Business Transactions, Corporate and Real Estate

Sister Who Made Brother’s Mortgage Payments Not Allowed Interest Deduction

“As a general rule, interest paid by individuals is not tax deductible. A principal exception to the general rule allows a deduction for “qualified residence interest,” i.e., interest with respect to indebtedness incurred in connection with and secured by a residence “of the taxpayer.”[1] The relevant regulations make it clear that a residence of the taxpayer includes property in which the taxpayer has an equitable ownership interest, even if the taxpayer does not hold legal title and is not a directly liable for the underlying indebtedness. In a recent case the Tax Court was faced with the issue of what constitutes equitable ownership as used in the regulation.

The Taxpayer’s brother, (“Brother”) purchased a home in 2002. Brother made a down payment toward the purchase price and took out a mortgage for the remainder. At all relevant times, Brother was the sole holder of legal title to the property. In 2003, the taxpayer, Ms. P., moved into the house and Ms. P.’s and Brother’s father subsequently also moved in. Brother continued to make all the payments on the mortgage until he became unemployed in 2009. At that point, Ms. P., who, together with Brother and their father, was still living in the house, began making mortgage payments. Ms. P. also paid at least part of the property taxes, homeowners’ insurance and household expenses although she was under no legal obligation to do so.

Because Brother was the sole obligor on the mortgage, the mortgagee sent reports of the interest paid during 2009 and 2010 to Brother. Nevertheless, Ms. P. deducted the interest for those years, claiming that her having made the mortgage (and tax, insurance and household expense) payments made her an equitable owner of the property and thus entitled to the deduction for interest paid by her.

In rejecting Ms. P’s claim, the Tax Court noted that whether Ms. P. was an equitable owner is to be determined under state (in this case, California) law. The court further noted that under California law, the legal title holder is also presumed to hold full beneficial title in the absence of clear and convincing proof to the contrary. Citing decisions of the California courts, the Tax Court found that the presumption “”cannot be overcome solely by tracing the funds used to purchase the property,”” but that some sort of agreement or understanding between the parties evidencing an intent contrary to that which is reflected in the deed may be required. As no evidence of such an agreement was reflected in the record, the Tax Court held that although Ms. P. had “acted admirably to enable her family to retain its home at a time of economic difficulty,” she was not entitled to the interest deduction.

Ms. P. actually has taken this case to the Tax Court twice, once for 2009 and again for 2010. Not surprisingly, she lost both times. But, rather than a manifestation of Einstein’s definition of insanity (repeating the same action and expecting a different result), Ms. P’s 2010 case would appear to be an attempt to keep her 2010 claim alive while her appeal of her 2009 claim is pending.

This case reflects yet another trap for the unwary — in this case family members wanting to help a financially distressed relative — waiting to spring from the byzantine provisions of the Internal Revenue Code.

[1] There are a number of qualifications and limitations included in the definition of “qualified residence” which are not relevant to this article.