Can You Have A Mortgage Interest Deduction Without A Mortgage?

A new client comes in to meet with you. Let's call him Burley. Burley lives with his girlfriend, Julie, who purchased a house. The deed and mortgage is in her name, as Burley has lousy credit. He would have been no help with a mortgage approval.

Burley and Julie consider themselves domestic partners with equal ownership of the house.

Burley pays Julie $1,000 a month as "interest only" mortgage payments. Burley is not a big fan of bank accounts, preferring to conduct much of his activity in cash. This means he does not have cancelled checks to back-up his claim.

QUESTION: Does Burley have a tax deduction for mortgage interest?

The first problem is that Burley does not own the house.

This may seem fatal, but there is a loophole. Many states recognize the doctrine of equitable ownership, and their courts will enforce express or implied contracts between nonmarital partners. It is possible to have a tax deduction, even if you are not on the deed or mortgage, as long as your nonmarital partner is and you can prove such a contract.

But while a necessary first step, the tax Code goes further. It wants to see that the equitable owner has taken on the burdens of ownership as well as the benefits. Such burdens, for example, would include:

            (1) the right to use the property and enjoy its use

            (2) a duty to maintain the property

            (3) a responsibility to insure the property

            (4) the assumption of risk of loss

            (5) a responsibility to pay taxes and assessments

            (6) the right to improve the property

Burley pays $1,000 a month, which amount would cover his share of the mortgage payment, as well as (supposedly) his share of the insurance, taxes and other expenses of ownership. The amount does not vary for repairs, or for snow removal in the winter or lawn-mowing in the summer.

That sounds a lot like rent.

It would help if the arrangement between Burley and Julie were reduced to writing. After all, real estate is a significant purchase for most people, and it is not be unreasonable to want the agreement documented.

Burley and Julie of course have no such document.

Well, at least Julie could show up in person at the hearing and answer the judge's questions. Considering that Burley has little proof to provide on his own power, her testimony would be important.

Julie doesn't want to do that, however, but she is willing to send a letter instead.

The case is Jackson, and it is a pro se Tax Court case decided in July.

Jackson lost, which is about as surprising as daily summer showers in south Florida.

Here is the Court:

           

Because she held legal title to the residence and was the sole mortgagee, [Julie's] testimony would have been highly relevant to the question whether she and petitioner had agreed (expressly or impliedly) that he would hold an interest in the property.... Despite ample advance notice of the trial date and the Court's considerable flexibility in scheduling the trial in these cases, [Julie] did not appear as a witness."

What happens when you anger the Court?

Under the circumstances, we give no weight to [Julie's] ... letter to respondent's counsel related to petitioner's history of transferring funds to her."                              

This was the Court's polite way of saying "we do not believe you."

Spouses Owning Businesses, Divorce And Taxes

A fundamental concept in taxation is that an “accession to wealth” represents taxable income, unless the Code says otherwise.

There are limits on this, of course, otherwise you would be immediately taxed when your mutual fund or house went up in value. The Code will (usually) want to see a triggering event, such as a sale, exchange or disposition by other means. You don’t pay tax on your stock gain, for example, until you sell the stock.

But the concept also creates problems. For example, consider the recent development of crowdfunding. You have an idea for the next great breakfast sandwich, and you reach out on the internet for money to get the idea going. You have accession to wealth, but is the money taxable to you? The tax consequence can get very murky very quickly. For example:

·        If you provide investors with breakfast sandwiches, there is an argument that you sold sandwiches.

·        If investors instead receive ownership (say shares of stock), we would sidestep that sale-of-sandwiches thing, but you might have an issue with securities laws.

·        If investors receive nothing, one could argue that the monies were a gift. The closer you get to detached generosity without expectation of economic gain, the better the argument.

Let's next consider accession to wealth in a divorce context. Here is Code Section 1041:

(a) General rule. No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of)—

(1) a spouse, or

(2) a former spouse, but only if the transfer is incident to the divorce.

(c) Incident to divorce. For purposes of subsection (a)(2), a transfer of property is incident to the divorce if such transfer— 

(1) occurs within 1 year after the date on which the marriage ceases, or

(2) is related to the cessation of the marriage.

