Caught In A (IRS Mortgage) Trap

Sometimes it seems that the tax Code is a trap waiting to spring on some unfortunate.  This time let’s talk about a trap involving mortgages.

(1) Chris and Jennifer bought a house in 2001 for $365,000.

(2) In 2003 they borrowed money ($427,333) from Jennifer’s mom. The note carried interest of 4.5%, and there was a document titled “Mortgage Note.”

(3) They also signed a second document titled “Mortgage.” This document included the following language:

“… hereby grant, convey and assign to … the property with the address of …..”

The document was signed, but it was not notarized or recorded at the courthouse.

(4) In 2008 Chris and Jennifer borrowed $200,000 from a bank. The bank required a note and mortgage. The bank recorded the mortgage.

(5) In 2009 Chris and Jennifer paid her mom $19,320 on her note and the bank $1,138 on theirs. They deducted the sum ($20,368) as mortgage interest on their tax return.

(7) The IRS audited their 2009 return.

What is there to look at?

The Code does not allow one to deduct personal interest. It used to, and people could deduct interest on their car loans and credit cards. That law changed in 1986, and the Code now restricts which types of interest are deductible.

One type is qualified residence interest. This is interest paid or accrued during the taxable year on acquisition indebtedness or home equity indebtedness secured by the qualified residence of the taxpayer. You and I call that a mortgage.

On first impression, it seems that Chris and Jennifer met this requirement.

Let’s look further at the definition of “acquisition indebtedness”:

(i)       In general – The term “acquisition indebtedness” means any indebtedness which –

(I)                Is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and

(II)             Is secured by such residence.

Regulation 1.163-10T(o) defines secured debt as “… recorded, where permitted, or is otherwise perfected in accordance with applicable State law.’

There is the trap. 

The debt has to be “perfected” under state law. The concept of “perfected” means that the secured creditor has a preferred position relative to an unsecured (or perhaps just a later) creditor. The money from that house goes to that mortgage holder, as he/she is first in line. Anyone else has to wait his/her turn.

Chris and Jennifer lived in Massachusetts, which requires a mortgage be recorded at the courthouse to be “perfected.”

Let’s start the unraveling:

(1) The mortgage was not perfected, meaning

(2) The debt to mom could not be “acquisition indebtedness,” meaning

(3) The interest on the debt could not be mortgage interest

The IRS – adding to its reputation of stabbing the dead – also charged Chris and Jennifer with the accuracy penalty. This is a “super” penalty and applies when the error trips certain dollar or percentage thresholds.

I cannot help but feel that the penalty was unnecessary. Is the IRS expecting people to be tax pros before they can fill-out their own tax returns? What are they going to do with me if I make a mistake on my return – shoot me?

I worry about this mortgage trap when working with intrafamily loans involving someone’s house. It can be tempting to cheat on attorney fees and not properly document or record the loan and mortgage.

If audited, one can expect the IRS to be as sympathetic to them as the IRS was to Chris and Jennifer.