Taxpayers Improperly Calculated Mortgage Interest Deduction for Year Home Was Sold

(Parker Tax Publishing July 2023)

The Tax Court held that taxpayers who claimed the Code Sec. 163(a) deduction for mortgage interest they paid on two homes they owned during the year at issue, one of which they owned for the entire year and one of which they sold in May of that year, incorrectly determined that their acquisition indebtedness was under $1 million as required by Code Sec. 163(h)(3) using a 12-month period rather than the 5-month period during which the home was secured by a mortgage. McNamara v. Comm'r, T.C. Summary 2023-22.

Background

In 2019 Collette and Frank McNamara owned two homes, which they acquired after October 1987 and before December 16, 2017. The McNamaras owned the first home in Virginia for the entire year. They owned the second home in Massachusetts (Massachusetts home) until or around May 10, 2019, when they sold it.

On their 2019 Form 1040, U.S. Individual Income Tax Return, the McNamaras claimed a total mortgage interest deduction of $39,226 for their two homes. The IRS disallowed $9,140 of the deduction, asserting that the McNamaras miscalculated the deduction for the Massachusetts home. Despite having sold the home in May 2019, the McMamaras calculated the deduction using a 12-month period to determine the average mortgage balance, the determination of which was necessary for calculating their mortgage interest deduction. In a notice of deficiency, the IRS determined a deficiency of $2,194 resulting from a partial disallowance of the McNamaras' 2019 mortgage interest deduction. The McNamaras challenged the notice in the Tax Court.

Code Sec. 163(a) allows a deduction for all interest paid or accrued within the tax year on indebtedness. Code Sec. 163(h)(1), however, provides that in the case of a taxpayer other than a corporation (i.e., an individual) no deduction is allowed for personal interest paid or accrued during the tax year. Nevertheless, under Code Sec. 163(h)(2)(D), qualified residence interest is excluded from the definition of personal interest and is deductible under Code Sec. 163(a).

Under Code Sec. 163(h)(3)(A), the term "qualified residence interest" means any interest paid or accrued during the taxable year on either acquisition or home equity indebtedness with respect to any qualified residence of the taxpayer. Code Sec. 163(h)(4)(A) provides that a taxpayer's qualified residence is his principal residence (within the meaning of Code Sec. 121) and one other residence of the taxpayer, which is selected by the taxpayer and is used by the taxpayer as a residence (within the meaning of Code Sec. 280A(d)(1)). Under Code Sec. 163(h)(3)(A), the determination of whether any property is a qualified residence of the taxpayer shall be made as of the time the interest is accrued.

Acquisition indebtedness is defined in Code Sec. 163(h)(3)(B)(i) as any indebtedness that is (1) incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer and (2) secured by such residence. Under Code Sec. 163(h)(B)(ii), the aggregate amount of acquisition indebtedness shall not exceed $1 million for any period.

Observation: Under changes made by the TCJA, the aggregate amount that a taxpayer may treat as acquisition debt for any period cannot exceed $750,000 for tax years beginning after December 31, 2017, and before January 1, 2026. This provision does not apply, however, to indebtedness incurred on or before December 15, 2017.

The issue in this case was not whether the McNamaras were entitled to deduct mortgage interest, but the amount of the deduction to which they were entitled. That amount depends on whether they may calculate the average mortgage balance for the Massachusetts home using a 12-month period or must use the 5-month period during which the home secured the outstanding balance on their mortgage. When a 5-month period is used to calculate the average mortgage balance for the Massachusetts home, the McNamaras' aggregate acquisition indebtedness exceeded the $1 million limit, making a portion of the mortgage interest they paid for 2019 not deductible. The McNamaras relied on examples provided in Publication 936, Home Mortgage Interest Deduction, to assert they correctly used a 12-month period to calculate the average monthly mortgage debt for their Massachusetts home.

Analysis

The Tax Court held that the McNamaras erred when they calculated the average mortgage balance on the Massachusetts home using the 12-month period instead of the 5-month period during which the home secured the outstanding balance on the mortgage. According to the court, calculating the average mortgage balance for the Massachusetts home using a five-month period caused the McNamaras' mortgage indebtedness for 2019 to exceed the $1 million limit such that a portion of the interest they paid was not deductible.

The court found that the McNamaras' reliance on Publication 936 to use a 12-month period to calculate the amount of their mortgage interest was misguided. The court noted that administrative guidance is not binding on the Tax Court when the plain meaning of a statute is clear. And in the court's view, Code Sec. 163 is unambiguous in providing that the mortgage interest deduction is allowed only for interest paid on the outstanding mortgage balance secured by the taxpayer's home. Further, the court noted that under Temp. Reg. Sec. 1.163-10T(h), when calculating the average mortgage balance, a taxpayer must consider the period the outstanding mortgage balance was secured by the taxpayer's home, which may be less than a calendar year. Thus, the court concluded that a taxpayer may not claim the mortgage interest deduction for periods during which the taxpayer's mortgage debt is not secured by the taxpayer's home.

For a discussion of the deduction for qualified residence interest, see Parker Tax ¶83,515.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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