Rental Property: Who Gets the Mortgage Interest Deduction?
One of the most revealing aspects of using WordPress as a blog host is having the ability to track the different search engine terms that have ultimately led people to Double Taxation.
Through analyzing this data, I’ve realized two things:
1. There are some sick, sick people out there. To wit: the single-most common string of words that have led web users to this blog during its 18-month history is “power ranger porn.” Sadly, I’m not making that up. Needless to say, when these deviants wound up getting this blog post instead of whatever depravity they were hoping for, they were more than a little let down.
2. People really want to know whether they can claim a tax deduction for mortgage interest they pay on a mortgage that’s not in their name. My previous discussion on the issue has been an oft-searched post, a result I attribute to our depressed economy. With banks having tightened their purse strings, many non-traditional arrangements for home ownership have sprung up. In many cases, the individual who owns the home and borrows the mortgage is not the same individual who lives in the home and pays the mortgage.
These arrangements are not unique to primary residences. Consider the case of Omar Abarca, a real estate investor who owned rental property through six partnerships. Because Abraca had limited borrowing capacity, each time he wished to purchase a rental property he would enter into a partnership; Abraca would contribute cash, while the other partner would use their borrowing ability to take out a mortgage and purchase the desired property. Abraca would then pay all the operating expenses of the property, including the mortgage interest.
It was unclear whether the borrowing partner ever actually contributed the title of the property to the partnership. What was clear, however, was that Abraca was never listed on the title for each property, nor was he listed as a lender. On his tax returns, Abraca failed to acknowledge the separate legal existence of the partnerships, opting instead to report the activity for each rental property directly on Schedule E, where he deducted the mortgage interest paid on behalf of each property.
The IRS challenged the deductions, asserting that because Abraca was neither the title holder nor the borrower on each property, he was not entitled to deduct the mortgage interest.
To support their position, the IRS cited I.R.C. § 163, which begins by providing the general rule that “There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.” However, I.R.C. § 163 further provides that the indebtedness must be an obligation of the taxpayer, and not an obligation of another. An exception to the general rule that interest paid on an obligation of the taxpayer is deductible only by that taxpayer is found in Treas. Reg. §1.163-1(b), which provides in part that:
“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 such mortgage, may be deducted as interest on his indebtedness.”
In summary, just as with primary residences, in order for an individual to deduct interest expense on a rental property he must be either:
1. named as a borrower on the mortgage, or
2. be either the legal owner or equitable owner of the property.
Because Abraca failed to establish that he met either test, the Tax Court sided with the IRS, holding that Abraca was not entitled to deduct any of the mortgage interest he paid on behalf of the rental properties.
