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Tax Tip – Interest Expense on Loan Secured by Residence

June 29, 2015

IRS Ruled in TC Memo 2015-56 that interest expense on loan proceeds secured by the taxpayers' residence was not deductible as investment interest expense when the proceeds of the loan were loaned to the taxpayers' C Corporation.

Married taxpayers were denied deductions for investment interest expenses. The individual taxpayers refinanced an existing personal loan through home equity indebtedness. They allocated some payments to mortgage interest and the remaining payments to investment interest expenses. The investment interest expense claimed by the individual taxpayers was disallowed because they could not substantiate that the money was used for investments. The money was deposited into the husband’s corporation’s bank account, with notations that the funds were a loan from the individual taxpayer to the company. Further, adjustments made by the IRS to the amount of allowable mortgage interest deduction were sustained.

Section 163 allows taxpayers a deduction for “qualified residence interest” paid on the mortgage on their first or secondary home. Qualified residence interest is either “acquisition indebtedness” or “home equity indebtedness”. Acquisition indebtedness is a loan of up to $1 million that is used to acquire, construct, or substantially improve a residence when that residence also secures the loan. New debt to refinance old acquisition indebtedness is also acquisition indebtedness as long as it is not more than the refinanced debt. Home equity indebtedness is any other type of loan secured by a qualified residence but is capped at the lesser of $100,000 or the fair market value of the residence minus any acquisition indebtedness on the residence.

The taxpayers contended that the interest paid is deductible as investment interest because the loan proceeds were deposited in the corporation's bank account. The taxpayers noted that the interest in the corporation is property held for investment because it is a type of property that generally produces dividend income. It is not necessary for the court to decide whether the corporation is property held for investment because the taxpayers did not purchase or contribute the loan proceeds to the corporation. Instead, the corporation's general ledger notes that the company treated the mortgage proceeds as a personal loan from the husband to the corporation. In other words, the husband borrowed the money so that he could lend it to the corporation and the corporation would repay him. The husband has not shown that the funds disbursed for his mortgage to finance his ancillary loan to the corporation were for investment.

The taxpayers did not demonstrate that the deduction is allowable pursuant to any statutory provision because they have not shown the funds were used for investment. Accordingly, the court determined that the taxpayers home mortgage and investment interest expense deduction for the interest paid on the home equity loan was not allowed.

Disclaimer: Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein.  Such content, comments, or advice may be based on tax statues, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities.  This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law.

 

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