Taxpayer Denied Mortgage Deduction for Capitalized Interes

A cash-basis taxpayer could not deduct qualified residence interest capitalized into the principal of a mortgage but not actually paid, the Tax Court has held (Smoker v. Commissioner, Dec. 59,458(M), TC Memo. 2013-56). The taxpayer’s obligation to pay the interest was not paid or discharged; instead, it was postponed.

Comment

Taxpayers may not claim a deduction for personal interest paid or accrued during the tax year unless specifically allowed by statute. Among the enumerated items of deductible personal interest allowed under Code Sec. 163 is qualified residence interest. The aggregate amount that may be treated as acquisition indebtedness for any period is generally limited to $1 million and the aggregate amount that may be treated as home equity indebtedness for any period is generally limited to $100,000.

The taxpayer owned a residence in California and a residence in Michigan. The taxpayer had purchased the Michigan property with a $450,000 adjustable rate note secured by a mortgage on the property. The note charged a floating interest rate on the unpaid principal until the loan was fully repaid.

The rate was initially set at 4.125 percent, was reset monthly on the basis of a specified index, and was capped at 9.9 percent. A new monthly payment amount was determined every 12 months; the new amount would not differ from the monthly payment due in the preceding 12-month period by more than 7.5 percent (higher or lower). If the monthly payment in any month was less than the interest portion of an amount determined to be necessary to repay the unpaid principal balance then owed in substantially equal monthly payments by maturity, the excess interest would be added (i.e., capitalized) into the principal of the note.

On his federal income tax returns for the years at issue, the taxpayer claimed deductions of $75,000 and $83,000 for home mortgage interest. The deduction for each year included interest which accrued but unpaid—that is the interest which had been capitalized into the principal of the mortgage.

The court agreed with the IRS that a cash-method taxpayer may not deduct accrued but unpaid interest. The court found that a cash-method taxpayer is allowed a deduction for interest paid during the tax year in cash or its equivalent. The mere delivery of a promissory note to satisfy an interest obligation, without an accompanying discharge of the note, is a mere promise to pay and not a payment in a cash equivalent, the court found.

The court rejected the taxpayer’s argument that he had “paid” interest because adding accrued interest to the principal of a mortgage note is akin to taking out a second mortgage to pay the interest accrued and is indistinguishable in substance from borrowing from a third party to make the interest payments. The taxpayer had not discharged but only postponed his obligation of paying interest. Therefore, the taxpayer could not deduct the deferred interest.