Originally published on Forbes.com Nov 13th, 2013
Loaning money to your kids can be a great planning maneuver. It is critical that you follow all the formalities to avoid nasty surprises. In the recent Tax Court decision in the case of Christopher DeFrancis and Jennifer Gross it was the borrowers that got the nasty surprise. They borrowed $427,333 from Jennifer’s mother, Joan Gross, on January 1, 2003. They signed a note and a mortgage. The mortgage was on their residence in Northampton, Massachusetts (A lovely city by the way). They had purchased the residence in 2001 for $365,000. In 2008 the taxpayers signed another mortgage to TD Bank for $200,000.
During 2009 the couple paid the bank $1,138 and Joan Gross $19,230. They deducted $20,368 as home mortgage interest. The IRS disallowed the $19,230. The IRS did not raise an issue about how the money was spent. In order for all the debt to qualify as home mortgage indebtedness, the couple would have had to have made some improvements to the residence, but nobody was making an issue out of that. The other big requirement to qualify as deductible home mortgage interest is that the indebtedness:
(II) is secured by such residence.
Secured debt means: a debt that is on the security of any instrument (such as a mortgage, deed of trust, or land contract)-
(i) That makes the interest of the debtor in the qualified residence specific security of the payment of the debt,
(ii) Under which, in the event of default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated, and
(iii) That is recorded, where permitted, or is otherwise perfected in accordance with applicable State law.
That is what the argument in Tax Court was about. The mortgage to Joan Gross was not recorded in Hampshire County. That proved fatal to the deduction.
Since the mortgage was not recorded, we consider whether the mortgage was otherwise perfected under Massachusetts law. The mortgage may be valid and enforceable under State law as between petitioners and Joan Gross. Petitioners have not, however, established that the mortgage was otherwise perfected under Massachusetts law. We are not persuaded that the mortgage qualifies as a secured debt for tax purposes simply because it may be valid under State law between Joan Gross and petitioners. Thus, petitioners have not satisfied the third element of a secured debt under the regulations requiring that the mortgage be recorded or otherwise perfected under applicable State law.
On the bright side, at least, the Tax Court let them go on the accuracy penalty.
In this circumstance, the requirement, for tax purposes, was highly technical, even requiring an inquiry into State law for purposes of determining the validity of the deduction. Thus, in this instance it would not have been apparent to petitioners from the mere fact that this interest was paid to a family member on a bona fide mortgage note that additional measures were necessary before claiming a home mortgage interest deduction.
It is interesting to note the trade-offs and, to be cynical, the tangled webs we sometimes weave. By not recording the family mortgage, there was probably a better deal on the subsequent bank mortgage. The loss of the deduction is an expensive trade-off. I feel both bad and good about this decision. I feel bad for the taxpayers, because it was an understandable mistake that is costing them quite a bit. I feel good about the decision, because I have been fanatical about having mortgages recorded on intrafamily residence loans in order to secure the deduction, when I have been involved in the planning. It is a relief to know that I was not wasting time and money for my clients.
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