Parent Buys House, Kid Pays The Mortgage. Who Gets the Interest Deduction?
As you’re likely aware, the lending market ain’t what it used to be. The free-wheeling days of the early part of this century — when banks were handing out cash faster than Stephen Hawking at a nudie bar — are long gone. The resulting housing market crashforced lenders to tighten their purse strings, leaving many hopeful homebuyers unable to secure a mortgage.
As a result, people have been forced to get creative, in some cases dividing the responsibilities of home ownership between family members. A typical arrangement looks something like this:
Parents: Purchase the home as legal owners and take out the mortgage in their own name.
Kid: Chips in for the down payment, maintains the house while living in it ashis primary residence, and pays the mortgage as it comes due.
These new types of arrangements, while achieving the desired goals, create confusion when determining which party 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 whether Parents or Kidare entitled to the interest deduction in the scenario posed above, you’ve got to work through a series of questions:
1. Who paid the mortgage? First things first, because individuals are cash basis taxpayers, only the taxpayer who actually pays the mortgage is entitled to a deduction. So Parents are out, since Kid paid the principal and interest as it came due.
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. [i] Thus, without some relief, Kid can’t deduct the mortgage interest either — even though he paid it — because he’s not listed as a co-borrower on the mortgage. Which takes us to…
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 a taxpayer is not directly liable on the mortgage, he can deduct any interest he pays on the debt as long as he is the legal owner of the house; i.e., a deed holder. Unfortunately, this doesn’t help Kid in our case becausehe is not listed on the deed, and thus is not a legal owner of thehome.
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 profitsthereof;
- 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. [ii]
In our fact pattern, Kid clearly meets the requirements of factors 1 and 2, as he lives in the home as his primary residence and is responsible for its upkeep. Presumably, Kid also meets factor 6 –since the house is recognized by Parents as belonging to him — and factor 7, assuming he could eventually borrow the funds necessary to buy out Parents’ legal interest.
Lastly, because Kid contributed to the down payment, he should meet factor 4, as he bears a portion of the risk of loss associated with the house to the extent of his piece of the down payment. This can be a critical factor; if Kid doesn’t contribute any cash towards funding the down payment, this factor swings the other way, and it may well sway the ultimate determination of Kid’s status as “equitable owner” from yay to nay.
So parents, as much as it may pain you to have Junior buck up for his share of the down payment, it’s actually in his best interest to do so. Without it, his mortgage interest deduction may go up in smoke.
