Parent Buys House, Kid Pays The Mortgage. Who Gets the Interest Deduction?

March 1, 2012 by WithumSmith Brown, CPAs

As you’re likely aware, the lending market is not what it used to be. The resulting housing market crash forced lenders to tighten their purse strings, leaving many hopeful homebuyers unable to secure a mortgage.

As a result, people have been forced to get creative, in some cases dividing the responsibilities of home ownership between family members. A typical arrangement looks something like this:

Parents: Purchase the home as legal owners and take out the mortgage in their own name.

Child: Chips in for the down payment, maintains the house while living in it as his/her primary residence, and pays the mortgage as it comes due.

These new types of arrangements, while achieving the desired goals, create confusion when determining which party is entitled to deduct the mortgage interest on their tax return. Fortunately, a mix of regulatory authority and judicial precedent provides the necessary guidance, but in order to determine whether parents or child are entitled to the interest deduction in the scenario posed above, you’ve got to work through a series of questions:

1. Who paid the mortgage? First things first, because individuals are cash basis taxpayers, only the taxpayer who actually pays the mortgage is entitled to a deduction. So Parents are out, since the child paid the principal and interest as it came due.
2. Who is listed as the borrower on the mortgage? In general, a taxpayer can’t deduct interest he pays on a debt that isn’t theirs. Thus, without some relief, the child can’t deduct the mortgage interest either – even though they paid it — because they are not listed as a co-borrower on the mortgage. Which takes us to…
3. Who has legal title to the house? Treas. Reg. §1.163-1(b) provides an exception to the general rule found in #2. Pursuant to the regulations, even if a taxpayer is not directly liable on the mortgage, he can deduct any interest he pays on the debt as long as he is the legal owner of the house; i.e., a deed holder. Unfortunately, this doesn’t help the child in our case because they are not listed on the deed, and thus is not a legal owner of the home.
4. So then nobody is entitled to deduct the mortgage interest? Not so fast. The regulations also allow a taxpayer who is an “equitable” owner of the house to deduct the mortgage interest he pays, even if he is not listed on the mortgage as a co-borrower.

What constitutes an “equitable” owner of a house? The Tax Court has typically defined an equitable owner as one who:

1. Has a right to possess the property and to enjoy the use, rents or profits thereof;
2. Has a duty to maintain the property;
3. Is responsible for insuring the property;
4. Bears the property’s risk of loss;
5. Is obligated to pay the property’s taxes, assessments or charges;
6. Has the right to improve the property without the owner’s consent; and
7. Has the right to obtain legal title at any time by paying the balance of the  purchase price.

In our fact pattern, the child clearly meets the requirements of factors 1 and 2, as he lives in the home as his primary residence and is responsible for its upkeep. Presumably, the child also meets factor 6 –since the house is recognized by parents as belonging to them — and factor 7, assuming he could eventually borrow the funds necessary to buy out parents’ legal interest.

Lastly, because the child contributed to the down payment, he should meet factor 4, as he bears a portion of the risk of loss associated with the house to the extent of his piece of the down payment. This can be a critical factor; if the child doesn’t contribute any cash towards funding the down payment, this factor swings the other way, and it may well sway the ultimate determination of the child’s status as “equitable owner” from yay to nay.

So parents, as much as it may pain you to have your child pay his share of the down payment, it’s actually in his best interest to do so. Without it, his mortgage interest deduction may go up in smoke.

[i] Golder v. Commissioner, 604 F.2d 34 (9th Cir. 1979).

[ii][ii] Blanche v. Commissioner, T.C. Memo 2001-63

Mortgage Interest Deduction: It’s All About Equitable Ownership

January 24th, 2012

The harsh economic environment, and stricter lending policies, have led many to fail to qualify for traditional lending. A popular solution has been to tap into the creditworthiness of parents or other family members, with the understanding that the occupant of the home will be responsible for the monthly mortgage payment. The question that arises from this arrangement is whether the mortgage interest expense can be deducted by the occupant of the home, even though he is not legally responsible for paying the mortgage.

