The lending market ain’t what it used to be. The free-wheeling days of the early part of the millennium — when banks were handing out cash faster than Stephen Hawking at a strip club
— are long gone. The subsequent housing market crash has forced lenders to tighten their purse strings, leaving many hopeful homebuyers – read: you — unable to secure a mortgage.
Faced with the ultimate indignity of running back to mom and dad, you might decide to get creative. After all, you’ve got cash to burn, just no credit.
So you find yourself a friend or sibling or craigslist serial killer with the opposite attributes: the credit necessary to have purchased a house in the past, but no cash to fund their current mortgage obligation. And you strike a deal: You’ll move in, share the place, and you’ll pay the mortgage.
These increasingly common types of arrangements, while achieving the desired goal of providing a roof over your head, create confusion when it comes time to determine who is entitled to deduct the mortgage interest on their tax return.
Fortunately, a mix of regulatory authority and judicial precedent provides the necessary guidance, but in order to determine who gets the deduction, you’ve got to work through a series of questions that may or may not yield the answer you want as the person parting with the cash.
1. Who paid the mortgage? Because individuals are cash basis taxpayers, only the taxpayer who actually pays the mortgage is entitled to a deduction. So the homeowner is out.
2. Who is listed as the borrower on the mortgage?
In general, a taxpayer can’t deduct interest he pays on a debt that isn’t his.1
Thus, without some relief, you won’t be able to deduct the mortgage interest — even though you paid it — because you’re not listed as a co-borrower on the mortgage.
3. Who has legal title to the house? Treas. Reg. §1.163-1(b)
provides an exception to the general rule found in #2. Pursuant to the regulations, even if you’re not directly liable on the mortgage, you can deduct any interest you pay on the debt as long as you are the legal
owner of the house (e.g., a deed holder). Unfortunately, this doesn’t help you in our scenario because you’re not listed on the deed.
4. So then nobody is entitled to deduct the mortgage interest? Not so fast. The regulations also allow a taxpayer who is an “equitable” owner of the house to deduct the mortgage interest he pays, even if he is not listed on the mortgage as a co-borrower.
What constitutes an “equitable” owner of a house? The Tax Court has typically defined an equitable owner as one who:
- Has a right to possess the property and to enjoy the use, rents or profits thereof;
- Has a duty to maintain the property;
- Is responsible for insuring the property;
- Bears the property’s risk of loss;
- Is obligated to pay the property’s taxes, assessments or charges;
- Has the right to improve the property without the owner’s consent; and
- Has the right to obtain legal title at any time by paying the balance of the purchase price.2
On Monday, the Tax Court examined just such a situation in Puentes v. Commissioner
, T.C. Memo 2013-277. In Puentes
, the taxpayer moved into a home owned by her brother. Her brother was the sole holder of legal title to the property, and the only obligor listed on the mortgage. Taxpayer, however, made the mortgage payments.
In 2009, taxpayer’s brother received a Form 1098, Mortgage Interest Statement, reflecting $29,000 of interest expense paid during the year. Because taxpayer had actually paid the interest, she claimed the deduction on her tax return.
The IRS denied the deduction because while the taxpayer had in fact paid the mortgage interest, she was neither the legal owner of the property nor was she listed as a debtor on the mortgage.
Conceding these points, the taxpayer instead argued that she was the equitable owner of the house, and thus was entitled to the deduction pursuant to the Section 163 regulations. The Tax Court, however, was unconvinced.
Because the taxpayer was not legally obligated to make the mortgage payments or pay any real estate taxes, had no duty to maintain or insure the property, and had no right to improve or purchase the property, the court concluded that she failed to establish that she was an equitable owner. As a result, her mortgage interest deduction was denied.
If the decision in Puentes has left you wondering how you can ever be respected as an equitable owner of a home, here’s some advice: buck up for part of the down payment. Do that, and the courts have respected the fact that you have skin in the game and bear some portion of the risk of loss (factor #4), even if you’re not listed on the deed or mortgage.
And that’s one to grow on.
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