The Tax Court upheld the IRS’s denial of a mortgage interest deduction under Sec. 163(a), holding that the taxpayer did not show that he was a legal or equitable owner of the property or that the property was his qualified residence.
Facts: Hrach Shilgevorkyan and his two brothers, Edvard and Artur, immigrated to the United States from Armenia in the 1980s. In the United States, the brothers co-owned several businesses, including Shilgevorkyan LLC, which owned and rented condominiums in Phoenix.
In 2005, Edvard purchased property in Paradise Valley, Ariz., for $1,525,000, partly by securing a bank loan from Wells Fargo for $1,143,750. The borrowers on this loan were Edvard and his wife, Lusine. At approximately the same time, they obtained a $1.2 million loan, also secured by the Paradise Valley property, to construct a house and a guesthouse on the property. In 2006, Edvard, Lusine, and Artur consolidated the loans by securing a “temporary bridge financing” agreement with Wells Fargo. In 2008, the consolidated loan was refinanced with a new $2 million loan from Wells Fargo. In 2010, Artur executed a quitclaim deed, for which he was not compensated, purportedly conveying his interest in the Paradise Valley property to Hrach.
Hrach lived in the separate guesthouse on the Paradise Valley property from September 2010 until he purchased a new house in April 2013 in Phoenix. However, he also stayed at the condominiums, which were used by other family members. Prior to living in the guesthouse on the Paradise Valley property, Hrach lived with Edvard’s in-laws.
During the tax year in question, 2012, Hrach paid cable and electricity bills associated with the condominiums and renewed his driver’s license, listing the guesthouse as his address. From 2010 to 2013, he received numerous third-party information returns, of which the majority listed his address as that of his brother’s in-laws and only one, in 2013, listed the Paradise Valley property as his address. He purchased a home in Phoenix in 2013 and used his new home’s address on his 2012 return.
On his 2012 individual income tax return, Hrach attached Schedule A, Itemized Deductions, which included a deduction of $66,354 as mortgage interest expense on the Paradise Valley property. This constituted half of the total interest associated with the property that was reported by Wells Fargo on Form 1098, Mortgage Interest Statement, issued to Edvard and Lusine.
The IRS examined Hrach’s 2012 return, disallowed the deduction for mortgage interest on the Paradise Valley property, and determined a deficiency of $22,867, along with a $4,573 accuracy-related penalty, which it later conceded he was not liable for. Hrach petitioned the Tax Court for a redetermination.
Issues: The question before the Tax Court was whether the interest on the Paradise Valley property was deductible qualified residence interest. Although Sec. 163(a) permits a deduction for all interest paid or accrued within the tax year on indebtedness, Sec. 163(h)(1) disallows any deduction by individual taxpayers for personal interest. However, personal interest excludes “qualified residence interest” (Sec. 163(h)(2)(D)).
The Tax Court reasoned that for Hrach to be entitled to the qualified residence interest deduction, he would need to meet three requirements: (1) The indebtedness must be his obligation; (2) he must be either the legal or equitable owner of the property subject to the mortgage; and (3) the residence must be his qualified residence (Secs. 163(a) and 163(h)(2)(D); see also Regs. Sec. 1.163-1(b)).
The Tax Court first considered whether the indebtedness was Hrach’s obligation. Hrach did not produce any evidence showing he made any mortgage payments to Wells Fargo or to his brother Edvard. Additionally, there was no record of Wells Fargo having issued Hrach a Form 1098 for the alleged payments. Edvard testified that there was an agreement between him and Hrach for Hrach to pay half of the Paradise Valley property expenses in exchange for half of the profits when the property was sold. Hrach, however, was unable to provide any documentary evidence in support of the purported agreement. Despite that, the court assumed for the sake of argument that Hrach was partially obligated to make payments on the loan.
Next, the Tax Court examined legal or equitable ownership of the property. Hrach argued that the quitclaim deed executed by his brother Artur showed that he had an interest in the property. State law determines property rights, while federal law determines the federal tax consequences, the court stated, citing National Bank of Commerce, 472 U.S. 713 (1985), and Blanche, T.C. Memo. 2001-63, aff’d, 33 F. App’x 704 (5th Cir. 2002). As a result, the court concluded that Arizona law applied to the question of Hrach’s property rights.
Under Arizona law, a quitclaim deed cannot convey greater property rights than those of the grantor, the court stated, citing SWC Baseline & Crimson Invs., LLC v. Augusta Ranch Ltd. Partnership, 265 P.3d 1070 (Ariz. Ct. App. 2011). Thus, the question was whether Artur had any property rights to transfer to Hrach.
Arizona law also provides for the existence of an accommodation party when a single instrument is signed by both a primary obligor who receives the benefit of the instrument and by a secondary obligor (the accommodation party) who does not receive the benefit. An accommodation party, if it makes payment on an instrument, can seek reimbursement from the primary obligor but does not have a right to the underlying property.
Based on the testimony, the Tax Court found that Artur was an accommodation party, as opposed to an owner, of the Paradise Valley property. Accordingly, the court found Artur did not have a legal interest in the Paradise Valley property to transfer to Hrach, and because the quitclaim deed could convey no greater interest than any Artur had in the property, Hrach was not an owner of the property. The court also determined that Hrach did not have equitable title to the property because he did not pay any consideration for the deed and there was no evidence he was liable for payments on the loan on the property or credible evidence that he paid expenses of the property or that he bore its benefits or burdens.
The Tax Court then considered whether the guesthouse that Hrach was living in constituted his qualified residence. Sec. 163(h)(4)(A)(i) defines “qualified residence” by reference to Sec. 121, which governs the exclusion of gain from the sale of a principal residence. Regs. Sec. 1.121-1(b)(1) specifies that whether property is used for purposes of Sec. 121 as a taxpayer’s principal residence depends upon all the facts and circumstances.
The Tax Court concluded that Hrach failed to meet the burden of substantiating that the guesthouse was his principal residence. The court came to this conclusion for a number of reasons, including that Hrach had mail sent to multiple addresses; the tax information returns issued to him listed his brother’s in-laws’ address; he did not list the Paradise Valley property on his bank statements or personal checks; he admitted to staying at and paying for certain utilities for the family’s condominiums; and the record did not establish how much time during 2012 he spent at either the guesthouse or condominiums. Finally, although Sec. 163(h)(4)(A)(i)(II) allows taxpayers to select one “other residence” in addition to the principal residence for the purpose of determining a qualified residence, the court found Hrach had failed to designate the guesthouse as his “other residence.”
Holding: The Tax Court found that Hrach failed to show that the guesthouse was his qualified residence or that he was the property’s legal or equitable owner. As a result, the $66,354 mortgage interest was not qualified residence interest, and he could not take the mortgage interest deduction for it that he claimed on his 2012 Schedule A.
■ Shilgevorkyan, T.C. Memo. 2023-12
— John McKinley, CPA, CGMA, J.D., LL.M., is a professor of the practice in accounting and taxation in the SC Johnson College of Business, and Matthew Geiszler, Ph.D., is a lecturer in accounting in the College of Human Ecology, both at Cornell University in Ithaca, N.Y.To comment on this column, contact Paul Bonner, the JofA’s tax editor.