Uslu, T.C. Memo. 1997-551, refers to a tax court case in which Saffat Uslu, who filed for bankruptcy, lived on a property financed and legally held by his brother. In 1992, he paid $18,980 in interest to the mortgage holder and claimed a deduction. The IRS disallowed the deduction on the premise that the taxpayer was not legally responsible for the property. The Tax Court, however, ruled in favor of Uslu, because of an important exception in the tax code. In Regs. Sec. 1.163-1(b), it states that an “equitable owner” may deduct interest expense, even though he is not directly liable for the mortgage. The Tax Court ruled that because Uslu exclusively occupied the residence, made all the mortgage payments directly to the lender, and paid all expenses for repairs, maintenance, property taxes, insurance, and improvements, he was deemed the “equitable owner”.

If you are considering alternative financing for which someone else will be legally responsible, we strongly recommend that you structure a written, enforceable agreement that clearly identifies you as the equitable owner and assigns you the benefits and burdens of home ownership. You should then make sure that both parties act consistently in upholding the agreement.

Equitable Owner Equals Deduction

By Charles J. Reichert

october 2008

The Tax Court held that a married couple could deduct mortgage interest and property tax payments made from a corporate checking account on a home that was owned by their son. The court held that the taxpayers were equitable and beneficial owners of the property and that the checking account was in essence their personal account. Thus they were entitled to itemized deductions for the payments.

Taxpayers may deduct interest paid by them on debt related to a qualified residence. Generally, the debt must be the taxpayer’s, not someone else’s. Treas. Reg. § 1.163-1(b) permits a deduction for interest paid on a mortgage when a taxpayer is the legal or equitable owner of the property, even though the taxpayer is not directly liable for the mortgage. In Saffet and Ana Uslu v. Commissioner, TC Memo 1997-551, the Tax Court held that a married couple was the equitable owner of a home titled to the husband’s brother since, from the date of acquisition, they had occupied the home and made all payments for the mortgage, taxes, repairs, maintenance and improvements. In Bruce D. Loria v. Commissioner, TC Memo 1995-420, the same court held that the taxpayer was unable to demonstrate that he was the equitable owner of a home owned by his brother—thus denying deductions for interest and property taxes.

In the instant case, Ndile George Njenge and Ekinde Sone Nzelle Rachel resided in a home owned by their son. In 2001, their son purchased the home in his name since the taxpayers were unable to obtain financing; however, from the date of acquisition until the date of the trial, Njenge and Rachel made all of the mortgage, property tax and maintenance payments and were the sole occupants of the home. In 2003, the taxpayers paid those housing costs from a checking account of a company called Camrock General Engineering Co., an entity for which the taxpayers had established a bank account but never actually formed or started and did not intend to do so in the future. The IRS disallowed the mortgage and property tax deductions for 2003, causing the taxpayers to petition the Tax Court for relief.

The IRS argued that no deduction for interest and taxes should be allowed since Njenge and Rachel were not the legal owners of the property and were not legally obligated to make any payments. Furthermore, the IRS argued that Camrock had made the payments, not the taxpayers. The court rejected both arguments, holding Njenge and Rachel were the equitable owners of the property since, from the date of acquisition, the taxpayers were the only ones who enjoyed the benefit and bore the burden of the home. Furthermore, the court found that the Camrock checking account was in essence the taxpayers’ personal account.

This case illustrates that the economic substance rather than the legal form of a home ownership situation can dictate the tax result. In this case, it is important to note that the taxpayers prevailed because the evidence suggested that their son was owner in name only and that the “business,” whose name was on the checking account used to make the housing payments, existed in name only.

Ndile George Njenge and Ekinde Sone Nzelle Rachel v. Commissioner, TC Summary Opinion 2008-84

By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.

Mortgage Interest Deductible Despite Not Holding Title: A taxpayer’s home mortgage interest, within certain dollar limitations, is generally deductible if he is the legal or equitable owner of the property even though he is not directly liable on the mortgage [Reg. Sec. 1.163-1(b) ]. The taxpayer, in a recent case, did not hold legal title, but was under an oral agreement to purchase the property from his family members. In 2010, he reported home mortgage interest expense of $35,880. Although the taxpayer did not hold legal title to the underlying property, nor did his name appear on the mortgage, the Tax Court determined that he provided clear and convincing evidence that he was an equitable owner because he paid the mortgage, taxes, insurance, and other bills associated with the property, maintained the property, and made improvements to it. Thus, he was entitled to take the mortgage interest deduction. Qui Van Phan, TC Summary Opinion 2015-1.