Believe it or not, the general definition of income could trigger when marital assets are divided upon divorce. That makes little sense, of course, so Section 1041 provides an escape clause.

Question: how much time do you have to separate the marital assets?

The first answer provided in (c)(1) is one year. It is immediately followed by (c)(2) which (appears to) expand the answer to any period as long as the asset transfer is related to the cessation of marriage. That is a bit open-ended, so the tax Regulations interpret (c)(2) as up to six years.

The Belots started a dance school in New Jersey in 1989. The wife was the dancer and creative force, while the husband attended to the business side. Eventually they had several dance studios, a corporation to manage them and a partnership to own the real estate. They did well. While owned 100% by the spouses, the husband and wife were not necessarily 50:50 owners in each entity.

They started divorce action in 2006,and adjusted their ownership in each entity to 50:50. The divorce was finalized in January, 2007.

There is a reason they got divorced. Tired of her ex-husband's participation, Ms. Belot bought-out his share in 2008 for $1,580,000.

Mr. Belot took the position that this was not taxable under Section 1041. The IRS took the opposite position and billed him almost $240,000 in tax and penalties.

Off to Tax Court they went.

The IRS argued that each and every transaction had to come under the umbrella of Section 1041. There was no question that the first transaction qualified, but the second transaction – cashing-out Mr. Belot entirely – did not because it represented an event arising after the divorce. The second settlement represented a business contingency and was not related to the divorce decree.

The IRS was following a hyper-technical interpretation of its Regulations.

The problem is that the Code does not say "pursuant to the divorce decree." It instead says "related to the cessation of marriage." The divorce decree is arguably the most vivid expression of such cessation, but it is not the only one. The Belots were clearly still dividing marital assets owned at the time of divorce.

The Court decided in favor of the Belots.

Why did the IRS even pursue this?

The IRS was enforcing the everything-is-taxable position, unless excluded by the Code somewhere. 

Credit Card Debt And Yankee Doodle Dandy

There is a tax doctrine known as the Cohan rule. It is named after the American composer and playwright George M. Cohan, the subject of the movie Yankee Doodle Dandy. While a renown musician, composer and playwright, he was not much of a recordkeeper, and he found himself in front of the Court defending his business expenses against challenge by the IRS. The Court took an extremely friendly stance and allowed him to estimate his deductions.

While the Cohan rule still exists (in some capacity) today, it should be noted that the tax Code has been changed to disallow the next George Cohan any tax deduction for estimated meals, travel and entertainment. Those particular deductions have to be substantiated or no deduction will be allowed, with or without a friendly judge.

I just read a case where (I believe) a variation on the Cohan rule came up.

The case has to do with cancellation of indebtedness income.

Did you know you could be taxed if a credit card company forgives your balance?

The reason is that the tax Code considers an "accession to wealth" to be "income" (with exceptions, of course). Take the conventional definition of wealth as 

... assets owned less debts owed ...

and you can see that the definition has two moving parts. The asset part is easy - your paycheck increases your bank account, if only fleetingly. The liability part in turn is the reason you can borrow money and not have it considered income (assets and liabilities increase by the same amount, so the difference is zero). Have the bank forgive the debt, however, and the difference is no longer zero.

Newman did something odd. He wrote a check on his Wells Fargo account and opened a new account at Bank of America. He withdrew money from the new account. Meanwhile the check on Wells Fargo bounced.

Bank of America wanted its money back. Newman did not have it anymore.

Impasse.

You may know that a bank will issue a Form 1099 (Form 1099-C, specifically) when it cancels a debt. That 1099 informs the IRS about the forgiveness, and it is a heads-up to them to check for that income on your tax return.

            Question: when does the the bank issue the 1099?

In general it will be after 36 months of inactivity. Newman bounced the check in 2008 and received the 1099 in 2011.

Newman left the 1099 off his tax return. The IRS put it back on.

The Court decided Newman had - potentially - income in 2011.

Newman fired back: he did not have income because he was insolvent in 2011, and the tax Code allows one to avoid debt income to the extent one is insolvent.

You and I use another word for "insolvent" in our day-to-day conversation:  bankrupt.

