However, there were no cash payments to Rodgers by the taxpayer in 2015 relating to the loan or the California property, and Rodgers received $96,000 of rental income from his niece and law firm office manager in 2015 with respect to the California property. The taxpayer’s 2015 tax return, prepared by Rodgers, indicated a home address of Minnesota. On Schedule A to this return, the taxpayer reported total mortgage interest of $48,514, including mortgage interest from a Form 1098 with respect to the New York property and mortgage interest purportedly paid to Rodgers with respect to the California property. On Schedule E to the return, the taxpayer reported rental income and expenses relating to the New York property, resulting in a suspended passive loss, and indicating 365 “fair rental days” and no personal use days.
The IRS disallowed these mortgage interest deductions and imposed penalties, finding that the New York property interest should have been reported on Schedule E and finding that the taxpayer did not substantiate payment of interest relating to the California property.
Qualified Residence Interest
A deduction is generally allowed under Internal Revenue Code § 163 for interest paid or accrued during a taxable year on indebtedness, which means an unconditional and legally enforceable obligation to pay money. Section 163(h) limits this general rule and prohibits deductions for personal interest.
An exception to the personal interest limitation allows a taxpayer to deduct “qualified residence interest,” which includes interest on acquisition indebtedness with respect to a qualified residence, defined as (i) the principal residence of the taxpayer and (ii) one other residence selected by the taxpayer for the taxable year for purposes of § 163 and used by the taxpayer as a residence as defined in § 280A(d)(1). For purposes of § 280A(d)(1), a dwelling unit is used as a second residence if the taxpayer uses it for more than the greater of (i) 14 days during the taxable year or (ii) 10% of the number of days during the taxable year that the unit is rented at fair rental value.
In defining “principal residence,” § 163 refers to § 121, which generally refers to property owned and used as a taxpayer’s principal residence. The § 121 regulations require a facts and circumstances determination and, if a taxpayer alternates residency between two properties, the property used the majority of the time during the year will ordinarily be considered the taxpayer’s principal residence. The taxpayer in McCarthy asserted that the New York property was his principal residence and the California property was his second residence. The court rejected both positions based on the analysis outlined below.
New York Property
The court found that the taxpayer resided in Minnesota in 2015, did not use the New York property as his residence, and in fact rented out this property for all of 2015. The court noted that renting out a property after moving does not preclude that property from being a principal residence, particularly if a taxpayer’s efforts to sell the property demonstrate that was a primary motivation, rather than holding the property for rental income. The taxpayer argued that a prior downturn in the real estate market made renting the New York property a financial necessity in 2015 prior to selling it in 2016. However, the court found evidence of the taxpayer’s intent lacking in the record.
In examining other relevant factors, the court found that the taxpayer’s place of employment, place of abode of family members, address on tax returns, driver’s license, automobile registration, voter registration, mailing address for bills and correspondence, location of banks, religious organizations, and recreational clubs all either indicated a Minnesota principal residence or were lacking from the record.
Based on these determinations, the court found that the taxpayer failed to carry the burden of proof that the New York property was his principal residence in 2015. The court also found that the taxpayer had not selected the New York property as a second residence under § 163(h), and the court further explained that the New York property would not meet the requirements for a second residence in any event since the property was rented out for 2015 and was not used by the taxpayer for personal purposes at all that year.
The taxpayer testified that he acquired a 32.5% interest in the California property with a seller-financed note to Rodgers and that payments of interest on the note in 2015 were offset against debt that Rodgers owed to the taxpayer. The taxpayer also presented a purported note, deed of trust, and conveyance documents. However, the court found that these documents were not authentic and excluded them from evidence due to discrepancies in testimony and notary dates.
The court further found that even if the documentary evidence were authentic, the taxpayer would not have substantiated his mortgage interest deductions for three independent reasons.
First, the taxpayer’s purported debt to Rodgers was not “secured debt” required to qualify as acquisition indebtedness. The court found that even if the debt was arguably secured by a qualified residence, the taxpayer’s failure to record the note or deed of trust failed the other requirements in the regulations for secured debt.
Second, the taxpayer failed to demonstrate that the California property was a qualified residence in 2015. The taxpayer argued that the California property was his second residence, and the court considered whether it would satisfy the requirements of § 280A(d)(1). However, the taxpayer failed to demonstrate that he personally used the California property for more than 14 days in 2015.
Third, the court found that the taxpayer, a cash basis taxpayer, made no cash interest payments to Rodgers in 2015. As noted, the taxpayer argued that his interest payments offset Rodgers’ other debt to him. However, the court rejected this argument, finding that the taxpayer reported no interest income (for the offset) in 2015 and further generally finding that there was insufficient evidence of any bona fide debt from Rodgers to the taxpayer.
The McCarthy case outlines key requirements for deducting mortgage interest with respect to a second residence and demonstrates the need to carefully document and track residence issues when there are multiple possible properties in question. The case also shows the intolerance that the IRS and courts may have for professionals in tax controversy matters who fail to adequately document their personal transactions and substantiate deductions.
1 Scott E. Vincent is the founding member of Vincent Law LLC in Kansas City.