Interest on Residential Property Debt Not Deductible as Investment Interest

Editor: Kevin D. Anderson, CPA, J.D.

Interest Income & Expense

In Norman, T.C. Memo. 2012-360, the Tax Court held that taxpayers who purchased a residence with the intention to treat part of the tract as investment property could not deduct any of the interest on indebtedness as investment interest. The Tax Court agreed with the IRS that the taxpayers failed to properly prove an allocation between residential property and investment property. Consequently, the taxpayers were allowed to deduct only the interest attributable to $1.1 million of the debt as qualified residence interest.

Facts

The taxpayers in late 2004 entered into an agreement to purchase a historic single-family residence on 9.875 acres in the Old Town area of Warrenton, Va., (the Yorkshire property) for $1.8 million. When the taxpayers had initially approached the sellers about purchasing the property in 2003, the sellers had indicated that they would sell the house and three acres for $1 million, but later the sellers reconsidered and offered the entire tract for $1.8 million. The taxpayers agreed and planned to recover $800,000 of the purchase price by subdividing the property into several lots and developing them.

The purchase agreement did not provide for an allocation of the purchase price into subparcels, and the parties to the agreement did not discuss an allocation. The purchase agreement provided for a 90-day study period, during which the taxpayers could investigate the property further before closing. During this period, the taxpayers contracted a civil engineering firm to study the property and provide a feasible plan of subdivision.

Some months after entering into the purchase agreement, the sellers placed the Yorkshire property onto a state historic registry and the National Register of Historic Places without notifying the taxpayers. The sellers consequently refused to allow the taxpayers to add an addendum to the purchase agreement that would have allowed the taxpayers to divide the property into two parcels, one including the residence with three acres, and the other consisting of the remainder of the property. In May 2005, the taxpayers settled on the Yorkshire property for $1.8 million. At closing, the loan documents stated that the bank agreed to make a loan of $2,310,000, which represented $1,760,000 to acquire the property and $550,000 to renovate the house.

The taxpayers began extensive renovations on the Yorkshire property shortly after closing with an advance from the bank to cover renovation costs and by drawing additional funds against the line of credit, with the draws ultimately totaling more than $500,000. In addition, the taxpayers applied proceeds from the sale of their former primary residence as a partial payoff of the mortgage loan on the Yorkshire property. Once the renovations were completed, the taxpayers moved into the residence in August 2005. By October 2006, the taxpayers refinanced the mortgage for a new principal amount of $1,860,000, which was secured by the newly renovated residence and all 9.875 acres of the Yorkshire property.

Applicable Law

Qualified residence interest: While personal interest is nondeductible, qualified residence interest, which includes interest on acquisition indebtedness and home-equity indebtedness, is generally deductible by individual taxpayers. Acquisition indebtedness is indebtedness incurred to buy, build, or substantially improve an individual’s qualified residence that is secured by the residence (Sec. 163(h)(3)(B)(i)). Sec. 163(h)(3)(B)(ii) provides that the total amount treated as acquisition indebtedness cannot exceed $1 million for any period ($500,000 for a married individual filing separately), and any indebtedness in excess of $1 million is not acquisition indebtedness.

Sec. 163(h)(3)(C) provides that home-equity indebtedness for any period cannot exceed $100,000 ($50,000 for a married individual filing separately). Home-equity indebtedness is indebtedness other than acquisition indebtedness secured by the taxpayer’s principal or secondary residence, to the extent the aggregate amount of the debt does not exceed the excess of the fair market value of the residence over the amount of acquisition indebtedness. Unlike acquisition indebtedness, the proceeds of home-equity indebtedness generally may be used for any purpose without affecting deductibility of the interest.

Investment interest: A taxpayer other than a corporation may deduct investment interest for a tax year that does not exceed the net investment income of the taxpayer for the tax year (Sec. 163(d)(1)). Investment interest generally means any interest that is paid or accrued on indebtedness properly allocable to property held for investment (Sec. 163(d)(3)(A)) and excludes qualified residence interest (Sec. 163(d)(3)(B)(i)).

