Mortgage Interest Deductible

In Rose v. Commissioner, TC Summary Opinion 2011-117, the Tax Court ruled that homeowners were entitled to mortgage interest deductions for a house under construction.

Background

In 2005 the taxpayers began looking for property along the Florida coastline to build a vacation home. The Roses entered into a contract in January 2006 which provided that the existing house would be torn down before closing. The taxpayers intended to build a new house on the lot.

To facilitate the purchase of the property the Roses took out a mortgage. The couple closed on the property in March 2006 when the previously existing house had been demolished, and the property consisted of vacant land.

In order to build a new house on the property, the taxpayers were required to obtain a construction permit from the Florida Department of Environmental Protection. Among other requirements, the process required that applicants exhibit the proposed building met hurricane and flood standards. After a lengthy process, the department ultimately granted the construction permit in February 2008, almost two years from the date the property was purchased.

By 2008 the residential real estate market in Florida had significantly changed. In order for the taxpayers to proceed with their construction plans, an additional bank loan was needed to cover construction costs. Due to the change in market conditions, the Roses were unable to secure financing that would allow them to proceed with their plans. Therefore, the couple sold the property for a loss in June 2009. The IRS claimed the mortgage interest expense deducted on the 2006 and 2007 tax returns was not qualified residence interest, and therefore disallowed the deductions.

Ruling

For taxpayers other than a corporation, a deduction is not allowed for personal interest except for qualified residence interest. This type of interest is any interest that is paid or accrued during the tax year on acquisition debt or home equity debt. Acquisition debt is debt secured by a qualified residence, and incurred in acquiring, constructing or substantially improving the qualified residence. A qualified residence is the principal residence of the taxpayer, and one other residence selected by the taxpayer which is used as a residence.

Under Treasury regulations regarding qualified residence interest, a taxpayer may treat a residence that is under construction as a qualified residence for a period of up to 24 months, if the residence becomes a qualified residence at the time it is ready for occupancy.

The court decided the case based upon the interpretation of under construction which is not defined in the statute or the regulations. The Roses contended that the term is broad enough to include permit application, doing prepatory measures and drawing up plans for construction. The IRS contended the term should be more narrowly defined as requiring a physical building process to begin.

The court ruled that extensive work and planning had been undertaken by the Roses in engaging multiple building and design professionals. Therefore the property was under construction as a residence in 2006 and 2007, and the mortgage interest on the acquisition was accordingly deductible.