Bankrupt means that you owe more than you are worth. The tax Code has an exception to debt income for bankruptcy, but it only applies if one is in Bankruptcy Court. But what if you are trying to work something out without going to Bankruptcy Court? The Code recognizes this scenario and refers to it as "insolvency."

So Newman had to persuade the Court that he was insolvent.

One would expect him to bring in a banker's box of bank statements, credit card bills, car loan balances and so forth to substantiate his argument.

The Court looked and said:

At trial petitioner provided credible testimony that his assets and liabilities were what he claimed they were."

"Testimony?"

What about that banker's box?

Newman ran a Hail Mary play with time expiring on the game clock. While a low-probability play, he connected for a touchdown and the win.

To a tax advisor, however, Newman was decided differently from Shepherd, another Tax Court case from 2012 where the taxpayer needed much more than his testimony to substantiate his insolvency.

Why the difference between the two Court decisions?

With that question you have an insight into the headaches of professional tax practice.

What Does It Mean To Rely On A Tax Pro?

You may know that permanent life insurance can create a tax trap.

This happens when the insurance policy builds up cash value. Nice thing about cash value is that you can borrow against it. If the cash value grows exponentially, you can borrow against it to fund your lifestyle, all the while not paying any income tax.

There is always a "but."

The "but" is when the policy terminates. If you die, then there is no tax problem. Many tax practitioners however consider death to be extreme tax planning, so let's consider what happens should the policy terminate while you are still alive. 

All the money you borrowed in excess of the premiums you paid will be income to you. It makes sense if you think of the policy as a savings account. To the extent the balance exceeds whatever you deposited, you have interest income. Doing the same thing inside of a life insurance policy does not change the general rule. What it does do is change the timing: instead of paying taxes annually you will pay only when a triggering event occurs.

Letting the policy lapse is a triggering event.

So you would never let the policy lapse, right?

There is our problem: the policy will require annual premiums to stay in effect. You can write a check for the annual premiums, or you can let the insurance company take it from the cash value. The latter works until you have borrowed all the cash value. With no cash value left, the insurance company will look for you to write a check.

Couple this with the likelihood that this likely will occur many years after you acquired the policy - meaning that you are older and your premiums are more expensive - and you can see the trap in its natural environment.  

The Mallorys purchased a single premium variable life insurance policy in 1987 for $87,500. The policy insured Mr. Mallory, with his wife as the beneficiary. He was allowed to borrow. If he did, he would have to pay interest. The policy allowed him two ways to do this: (1) he could write a check or (2) have the interest added to the loan balance instead.

Mallory borrowed $133,800 over the next 14 years - not including the interest that got charged to the loan.

Not bad.

The "but" came in 2011. The policy burned out, and the insurance company wanted him to write a check for approximately $26,000.

Not a chance said Mallory.

The insurance company explained to him that there would be a tax consequence.

Says you said Mallory.

The policy terminated and the insurance company sent him a 1099 for approximately $150,000.

It was now tax time 2012. The Mallorys went to their tax preparer, who gave them the bad news: a big tax check was due.

Tax preparer became ex-tax preparer.

The Mallorys did not file their 2011 tax return until 2013. They omitted the offending $150,000, but they attached the Form 1099 to their tax return with the following explanation:

Paid hundreds of $. No one knows how to compute this using the 1099R from Monarch -- IRS could not help when called -- Pls send me a corrected 1040 explanation + how much is owed. Thank you."

The IRS in turn replied that they wanted $40,000 in tax, a penalty of approximately $10,000 for filing the return late and another penalty of over $8,000 for omitting the 1099 in the first place.

The Mallorys countered that they had no debt with the insurance company. Whatever they received were just distributions, and they were under no obligation to pay them back.

In addition, since they received no cash from the insurance company in 2011, there could not possibly be any income in 2011.

It was an outside-the-box argument, I grant you. The problem is that their argument conflicted with a small mountain of paperwork accumulated over the years referring to the monies as loans, not to mention the interest on said loan.

They also argued for mitigation of the $8,000 penalty because no one could tell them the taxable portion of the insurance policy.

The Mallorys had contacted the IRS, who gave them the general answer.  It is not routine IRS policy to specifically analyze insurance company 1099s to determine the taxable amount.

