Tax Court Rejects Homeowner’s Investment Interest Strategy on Mortgage Loan Interest

A homeowner’s efforts to recover an additional sum of his mortgage loan interest failed largely because the homeowner’s stated categorization did not pass the “eyeball test.” In Norman v. Commissioner, the U.S. Tax Court sided against the taxpayer, noting that the alleged investment property produced no income, and the taxpayers used one loan to purchase both their primary residence and the alleged investment property.

John J. Norman, Jr. and his wife sought to purchase a single-family residence on 9.9 acres in Warrenton, Va. The Normans initially negotiated to purchase the house and three acres for approximately $1 million, but the sellers declined. In 2005, the parties eventually agreed to a price of $1.8 million, in exchange for the entire parcel.
Norman planned to subdivide the parcel into at least seven additional lots, but never discussed this allocation with the sellers. The parties’ purchase agreement also made no mention of an allocation. The Normans obtained a mortgage loan for $1.8 million for the entire property.

After completing the purchase, Norman encountered significant problems with his subdivision plan. Ultimately, the plan did not come to fruition. On their 2005 federal income tax return, the Normans claimed an $88,000 mortgage interest deduction, claiming no investment income or investment interest deduction. The next year, the taxpayers claimed an $85,000 mortgage interest deduction and an $18,000 investment interest deduction.

The Internal Revenue Service declared the taxpayers deficient. The IRS concluded that the taxpayers could only claim the interest paid on the first $1.1 million of the loan.

Before the Tax Court, both sides agreed that the first $1 million of the taxpayers’ loan represented the acquisition indebtedness, and the IRS conceded that the taxpayers could claim interest paid on an addition $100,000 of home equity indebtedness. The taxpayers claimed that the remaining $800,000 above $1 million was for the purchase of an investment property, that they should be allowed to reclassify some of their 2005 mortgage interest as investment interest and that they were allowed to take the full deduction they claimed.

The lack of investment income in 2005 doomed the couple’s claimed deduction in that year. Because they “reported no net investment income for 2005, … they are not entitled to deduct any amount as investment interest for that year,” the court wrote. The court also agree with the IRS regarding the 2006 deductions, concluding that the documentation related to the transaction simply did not match the couple’s characterization of the property. None of the records relating to the purchase indicated that the taxpayers were purchasing two subparcels. The purchase agreement made no mention of allocation. Further damaging the case, the taxpayers’ “credit line deed of trust note and the loan agreement indicate that there was a single loan rather than separate loans.”

The tax code is filled with nuances that permit knowledgeable persons to recoup many expenses through permissible use of tax deductions and credits. The key is to ensure that your “creative” application is also a legal one. The experienced tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C. have extensive experience helping people throughout New York and northern New Jersey maximize their credit and deductions, in a permissible manner. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

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