MORTGAGE INTEREST DEDUCTIBLE BY BENEFICIAL OWNER OF PROPERTY

By Joel B. Steinberg, CPA, Richard A. Eisner & Company, LLP

Can a taxpayer deduct mortgage interest paid with respect to a residence owned by someone else who is also the only person named as a borrower on the mortgage? In a recent tax court decision, the taxpayers were allowed such a deduction on the particular facts because they had established equitable and beneficial ownership of the property in which they resided.

In Uslu v. Commissioner, [Tax Court Memo 1997-551 (December 16, 1997)], the taxpayer and his wife were unable to obtain financing to purchase a home due to their bankruptcy and a poor credit rating. In order to help them, the taxpayer's brother and sister-in-law purchased the home for the taxpayers, taking legal title in their own name and obtaining the mortgage in their own name. In accordance with the families' oral agreement, the taxpayers occupied the home, made all required mortgage payments directly to the mortgagee, and paid for all repairs, improvements, and maintenance of the property.

In 1992, the taxpayers paid nearly $19,000 in mortgage interest which they deducted on their personal income tax return. The IRS disallowed the deduction, taking the position that the mortgage was not "acquisition indebtedness" of the taxpayers since they were not legally liable for the debt.

IRC section 163(h)(3)(A)(i) provides that interest is deductible if it is paid or accrued on acquisition indebtedness with respect to any qualified residence of the taxpayer. There was no dispute that the taxpayers' home was a qualified residence. The issue was whether the taxpayers' payments constituted interest on acquisition indebtedness with respect to the property. Usually, acquisition indebtedness is a debt of the taxpayer and not an obligation of someone else. However, regulations section 1.163-1(b) provides, "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." This regulation would allow an interest deduction for a nonrecourse mortgage, or where the property was acquired "subject to" an existing mortgage.

The IRS contended that the taxpayers could not deduct the mortgage interest payments because they had no legal obligation to the mortgagee. The IRS cited Loria v. Commissioner [TC Memo 1995-420, 70 TCM 553 (1995)] and Song v. Commissioner [TC Memo 1995-446, 70 TCM 745 (1995)], wherein the tax court held that taxpayers could not deduct mortgage interest payments made by themselves on their residences when legal title was held by the taxpayers' brothers. However, in these cases the mortgage interest deductions were disallowed because the taxpayers did not prove that they held any equitable or beneficial ownership in the residences. In each case, the court held that the debt was not the taxpayers' and that the taxpayers did not have an ownership interest in the mortgaged property.

In Uslu, however, the taxpayers had an agreement with their relatives (albeit oral), occupied the property, and performed all of the obligations under the mortgage. In addition, the taxpayer's brother and sister-in-law did not make any payments in connection with the mortgage, repairs, or maintenance of the property and did not take any actions which would indicate an ownership interest in the property. The only reason they took legal title to the property and obtained the mortgage was to help the taxpayers obtain the property for a residence. The court also noted that legal title was transferred to the taxpayers in 1995 via a quitclaim deed, although it was not recorded. In a footnote, the court stated that it believed that the quitclaim deed was intended to be retroactive to the purchase date of the property. Additionally, the brother testified that, if the taxpayers were to default on the loan, he would seek to recover from the taxpayers any payments he and his wife would have to make to the mortgage lender. In this event, the court believed the brother and sister-in-law would have a cause of action against the taxpayers.

Based on the evidence presented, the court held that the parties always treated the property as if the taxpayers were the equitable and beneficial owners of the property, holding the benefits and burdens of ownership thereof, and were liable to their brother and sister-in-law for the mortgage interest paid. Therefore, the court concluded that the payments of interest were deductible. The opinion of the court in Uslu may have interesting implications. For example, suppose parents wish to help a child who cannot qualify for a mortgage to purchase a home. The parents can acquire the home and obtain the mortgage in their own name. Under the rationale of the Uslu case, if the child makes the mortgage payments, establishes equitable and beneficial ownership of the property, and is effectively liable to the parents for the loan, the child should be the taxpayer deducting the mortgage interest paid.

Query: Do the parents have interest income and an interest expense which could be subject to the investment interest rules or disallowed under other provisions of the Internal Revenue Code?

It is important to note that the court did not address any other tax (income, gift, and estate) or legal issues that may apply to either the legal or equitable owner of the property. Careful consideration should be given to all such ramifications before entering into this type of an arrangement. *