Deductibility of home mortgage interest.

Individual taxpayers are permitted to take an itemized deduction for qualified residence interest. The interest must have been paid on a loan used to purchase or build a residence or on home equity indebtedness of up to $100,000. The debt, to qualify, must have been secured by the residence. The Tax Court recently considered whether actual ownership of the residence also was a requirement for the deduction.

Saffett Uslu and his wife, Ana, wanted to purchase a home. Because of his poor credit rating and prior bankruptcy filing, however, he was unable to obtain financing. Saffett arranged for his brother to buy a house using money the brother had borrowed on a debt secured by the home. Saffett and his family occupied the house and made the mortgage payments as well as all payments for repairs and maintenance. Saffett deducted the mortgage interest as qualified residence interest. The IRS disallowed the deduction because he did not own the property.

Result: For the taxpayer. Saffett Uslu and his wife were permitted to take a home mortgage deduction.

While it is generally accepted that interest is deductible only on obligations of the taxpayer, there have been challenges to this rule. In Golder (604 F.2d 34, 79-2 USTC P9451), the taxpayer argued that Treasury regulations section 1. 163-1 (b) created an exception: The regulation says interest is deductible if the taxpayer is "the legal or equitable owner" of the real estate. In rejecting Golder's argument, the 9th Circuit Court of Appeals said the regulation permits a deduction only in cases of nonrecourse debt when the debtor will lose the property if the debt is not paid.

In two other cases, Loria (TC Memo 1995-420) and Song (TC Memo 1995-446), taxpayers again argued that the regulation created an exception. In both, a family member purchased the home and borrowed the funds while the taxpayer who occupied the home made the payments. The Tax Court, basing its decision on Golder, rejected both taxpayer's arguments.

Although Uslu appears similar to Loria and Song, there are certain differences distinguishing it. In the prior cases, the taxpayers were unable to prove they were the "beneficial" owners of the homes. In Uslu, the fact the taxpayer had made all the mortgage payments and all parties considered the home to belong to him and his wife created an implied debt between Saffett and his brother. The interest paid to the bank, therefore, was interest on that intrafamily loan. This is why Saffett Uslu was permitted to take the deduction.

A taxpayer attempting to deduct interest on a home owned by a relative must be able to show that the ownership is an accommodation necessary to obtain financing and that all parties expect the taxpayer ultimately to be responsible for the debt. Written documentation of this understanding always is helpful. But it is imperative that only the taxpayer claim the related deductions, not the family member who facilitated the sale. The family should consider transferring ownership of the home to the occupying taxpayer at the first convenient opportunity. It will be interesting to see whether, in the future, taxpayers who are the beneficial owners of nonresidential property are also permitted interest expense deductions.

* Saffett and Ana Uslu, TC Memo 1997-551.

Prepared by Edward Schnee, CPA, PhD, Joe Lane Professor of Accounting and director of the MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.