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TAX MATTERS

Mortgage interest deduction allowed for home never built

 

By Charles J. Reichert, CPA
January 2012

The Tax Court held that a couple could deduct interest paid on a loan incurred to purchase property on which they intended to construct a new home but never did. According to the court, a qualified residence was deemed to be under construction when an existing home was demolished and when other preparatory work, such as planning and acquiring permits for the new home, occurred. Furthermore, the court stated, the relevant Treasury regulation does not require that the residence under construction ever be occupied.

Taxpayers may deduct mortgage interest related to acquiring, constructing or substantially improving a qualified residence, defined as their principal residence and one other qualified dwelling. A residence under construction can be treated as a qualified residence for up to 24 months if, at the time the residence is ready to be occupied, it is a qualified residence (Temp. Regs. Sec. 1.163-10T(p)(5)(i)).

In January 2006, Thomas and Cheryl Rose signed a contract to purchase beachfront property in Fort Myers Beach, Fla., with the condition that prior to closing, the property’s existing house would be demolished. The purchase was financed with a $1.26 million loan, and final closing occurred on March 6, 2006. During 2006, the couple started the permitting process, had the property surveyed and began working with architects, engineers and designers. In 2007, the Roses signed a contract with a construction company, and they received a building permit on Feb. 11, 2008. However, due to a decline in property values, they were unable to obtain additional financing and sold the property for $750,000 in 2009. On their 2006 and 2007 joint tax returns, the couple deducted interest paid on the $1.26 million loan. The IRS disallowed the interest deduction, claiming the property was not under construction. After the IRS assessed deficiencies of $25,574 and $16,556 for 2006 and 2007, respectively, the couple petitioned the Tax Court for relief.

The IRS argued that the term “under construction” should be interpreted as the start of the physical building process, but the court adopted a broader definition encompassing “the entire process of construction and not simply the physical assembly of building materials.” It held the process of construction began when the existing home was demolished, because the Roses, as equitable owners of the property prior to closing, caused the demolition to take place. Also, the court held that all of the couple’s activities that resulted in obtaining a building permit were a necessary part of the construction process, and thus the home was under construction while those activities occurred as well.

Since the Roses sold the property before a residence was ready for occupancy, the IRS also argued it did not become a qualified residence. The court rejected this interpretation of Temp. Regs. Sec. 1.163-10T(p)(5)(i), stating that, although it requires that the residence must be a qualified residence when it is ready for occupancy, it is silent about a situation in which the residence is never ready for occupancy. Since each tax year stands on its own, the Roses’ tax deductions for 2006 and 2007 should be based on the information available in 2006 and 2007, according to the court, and during those years they did not know the residence would not be built.

  Thomas G. Rose and Cheryl G. Rose, T.C. Summ. 2011-117

By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.

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