Sec. 163(d)(4)(B) defines investment income as income derived from property held for investment. Sec. 163(d)(5)(A) further defines “property held for investment” to include (1) any property that produces income of a type described in Sec. 469(e)(1); and (2) any interest held by a taxpayer in an activity involving the conduct of a trade or business that is not a passive activity and with respect to which the taxpayer does not materially participate. Investment interest disallowed as a deduction for a tax year because it exceeds investment income for the tax year is carried forward indefinitely (Sec. 163(d)(2)).

Sec. 469(e)(1) portfolio income includes gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business (i.e., most types of passive income other than rental income), as well as gain or loss attributable to the disposition of such property. Property need not currently produce interest, dividends, or other portfolio income to be classified as investment property, but it must normally produce such income. Furthermore, the actual receipt of income is not required for property to be classified as investment property.

Analysis

The Tax Court disallowed an allocated amount of interest as investment interest, holding that the taxpayers produced insufficient evidence to support their contention that part of the property was investment property.

Provisions of the contract and affirmative action to subdivide: The taxpayers contended that they paid the additional $800,000 to purchase 6.875 acres of the tract with the intention of developing them, while the historic residence on the other three acres would be their primary residence, which accounted for $1 million of the total paid. Thus, the taxpayers argued, the interest on $1 million of the mortgage debt was deductible as qualified personal residence interest, and the interest on the remaining $800,000 of the mortgage debt was deductible as qualified investment interest. The taxpayers submitted no expert witness testimony to support the values on which they sought to base the allocation of mortgage debt.

The IRS disagreed with the taxpayers that they were entitled to deduct any of the mortgage interest as investment interest and contended that the taxpayers could deduct only $1.1 million of the mortgage interest as qualified residence interest. The Tax Court found that the taxpayers failed to provide adequate evidence for the allocation between the residence and the investment property and that their testimony of conversations with the sellers for purchasing the residence for $1 million was insufficient, given that the purchase agreement made no such allocation and contained terms and restrictions not contemplated in the conversations.

The purchase agreement also provided that the sellers intended to place a historic conservation easement on the Yorkshire property that would limit the number of residential units that could ultimately be built on it (the sellers later waived this provision). The agreement expressly acknowledged that such a deed restriction would have a significant impact on the value of the property and that any resulting tax benefits would accrue to the sellers.

The purchase agreement provided that to facilitate financing and development, the taxpayers could elect before settlement to subdivide the residential structure plus approximately three acres from the balance of the property and take ownership of the property as two separate parcels. However, the taxpayers did not elect to subdivide the property because they were unsure how they would configure the three acres until they knew what access could be provided for the acreage to be developed.

The court noted that an accurate valuation was difficult because the boundaries of any geographic division between the house and the purported investment portion of the parcel remained unclear. Plans for the property over time showed different designations. Had the taxpayers elected to subdivide the property before settlement or taken the additional steps of having experts value the residence separately from the undeveloped land, perhaps such an affirmative action to subdivide would have helped their case. In addition, had the taxpayers invested more time and effort to prove an income-producing motive, such as devoting substantial time to subdividing the property and demonstrating their intent to resell the subdivided parcels, they may have obtained a more favorable outcome.

Financing and refinancing: The Tax Court pointed out that the purchase of the property was indebted with a single credit line deed-of-trust note. The note and the loan agreements both indicated that there was a single loan rather than separate loans for the taxpayers’ primary residence and the purported investment property. Moreover, when the taxpayers refinanced their mortgage in late 2006, the refinanced debt gave rise to new acquisition indebtedness for purposes of determining the limitation on the qualified residence interest deduction. The new indebtedness was secured by both the primary residence, which by that time had been improved by more than $500,000 of renovations, and the entire 9.875 acres. In deciding what portion, if any, of the acquisition indebtedness should be allocated to investment property, the court could not ignore the extensive value-enhancing renovations to the property, the various draws and repayments on the note by the taxpayers, and the ultimate refinancing of the loan.

EditorNotes

Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.

For additional information about these items, contact Mr. Anderson at 301-634-0222 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.