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."

Pouring Concrete In Phoenix

I read the tax literature differently than I did early in my career. There is certainly more of “been there, read that,” but there is also more consideration of why the IRS decided to pursue an issue.

I am convinced that sometimes the IRS just walks in face-first, as there is no upside for them. Our recent blog about the college student and her education credit was an example. Other times I can see them backfilling an area of tax law, perhaps signaling future scrutiny. I believe that is what the IRS is doing with IRAs-owning-businesses (ROBS).

A third category is when the IRS goes after an issue even though the field has been tilled for many years. They are signaling that they are still paying attention.

I am looking at a reasonable compensation case.  I believe it is type (3), although it sure looks a lot like type (1).

To set up the issue, a company deducts someone’s compensation – a sizeable bonus, for example. In almost all cases, that someone is going to be an owner of the company or a relation thereto. 

There are two primary reasons the IRS goes after reasonable compensation:

(1)  If the taxpayer is a C corporation (meaning it pays its own tax), the deduction means that the compensation is being taxed only once (deducted by the corporation; taxed once to the recipient). The IRS wants to tax it twice. In a C environment, the IRS will argue that you are paying too much compensation. It wants to move that bonus to dividends paid, as there is no tax deduction for paying dividends.

(2) If the taxpayer is an S corporation (and its one level of tax), the IRS will argue that you are paying too little compensation. There is no income tax here for the IRS to chase. What it is chasing instead is social security tax. And penalties. Some of the worst penalties in the tax Code revolve around payroll.

There is a world of literature on how to determine “reasonable.” The common judicial tests have you run a gauntlet of five factors:

(1) The employee’s role in the company

(2) Comparison to compensation paid others for similar services

(3) Character and condition of the company

(4) Potential conflict of interest

(5) Internal consistency of compensation

Let’s look at the Johnson case as an example.

Mom and dad started a concrete company way back when. They had two sons, each of which came into the business. They specialized in Arizona residential development. As time went on, the brothers wound up owning 49% of the stock; mom owned the remainder. The family was there at the right time to ride the Phoenix housing boom, and the company prospered.

A downside to the boom was periodic concrete shortages. The company did not produce its own concrete, and the brothers came to believe it to be a business necessity. They presented an investment opportunity in a concrete supplier to mom. Mom wanted nothing to do with it; she argued that the company was a contractor, not a supplier. This was how companies overextend and eventually fail, she reasoned.

The brothers went ahead and did it on their own. They invested personally, and mom stayed out. They even guaranteed some of the supplier’s bank debt.

Who would have thought that concrete had so many problems? For example, did you know that concrete becomes unusable after 

(1) 90 minutes or

(2) If it reaches 90 degrees.

I am not sure what to do with that second issue when you are in Phoenix. 

The brothers figured out how to do it. They developed a reputation for specialized work. They worked 10 or 12 hours a day, managed divisions of 100 employees each, were hands-on in the field and often ran job equipment themselves. Sometimes they even designed equipment for a given job, having their fabrication foreman put it together.

Not surprisingly, the developers and contractors loved them.

That concrete supplier decision paid off. They always had concrete when others would not. They could even charge themselves a “friendly” price now and then.

We get to tax years June 30, 2003 and 2004 and they paid themselves a nice bonus. The brothers pulled over $4 million in 2003 and over $7 million in 2004.

COMMENT: I really missed the boat back in college.

The brothers were well-advised. They maintained a cumulative bonus pool utilizing a long-time profit-sharing formula, and they had the company pay annual dividends.

The IRS disallowed a lot of the bonus. You know why: they were a C corporation and the government was smelling money.

The Court went through the five tests:

(1) The brothers ran the show and were instrumental in the business success. Give this one to the taxpayer.

(2) The IRS argued that compensation was above the average for the industry. Taxpayer responded that they were more profitable than the industry average. Each side had a point. Having nothing more to go on, however, the Court considered this one a push.

(3) Company sales and profitability were on a multi-year uptrend. This one went to the taxpayer.

(4) The IRS appears to have wagered all on this test. It brought in an expert who testified that an “independent investor” would not have paid so much compensation and bonus, because the result was to drop the company’s profitability below average.

Oh, oh. This was a good argument.

The idea is that someone – say Warren Buffett – wants to buy the company but not work there. That investor’s return would be limited to dividends and any increase in the stock price. Enough profitability has to be left in the company to make Warren happy.

This usually becomes a statistical fight between opposing experts.

It did here.

And the Court thought that the brothers’ expert did a better job than the government’s expert.