They had also called random tax professionals asking for free tax advice.

COMMENT: Think about this for a moment. Let's say you receive a call asking for your thoughts on a tax question. The caller is not a client. Your first thought is likely: why get involved? Let's say that you take the call. You are then asked for advice. How specific can you be? They are not your client, and the risk is high that you do not know all the facts. The most you can tell them - prudently, at least - is the general answer.

This is, by the way, why many practitioners simply do not accept calls like this.                            

The Court did not buy the Mallory's argument. It was not true that the Mallorys were not advised: they were advised by their initial tax preparer - the one they unceremoniously fired. After that point it was a stretch to say that they received advice - as they never hired anyone. A phone call for free tax advice did not strike the Court as a professional relationship providing "reasonable cause" to mitigate the $8,000 penalty. 

The Mallorys lost across the board.

Stop Shoveling, Mr. Edwards

I am looking at a case where the IRS assessed over $1 million in tax and over $790,000 in penalties against a taxpayer.

Apparently this amount was too low, so the IRS added another $202,000 in tax and $152,000 in penalties.

Good grief. Just because you have a shovel doesn’t mean you should keep digging.

If you wondered how $202,000 in tax triggers $152,000 in penalties, it is because the IRS asserted fraud. The fraud penalty is 75%.

This immediately removes this taxpayer (?) from my range of practice. It is one thing to take an aggressive tax position. It is quite another to cross the street, jump the fence and walk into marching-band halftime fraud show.

Fraud requires the IRS to show intent by the taxpayer. This is a difficult standard and made more so by a tax Code that can be heatedly argued by opposing parties.

That said, I was speaking with another CPA this week representing a business tax audit which has stretched over several years. We have bounced ideas on this audit before, and he was telling me that the IRS intends to assert fraud penalties. That surprised me a bit, as there was (to the extent of my knowledge) no indication that revenues were underreported. Deductions, however, were a different story. This was one of those clients that deducted everything in sight – whether or not it was his and twice if you weren’t keeping count. Bam!! Fraud penalty.

And I tell you what I told my friend: I do not believe the penalty will stick if his client pursues the matter. Mind you, the case may have to go to Court, as there is a price to pay for being reckless. His client may not pay the fraud penalty, but the client will pay a tax professional.

Back to our tax case: Edwards.

This case has been in the system for a long time, as the IRS is assessing the 2000 tax year.

Edwards owned a corporation (Magna Corp) in North Carolina. Magna was involved with health insurance and workers’ compensation.  It received commissions from selling insurance, including:

                Sunshine Co                                     $128,239

                Fidelity Group                                   $276,528

Sunshine Co made the checks payable to Edwards individually. This happens, and generally the business owner endorses the check over and deposits it in the business account. That did not happen here.

Fidelity made its checks payable to Capital Marketing, a company owned by a Magna employee.

COMMENT: OK, that is odd. It goes without saying that the money did not make it back to Magna via normal channels.

There must be more to the story, as Capital Marketing also sent over $1.1 million to a Bear Stearns brokerage account owned by Edwards. The account was not in his name, though. It was in the name of “Carolina Green.” 

COMMENT: Folks, here is a tip from a 30-year tax CPA. You probably want to hold up going all Shakespeare-like naming personal bank and brokerage accounts.  Couple that with opaque, almost untraceable and frequent cash transfers and you are likely to have a revenue agent parked in your life for a while.

Edwards was also building a house, and Capital Marketing transferred over $1.4 million to his builder.

                COMMENT:  Enter opaque and untraceable.

Edwards and his wife filed their 2000 tax return and reported a little over $36,000 in income.

Edwards was indicted for mail fraud, wire fraud, money laundering and a rash of other things. He entered a voluntary guilty plea to many of the charges. The IRS held up until the criminal trial was done. That is the reason that we are reading about a 2000 tax case in 2016.

It has to be an upstream row to defend yourself in Tax Court when you have already been criminally convicted. Suffice to say, it did not go well for Edwards.

He could have tried a little harder not to insult the Court’s intelligence, however. He argued, for example, that the $1.4 million that went to the builder was actually a loan to him.

Sure.

Banks make $1.4 million loans to people making $36,000 all the time.