Tax Court Shuts Door on Mortgage Interest Deduction

If your clients own a second home, they can still claim a mortgage interest deduction from the IRS. However, as a new Tax Court case shows, this can only be done if they meet certain IRS reporting requirements.

Aug 6th 2020
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Even though Congress recently chipped away at the mortgage interest deduction, you can still usually write off most, if not all, of the interest you pay during the year, However, as shown in a new case, McCarthy, TC Memo 2020-74, 6/3/20, you must meet certain requirements to deduct interest for a particular home.

Previously, the tax law allowed you to write off interest on the first $1 million of acquisition debt for a qualified home. For this purpose, “acquisition debt” is a debt incurred to buy, build or substantially improve a qualified residence. In addition, you could deduct mortgage interest paid on the first $100,000 of home equity debt.

However, the Tax Cut and Jobs Act (TCJA) modified the rules, beginning in 2018 and ending after 2025. Currently, you can deduct mortgage interest on the first $750,000 of acquisition debt, down from $1 million (although the rules for pre-December 16, 2017 loans are grandfathered). The TCJA also suspended the deduction for home equity debt for 2018 through 2025.

Despite these changes, you may have plenty of leeway on your personal return for interest paid on a qualified home like your main home or a second home. The second home might be a vacation home that you rent out when you’re not using it personally. In this instance, to be able to deduct interest on Schedule A of your Form 1040, your personal use must exceed the greater of 14 day or 10 percent of the time it is rented out.

In the new case, the taxpayer, who was a CPA, purchased a partial interest in a home in Hermosa Beach, California from a business associate who was also a close friend. The taxpayer used the stay at the place prior to the purchase, but did not reside there at all during the tax years in question. Instead, the home was rented out to the taxpayer’s niece.

During this time, the taxpayer primarily resided in New York before he unexpectedly moved to Minnesota due to a job change. He claimed mortgage interest deductions based on his ownership percentage of the California home, but the IRS assessed a tax deficiency. Eventually, the case went to the Tax Court.

Although he didn’t select a primary residence on his tax return, at trial the taxpayer deemed his New York City residence to be his primary home. Thus, the Court proceeded under the assumption that he was claiming the California residence as a second home.

Tax lock-out: Among other issues relating to the deduction, including questions about legal title to the property, the taxpayer failed to establish that he lived at the California home personally more than 14 days or the greater of the time the home was rented out. Accordingly, the Tax Court denied the mortgage interest deduction.

Note that mortgage interest deductions may be claimed for a second home where you don’t live if the home isn’t held out for rental use. Furthermore, landlords may be entitled to mortgage interest deductions that can offset rental income. Develop a strategy for each client that suits his or her personal needs.

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By Lewis C. Taishoff
Aug 7th 2020 17:33

I reported this opinion the day it was issued. See my blog taishoifflaw.com. My comments can be found under the title "Real Estate Taxation 102," 6/3/20. To find out what's going on at US Tax Court without waiting two months, take a look.

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By SimonP
Aug 7th 2020 19:30

As a landlord, why didn't the taxpayer claim the mortgage interest against the rental income? Was he precluded in some way?

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