Tax Court Upholds Denial of Taxpayer's Qualified Residence Interest Deductions

(Parker Tax Publishing June 2020)

The Tax Court held that the IRS properly disallowed a taxpayer's qualified residence interest deductions under Code Sec. 163(h)(3) with respect to two real properties. The court found that one property was not a qualified residence because the taxpayer rented it out and did not use it at all during the year at issue, and with respect to the other property, the court found that the debt was not a secured debt, the property was not a qualified residence, and the taxpayer did not actually make any payments of qualified residence interest. McCarthy v. Comm'r, T.C. Memo. 2020-74.

Background

Thomas McCarthy is a CPA with a master's degree in business administration. For many years he has been friends with John Rodgers, an attorney, CPA, and tax return preparer. Over the years they have consulted on various business matters and engaged in recreational activities together, including scuba diving trips around the world.

In 1991, Rodgers purchased as his residence a four-story beach house in Hermosa Beach, California (Hermosa Beach property). From about 1999 to 2003, McCarthy lived at the Hermosa Beach property and paid rent to Rodgers. In 2005, McCarthy moved to New York City. He bought a co-op unit there (NYC property) and lived in it until 2014, when his job ended unexpectedly and he moved to Minnesota. Throughout 2015, McCarthy lived and worked in Minnesota while renting out the NYC property. McCarthy sold the NYC property in 2016.

McCarthy claimed to have purchased from Rodgers a 32.5 percent interest in the Hermosa Beach property in 2010, financed by an interest-bearing loan from Rodgers. During 2015, McCarthy made no cash payments to Rodgers with respect to this purported loan, and made no monetary contributions for taxes, insurance, or maintenance of the Hermosa Beach property. In 2015, Rodgers received $96,000 in rental income from his niece with respect to the Hermosa Beach property.

Rodgers prepared McCarthy's tax return for 2015. The return listed McCarthy's Minnesota address as his home address. McCarthy reported no interest or rental income for 2015. On Schedule A, he reported mortgage interest payments totaling $48,514 on both the NYC and the Hermosa Beach properties. In a notice of deficiency, the IRS disallowed all of McCarthy's claimed mortgage interest deduction and applied accuracy-related penalties. McCarthy challenged the notice in the Tax Court.

Deductions for Qualified Residence Interest

Although payments of personal interest are generally not deductible, an exception is provided in Code Sec. 163(h)(3) for payments of qualified residence interest. One type of qualified residence interest is acquisition indebtedness with respect to a qualified residence of the taxpayer. Acquisition indebtedness is defined in Code Sec. 163(h)(3)(B)(i) as debt that is used to acquire, construct, or substantially improve a qualified residence and that is secured by the residence. Under Reg. Sec. 1.163-10T(o)(1), a secured debt means a mortgage, deed of trust, or similar instrument under which, in the event of a default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage or deed of trust, and which is recorded or otherwise perfected under state law. Under Code Sec. 163(h)(4)(A)(i), a qualified residence means (1) the taxpayer's principal residence within the meaning of Code Sec. 121, and (2) one other residence, selected by the taxpayer, which is used by the taxpayer as a residence within the meaning of Code Sec. 280A(d)(1). Under Reg. Sec. 1.121-1(b)(2), if a taxpayer alternates residency between two properties, the principal residence is the property used by the taxpayer the majority of the time. Under Code Sec. 280A(d)(1), a dwelling unit is used as a residence if the taxpayer uses it for personal purposes for more than the greater of (1) 14 days during the year, or (2) 10 percent of the number of days during the year that the unit is rented at a fair market value.

McCarthy asserted that the NYC property was his principal residence and that he selected the Hermosa Beach property as his second residence. He claimed that renting out the NYC property was a financial necessity for him in 2015 because, due to the downturn in the real estate market, the property was worth significantly less than what he paid for it. As for the Hermosa Beach property, McCarthy asserted that when he purchased the 32.5 percent interest, Rodgers owed him $150,000, and the purchase was structured as a "seller financed note." McCarthy said he made payments on the note in 2015 by forgiving equivalent amounts of Rodgers' debt. McCarthy explained that Rodgers had borrowed money over the years and that in 2010, he and Rodgers negotiated the amount of the debt to be $150,000, which was McCarthy claimed was evidenced by a promissory note from Rodgers requiring monthly payments and specifying a 12.75 percent interest rate.

Tax Court's Analysis

The Tax Court held that the IRS properly disallowed McCarthy's qualified residence interest deductions. The court found that the NYC property was not McCarthy's principal residence because McCarthy did not use the NYC property at all, much less a majority of the time, during 2015. The court explained that renting out a property does not necessarily prevent it from being considered a taxpayer's principal residence, if the taxpayer's dominant motive was to sell the property at the earliest possible date instead of holding it for rental income. But the court was unconvinced that McCarthy's dominant motive was to sell the NYC property at the earliest date instead of renting it, because McCarthy offered no evidence of what he paid for the property, how much he sold it for, or what efforts he made to sell the property after moving out in 2014. The court also found that the NYC property did not qualify as a second residence because it did not qualify as a residence under Code Sec. 280A(d)(1) given that McCarthy rented it out for all of 2015.

With respect to the Hermosa Beach property, the court found that McCarthy's purported debt to Rodgers was not acquisition indebtedness because (1) it was not a secured debt, (2) the property was not a qualified residence, and (3) McCarthy failed to show that he actually paid any qualified residence interest with respect to the property. The court found that McCarthy's purported debt to Rodgers was not secured because neither the loan agreement nor the deed of trust were recorded, and under California law, an unrecorded conveyance of real property is invalid against a subsequent purchaser who lacks notice of it. Thus, the court found that in the event of a default the unrecorded deed would be insufficient to subject McCarthy's purported interest in the property to the satisfaction of the debt with the same priority as a recorded mortgage or deed, because the unrecorded deed would be valid only against a third person having notice of it.

The court found that the Hermosa Beach property was not a qualified residence because McCarthy could not show that he used the property for personal use for more than 14 days during 2015. The court also noted that Rodgers' niece had paid $8,000 per month in rent on the property in 2015. The court doubted that she paid that amount to rent only one bedroom and reasoned that if she were renting the entire property, it was unlikely that McCarthy could have used his purported interest in the property for more than 10 percent of the number of days during 2015 that it was rented at fair market value.

Finally, the court found that McCarthy did not pay interest with respect to the Hermosa Beach property because, in the court's view, there was no bona fide debt between McCarthy and Rodgers. The court found that McCarthy and Rodgers never intended to impose any real liability on Rodgers to repay the $150,000. The court noted that Rodgers never paid interest on the promissory note and did not make any regular monthly payments. The court also noted that McCarthy reported no interest income on his 2015 return. In the court's view, the note was just a device to effect McCarthy's preconceived plan to create an artificial tax benefit.

The court did not uphold the imposition of a penalty, however, because it found that the initial determination of the penalty was not approved in writing by the immediate supervisor of the IRS agentwho made the initial determination as required under Code Sec. 6751(b)(1).

For a discussion of qualified residence interest, see Parker Tax ¶83,515. For a discussion of the penalty supervisory approval requirement, see Parker Tax ¶262,195.

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.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com