Mortgage interest and bankruptcy.

Taxpayers often are forced to file for bankruptcy as the result of business reversals. In such cases, their assets are sold to pay off creditors. When one of the assets is a taxpayer's personal residence, issues arise concerning the deductibility of interest and other expenses.

To purchase his residence, Patrick E. Catalano, an attorney, borrowed $1.4 million in a nonrecourse loan. In 1994, he and his law firm filed for voluntary bankruptcy under chapter 11. The lender, who had received permission from the bankruptcy trustee to sell the house, sold it for $1,215,000 in January 1995--at which time the principal balance was $1,341,352, including $126,352 of accrued but unpaid interest. Following the sale, Catalano deducted the accrued interest plus $46,412 in bankruptcy fees. The IRS objected to the deductions.

Result. For the taxpayer. The first question the Tax Court had to decide was who sold the residence. For the bankruptcy estate to have sold it, all related items should have appeared on the estate's return, not the taxpayer's. For the taxpayer himself to have reported the sale, the bankruptcy trustee would have had to abandon the property. Based on bankruptcy precedent, the Tax Court concluded that the estate's release of the residence for sale by the lender was an abandonment that caused the sale to be treated as having been made by the taxpayer.

The Tax Court next determined the sale price and the amount, if any, of accrued interest paid. Normally the sale price would be the amount paid for the residence--in this case $1,215,000. However, based on the U.S. Supreme Court decision in Tufts, (461 U.S. 300), since the debt was nonrecourse, the sale price was deemed to be the full amount of the debt. Based on Harris (TC Memo 1975-125, aff'd 554 F.2d 1068), the debt includes the full amount of accrued interest. Therefore, the sale price equals the principal and accrued interest up to the date of the sale--in this case, $1,341,352. Catalano is treated as having paid the accrued interest. Since the debt was to acquire a personal residence, the interest is deductible. However, under IRC section 163(h), the maximum amount of residential debt that qualifies is $1 million. Therefore, Catalano is entitled to only a pro-rata interest deduction--in this case, $83,425.

The Tax Court next turned its attention to the bankruptcy fees. Normally, these amounts are nondeductible personal expenses. However, since a business failure caused the bankruptcy, a portion of the fees was deductible. In this case, lawsuits stemming from Catalano's law practice caused the bankruptcy. Since $159,823 of the total liabilities of $163,820 were business liabilities, the Tax Court allowed Catalano to deduct 93.7% of the bankruptcy fees. The IRS argued that the allocation should be based on the time Catalano spent on business items as a percent of the total time he billed. The Tax Court rejected this in favor of an allocation based on the percentage of liabilities related to the failed business. As a result Catalano was allowed to deduct $41,574 of the bankruptcy fees.

* Patrick E. Catalano, TC Memo 2000-82.

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