Wednesday, September 2, 2009

The IRS May Take a Closer Look at Home Mortgage Interest Deductions

A July 2009 report on Home Mortgage Interest Deductions by the Government Accountability Office has received a lot of publicity recently. The report highlights the tremendous amount of confusion on how to appropriately report Mortgage Interest. And many people speculate that the IRS will soon pay more attention to how people report their Home Mortgage Interest.

Many people fear that the recently unemployed will be the first targets of the IRS’s more focused investigations. This is because the IRS would likely target individuals who are paying more annually for their mortgages than their reported income would make appear reasonable. However, there may be another group of people whose deductions are questioned in the year to come.

IRS Publication 936 states:
You can deduct home mortgage interest if all the following conditions are met:
  • You file Form 1040 and itemize deductions on Schedule A (Form 1040)
  • You are legally liable for the loan
  • There is a true debtor-creditor relationship between you and the lender
  • The mortgage is a secured debt on a qualified home in which you have an ownership interest.

You cannot deduct interest you pay for someone else if you are not legally liable to pay it. Both you and the lender must intend that the loan be repaid.

If the IRS starts taking a closer look at mortgage interest, two things may happen:
  • Elderly people whose only income is from social security, but who are listed on the mortgage for a home that their children live in (and pay the mortgage for), may be audited due to speculation that they may have unreported income even if they do not deduct mortgage interest

  • Taxpayers who claim the mortgage interest deduction for a home but are not listed on the mortgage may be investigated by the IRS

United States Tax Court Opinion 2008-84

While IRS Publication 936 states that you cannot deduct mortgage interest unless you are legally liable for the loan, a recent US Tax Court case ruled in the favor of two taxpayers (in this example I will refer to them as petitioners) who were not on the title or the mortgage for their house.

The petitioners needed the help of their son to acquire their home and secure a mortgage because they had filed for Chapter 7 bankruptcy just two years prior. The petitioners lived in the home continuously, and they made all mortgage and real estate tax payments. The respondent (the IRS) pled that since the petitioners were not legally obligated to pay the mortgage and did not hold legal title on the property, they were not entitled to deduct the interest.

The key to validating the deduction was proving that the petitioners were equitable and beneficial owners of the property, exclusively enjoying the benefit and burden of the property.

Although the example above yielded a favorable outcome for taxpayer, it is very important to note that past positive results in tax court do not guarantee future success (nor can past negative results guarantee future failure). As stated in the initial lines of the ruling opinion, “the decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case.” Every case is different, just as every court is different. So what works for one taxpayer may not work for another. Still, it may be reassuring to taxpayers who get caught up in future IRS investigations that there may be some hope.

For more information on home mortgage interest deductions, please see the resources below:
IRS Publication 936
US Tax Court Summary Opinion 2008-84
Government Accountability Office report on home interest deductions
Wall Street Journal article about the potential crackdown on taxpayers who “inaccurately” deduct their home mortgage interest

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