Equitable Ownership and Mortgage Interest Deductions

Editor: Valrie Chambers, Ph.D., CPA

Expenses & Deductions

Due to the economic climate over the past three years, many individuals have experienced difficulty in obtaining a loan for a new home or refinancing a present home. Unemployment or reduced earnings, foreclosures, and even bankruptcy, combined with stricter lending policies, have left many individuals unable to qualify for traditional lending. An alternative for many individuals is to tap into the creditworthiness of parents or other family members. The debt is obtained by and in the name of the family member, with the understanding of the parties that the occupant of the home will be responsible for the monthly mortgage payment. The question in these situations is who is entitled to the mortgage interest deduction under Sec. 163(h)(2)(D).

Sec. 163(a) provides for a deduction of “all interest paid or accrued within the taxable year on indebtedness.” For taxpayers other than a corporation, however, Sec. 163(h)(1) prohibits a deduction for personal interest but provides for limited exceptions. One of the exceptions is for “qualified residence interest” (Sec. 163(h)(2)(D)). Qualified residence interest is defined by Sec. 163(h)(3)(A) as interest paid or accrued during the tax year on acquisition or home equity indebtedness with respect to any qualified residence of the taxpayer. Acquisition indebtedness is “incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by such residence” (Sec. 163(h)(3)(B)(i)).

In most instances, interest can be deducted only by the person or entity that is legally responsible for the debt. Therefore, an individual who has entered into the financial arrangement described above cannot deduct the interest, since he or she is not legally responsible for paying the mortgage. However, a potential exception appears in Regs. Sec. 1.163-1(b), which states:

Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by the mortgage, may be deducted as interest on his indebtedness. [Emphasis added.]

Thus, if the taxpayer is not the legal owner of the residence but can demonstrate “equitable ownership,” he or she will be entitled to the mortgage interest deduction. In Uslu, T.C. Memo. 1997-551, the Tax Court held that, because the taxpayers were able to prove that they had the benefits and burdens of ownership of a residence, they were the equitable owners of the residence and therefore under Regs. Sec. 1.163-1(b) were entitled to the mortgage interest deduction.

The taxpayers, Saffet Uslu and his wife, filed for Chapter 7 bankruptcy in 1990. Later the same year, they attempted to purchase a house as their principal residence, but because of their poor credit rating they could not qualify for financing. They sought financial assistance from Saffet Uslu’s brother. The brother and his wife agreed to obtain financing and hold legal title to the property in their names. Under their agreement, the taxpayers exclusively occupied the residence and made all the mortgage payments directly to the lender and paid all expenses for repairs, maintenance, property taxes, insurance, and improvements. The brother and his wife never resided at the property, nor did they ever make payments toward the mortgage, upkeep, or other expenses of the house.

In 1992, the taxpayers paid $18,980 in interest to the mortgage holder and claimed a deduction for that amount on Schedule A on their individual income tax return for that year. The IRS disallowed this deduction, stating that the expense was not deductible since the taxpayers were not legally liable for the debt. The IRS argued that Regs. Sec. 1.163-1(b) applies only where a taxpayer obtains nonrecourse debt and not where someone other than the taxpayer is legally obligated for the mortgage. The brother and his wife, who were legally liable to the lender for the debt, did not claim any deductions related to the property on their federal return.

The Tax Court ruled in favor of the taxpayers, finding that they exclusively held the benefits and burdens of ownership because they made all the mortgage payments on the house, paid all the other expenses related to it, and were its sole occupants. Although the brother and his wife held legal title to the property, they made no claim of an ownership interest and did not act as if they held an ownership interest, the court said. In addition, in 1992 the brother and his wife executed a quitclaim deed to the taxpayers, although they did not record it.

Under the agreement between the brothers, the taxpayers’ obligation and performance in paying the mortgage constituted an enforceable debt to the brother, the court stated. The court thus held that the taxpayers’ mortgage payments to the financial institution were payments of principal and interest to the brother and qualified as interest from acquisition indebtedness. Because the IRS had conceded at trial that the home was a qualified residence, the interest payments therefore were deductible under Sec. 163(a).

The key point in the Uslu case is that the Tax Court found that the taxpayer’s actions had established that they were the equitable owners of the house. In Loria, T.C. Memo. 1995-420, the Tax Court sided with the IRS, denying the taxpayer’s mortgage interest deduction claim as equitable owner and holding that the taxpayer had failed to provide evidence establishing equitable or legal ownership. In Song, T.C. Memo. 1995-446, despite a handwritten document signed by the parties, the court similarly ruled that the taxpayer had failed to demonstrate equitable ownership. It stated that the taxpayer’s case relied heavily on testimony that the court did not deem credible.

Taxpayers considering alternative financing for which someone else is the legal obligor should be careful to structure a written, enforceable agreement that clearly identifies them as the equitable owner of the property and assigns to them the corresponding burdens and benefits. Contemporaneous written documentation of an agreement will help demonstrate the intent of equitable ownership. Then the taxpayers should make sure that both parties act consistently in keeping with the agreement.