COMMENT: One can tell that the Court liked the brothers. It was not overly concerned that one or two years’ profitability was mildly compromised, especially when the company had been successful for a long time. The Court decided there was enough profitability over enough years that an independent investor would seriously consider the company. 

Give this one to the taxpayer.

(5) The company had a cumulative bonus program going back years and years. The formula did not change.

This one went to the taxpayers.

By my count the IRS won zero of the tests.

Why then did the IRS even pursue this?

They pursued it because for years they have been emphasizing test (4) – conflict of interest and its “independent investor.” They have had significant wins with it, too, although some wins came from taxpayers reaching too far. I have seen taxpayers draining all profit from the company, for example, or changing the bonus formula whimsically. There was one case where the taxpayer took so much money out of the company that he could not even cash the bonus check. That is silly stuff and low-hanging fruit for the IRS.

This time the IRS ran into someone who was on top of their game.

Vacation Or Business Deduction?

Let’s say that we work together. I cannot attend an appointment with a new client first thing in the morning. You volunteer to cover for me.

By the way, welcome to tax practice. Believe me, it is not the glitz and glamour that Hollywood makes it out to be. I know: hard to believe.

You meet the Fishers. They are both attorneys, he as partner in a firm and she as a sole practitioner. They have three children, all under the age of 10. She takes her kids to work periodically for the customary reason: the cost of day care and family members unable to care for the kids at the time.

She had an opportunity to represent a client in the Czech Republic for a few weeks, and she took it. It turned out however that he was unable to watch the kids. Seeing herself in a jam, she took the kids with her but came up with a novel twist:

She would write a travel book about the Czech Republic. It would be written to and for kids and would lessen their tedium while travelling.

She had no previous writing experience, so this was new territory. It occurred to her that other parents might be interested in such books – and this could be a business opportunity for a sharp and motivated person.

She has kept this up now for three years. She has now taken the kids to Disney World as well as to several cities in Europe.

You talk to her about the IRS and its “hobby loss” rules. She is an attorney, not a writer; there is a gigantic personal enjoyment factor present, ….

She cuts you off. Remember: she is an attorney. She has read up on this area of tax law, and she thinks she meets the requirements. For example,

·        She consulted with one of her clients, a published author, who gave her advice on both writing and publishing.

·        That person introduced her to a book distributor, who suggested she hire a graphic designer. She did so.

·        She also consulted with a friend who works at HarperCollins; the friend recommended she hire an agent. She has not done that yet.

·        She completed four prototype books, but has not submitted them for publication. She has instead self-published. Sales however have been minimal.

The Fishers need to file returns for the last three years. Her combined loss from the book-writing activity is approximately $75,000.

They ask whether you can prepare their returns and claim the book-writing loss.

What do you say?

The big issue is whether the activity rises to the level of a tax deduction. You remember some of the factors that the IRS uses to identify a hobby:

·        Not run in a business-like fashion

·        Failure to consult experts

·        Failure to revise business plans when losses pile up

·        Profits dwarfed by the losses

But Ms. Fisher has been meeting people. She has made contacts at a publishing house. She has written prototypes. She has self-published. She seems to be getting some things right.

You don’t see a clear-cut answer. Two people can reasonably disagree. The problem of course is that the IRS has a bit more horsepower than the average person you might disagree with.

You wobble. You tell them that you want to review the literature in this area, as the issue is walking the grey lands. You will call them tomorrow.

We have a chance to talk about the meeting.

I see two things immediately:

(1)   Can we prepare and sign the return under professional standards?

(2)   If so, there is still a significant chance that they would lose the deduction on audit.

Professional standards allow a tax practitioner some leeway when confronted with certain issues. This is fortunate, or professional practice would likely grind to a near halt.  The bar can be higher or lower depending upon the particular issue under discussion. Take a “listed transaction,” for example, and the bar is pretty high. Listed transaction is jargon for tax shelter, and we are nowhere near that with the Fishers. Our bar is much lower.

However, I would say our best chance with the IRS is 50:50, and likely less than that.  We would discuss this with the client and allow them to decide. It is their return, after all. Maybe they will get another accountant’s opinion. Maybe I am wrong.

This is a real case, by the way.

The Fishers are from New York and took this issue to Tax Court.

They lost.

The Court decided that her activity was not so much a business as her investigating going into business. The Court pointed out a few things: she had not hired an agent, had not finalized a book, and had not submitted a proposal to a publishing house. Since business activity had not started, it did not have to consider whether the activity was a hobby.

No business activity = no business deduction.

What do I think?

The Court saw too much personal and not enough business. I suppose that had she been making money the Court may have relented. She had to clear the hurdle of deducting what many people would see as vacations, and that required some serious weight on the other end of the see-saw to sway the Court.