Regulations

Unrecorded mortgage from ‘Bank of Mom’ fails to qualify for interest deduction

Real Estate Tax Talk

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One of the greatest tax benefits of homeownership is the home mortgage interest deduction, which permits homeowners to deduct the mortgage interest for a home loan or loans up to $1 million as an itemized deduction.

You don’t have to borrow the money from a bank or other financial institution to qualify for this deduction. Interest paid on money borrowed from other sources, such as relatives, can also be deductible.

However, certain technical requirements must be satisfied to get this deduction. If you fail to dot all your i’s and cross all your t’s, you could lose your entire deduction.

That’s what a Massachusetts couple named Christopher and Jennifer Gross recently discovered. They borrowed $427,333 from Jennifer’s mother to purchase a home in Northampton.

They weren’t legal experts, but they did their best to ensure that the interest they paid on the loan qualified for the home mortgage interest deduction. They all signed a document described as a “mortgage note” promising to pay Jennifer’s mother $427,333 — plus interest — in return for the loan.

The Grosses did in fact pay the interest to Jennifer’s mother — they paid $19,230 in 2009, and deducted this amount on their taxes as a payment of home mortgage interest.

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The IRS never questioned the validity of the loan itself. It was clearly not a disguised gift or otherwise fraudulent.

The moral of the story is that relatives who loan money to each other to purchase homes should seek expert assistance to help them properly draft and record their mortgage documents."

Nevertheless, the IRS denied the mortgage interest deduction — and the Tax Court agreed. What went wrong?

The Grosses failed to comply with a simple technical requirement. For home mortgage interest to be deductible, the home loan must be secured debt. Secured debt means a debt that is on the security of any instrument (such as a mortgage, deed of trust, or land contract):

  • i. That makes the interest of the debtor in the qualified residence specific security of the payment of the debt,
  • ii. 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
  • iii. That is recorded, where permitted, or is otherwise perfected in accordance with applicable state law. (Reg. § 1.163-10T(o)(1).)

Unfortunately, the Grosses failed to record their mortgage or otherwise “perfect” it. Thus, it did not qualify as “secured debt.”

They lost a $19,230 deduction because they failed to spend the $20 or so to record a few pieces of paper with their county recorder.

However, the Tax Court took a little pity on the Grosses, ruling that they were not liable for a 20 percent accuracy-related tax penalty that the IRS had imposed. Noting that they were not tax experts, the court said it would not have been apparent to taxpayers that the interest on an otherwise bona fide home mortgage would not be deductible unless it was recorded. (Defrancis v. Comm’r, TC Summary Opinion 2013-88.)

The moral of the story is that relatives who loan money to each other to purchase homes should seek legal or other expert assistance to help them properly draft and record their mortgage documents.

Stephen Fishman is a tax expert, attorney, and author who has published 20 books, including “The Real Estate Agent’s Tax Deduction Guide,” “Working for Yourself,” “Deduct It!,” and “Working with Independent Contractors.” His website can be found at fishmanlawandtaxfiles.com.