An individual who wishes to claim a home mortgage interest deduction has to be able to document his equitable ownership interest in the property, a U.S. Tax Court ruled earlier this year. The opinion, which was handed down in Dolorosa Luciano-Salas, Petitioner v. Commissioner Of Internal Revenue, Respondent appears to provide some useful guidance when it comes to claiming a mortgage interest and other deductions.
The Taxpayer’s Disputed Deductions
On her 2008 federal income tax return, California resident Luciano-Salas claimed a deduction for $24,144 of home mortgage interest on Schedule A, Itemized Deductions; and she also took a deduction for a rental real estate loss of $25,000 on Schedule E, Supplemental Income and Loss.
But the IRS disallowed $24,144 of the $25,717 deduction for mortgage interest that she claimed on Schedule A, as well as the $25,000 deduction (rental real estate loss) that she claimed on Schedule E. The IRS said Luciano-Salas had failed to show that the duplex was used as a rental property or that she was otherwise entitled to the disallowed deductions.
When is Interest Expense Deductible?
Although personal interest expense cannot generally be deducted by an individual taxpayer, the tax code generally does allow a deduction for interest paid on a mortgage that is secured by a qualified residence. The mortgage, however, “must be the obligation of the taxpayer claiming the deduction, not the obligation of another,” although there is an exception if the individual paying the mortgage is the “legal or equitable owner,” even if he or she is not directly liable upon the bond or note secured by such mortgage, according to the Tax Court.
There was no dispute that, at the time of her tax filing, Luciano-Salas lived in a Van Nuys duplex that had been purchased by her sister, who bought the property with a first and second mortgage. The sister later obtained a third-mortgage loan that was secured by a recorded “short form deed of trust” granting the lender a security interest in the duplex and the power to sell the property.
Can You Legitimately Claim an Ownership Interest?
Despite this, Luciano-Salas said that she was the true owner of the duplex—and was eligible to take the interest deduction and the loss on rental activity. Luciano-Salas said that her sister, who allegedly lived with her husband in Arizona, owned the property “in name only.” Luciano-Salas also said that her own credit rating was poor, so her sister agreed to help her out by acting as the purchaser of the property.
There was a hitch, however. Luciano-Salas did not present a written agreement memorializing the supposed arrangement. Additionally, she was unable to present a reasonable paper trail showing that she, and not her sister, had made the mortgage payments. Adding to the confusion, she was unable to document the use of the duplex as a rental property. To top it off, in 2009 when Luciano-Salas’ sister declared bankruptcy, all the documents filed in connection with the matter indicated that she, not Luciano-Salas, was the legal and equitable owner of the duplex, according to Tax Court records.
The Ruling
“There is no objective evidence, however, that Ms. Hileman [the sister of Luciano-Salas], the legal owner of the duplex, entered into an agreement vesting petitioner with any ownership interest in the property. There is no evidence that petitioner had any duty or obligation to maintain or insure the property or that she was responsible for real estate taxes,” noted the Tax Court. “We have disallowed a deduction for mortgage interest where the taxpayer is unable to establish legal, equitable, or beneficial ownership of mortgaged property.”
Our recommendation: to reduce the likelihood of trouble, maintain adequate documentation for income and expense positions, and consult with your accountant.