Discussion:Auditor denying investment interest

The home mortgage interest deduction taken was 7/12 of the original primary home, all of the new primary and all of the secondary. There is no issue related to $1 million mortgage indebtedness at any time in 2006.

Can remaining 5/12 of the original primary home mortgage be taken as investment interest expense?

The IRS NRP auditor says no. The reason given is that the taxpayer is still in the 2 out of 5 year period for Sec 121 exclusion, so including the interest would be allowing 3 home mortgage interest deductions. The auditor’s believes the interest should be capitalized until the Sec 121 exclusion period is over.

This does not make sense to me. Am I off base?

1) Property Held for Investment There are two types of “property held for investment”: • property that produces interest income, dividends, annuities, or royalties not derived in the ordinary course of a trade or business; 424 and • an interest in (or property used in) a trade or business that is not a passive activity and with respect to which the taxpayer does not materially participate. 425 424 §163(d)(5)(A)(i) (Referring to §469(e)(1)). The property need not actually produce portfolio income; rather, it need only be property that normally produces interest, dividends, or royalty income. Russon v. Comr., 107 T.C. 263 (1996) (Investment interest limitation applies to purchase of stock with debt despite stock not paying dividends); Rev. Rul. 93-68, 1993-2 C.B. 72. In PLR 200503004 and TAM 9526003, the IRS concluded that interest-free demand loans that a taxpayer made to a §501(c)(3) foundation were “property held for investment” by the taxpayer, within the meaning of §§163(d)(5) and 469(e), even though the only income that the taxpayer expected the loans to produce was the interest imputed to it under §7872(a)(1). For a discussion of the tax consequences of below market loans, see ¶2330.01.A.9.a, above. In TAM 9209004, the National Office advised that interest on a loan used to purchase shares in a worker's cooperative, which the taxpayer was required to purchase to become a member of the cooperative, was investment interest because the stock was capable of producing regular corporate dividends. The National Office explained that the actual payment of dividends is not a requirement under §163(d)(5)(A). But see Tedori v. U.S., 211 F.3d 488 (9th Cir. 2000) (Interest paid on deferred tax from a DISC is nondeductible personal interest, interest does not qualify for §163(h)(2)(B) exception). 425 §163(d)(5)(A)(ii). “Passive activity” and “materially participate” are specifically defined terms of art. 426 See ¶2980, below, for a complete discussion of passive activity losses, and ¶2330.02.G, below, regarding passive activity interest. 426 §163(d)(5)(C).

Isn't the capitalization of interest an election? Is this still available to the taxpayer?

However, I believe that 265(a)(1) applies to expenses relating to a “class of income” which wholly excludible from gross income or wholly exempt from subtitle A taxes. Don’t believe that this class of income (capital gains) is “wholly excludible.”

The auditor’s comment that this is a third qualified residence is wrong since a qualified residence under Sec. 163 is the principal residence and one other residence of the taxpayer’s choosing.

The real issue is whether a principal residence can be treated as investment property if the home is not immediately sold. I believe the answer is yes.

Totally unrelated, I hope your client is reasonable because alot of taxpayers would blame the CPA for not knowing basic tax law. That is so ridiculous. This is complex.

I don't see the taxpayer winning here. But this is how case law gets developed. I get Rileys point and it is a very good one, but I believe that 163 will supersede. Please keep us informed.

The interest on carrying real property held for investment (raw land) is deductible.

So, the IRS position is that even tho the property is now investment property, you can not deduct the interest because you may be able to exclude gain under Section 121.

See Riley2 comments.

Investment interest can also be claimed for interest used to carry investments (other than obligations that are exempt from tax) that could potentially produce capital gains. See Sec. 469(e)(1).

I have a twist to the original post which leads me to believe the auditor’s results are correct, he just got there on the wrong path.

The mortgage indebtedness on the property which was a primary residence for 7 months and investment property for 5 months was a $100,000 HELOC. The taxpayer paid cash for the home in 2004. The taxpayer indicates the majority (75%) of the HELOC draws were used for personal expenses unrelated to the property or other investment activity.

So when the property was converted to investment property, I assume the tracing rules kick in on the HELOC draws and the taxpayer has no investment interest deduction related to the HELOC.

Comments?

As such, you do an analysis of Aquisition debt and a further home equity debt. If the older "investment" house has $300,000 of debt, of which 100% was release of equity, the auditor could limit it to $100,000. However, if the entire release of equity was then used to aquire the new property, then it is aquisition debt (even though it is secured on the first property rather than the second). It's also considered aquisition if the proceeds were used to improve the first property (such as adding an extension).

In short, you should be able to argue that the entire sum is aquisition debt of personal real estate, if you can find a paper trail leading to that conclusion.