Expenses & Deductions
The Tax Court held that the taxpayers were not entitled to take an investment interest deduction for any of the mortgage interest they paid on property they had purchased because they failed to substantiate their claimed allocation of the mortgage debt.
John Norman, a real estate broker who lived in Alexandria, Va., decided to purchase a house to use as a personal residence in his hometown of Warrenton, Va. Norman found a suitable house in the old town area of Warrenton that was located on 9.875 acres (the Yorkshire property). However, Norman only wished to purchase the house and some of the land. Initially, the owners of the Yorkshire property were interested in selling the home and three acres and developing and subdividing the rest of the land in conjunction with an adjoining parcel (the Yonder Lea property). According to Mr. Norman, one of the owners of the Yorkshire property said they would sell Norman the house and three acres of the land for $1 million.
The owners later decided that they would only sell the entire property to Norman and offered it to him for $1.8 million. After making some financial analyses, Norman decided he could purchase the entire property and recover the additional $800,000 by developing part of the land himself. On May 4, 2005, Norman and his wife settled on the Yorkshire property for $1.8 million with the intent to develop about seven acres.
At the closing, the Normans executed a credit line deed of trust note, whereby they agreed to pay “the principal sum” of $2,310,000 plus interest at a stated rate, and the bank agreed to make “a loan in the principal amount” of $2,310,000. Of this amount, the Normans and the IRS agreed that $1,760,000 was for the acquisition of the Yorkshire property (the house plus the 9.875 acres) and the remaining $550,000 was for renovation costs anticipated for the house. Security for the loan included the Yorkshire property as well as the Normans’ existing Alexandria residence, which they had listed for sale.
On July 13, 2005, the Normans closed on the sale of their Alexandria residence, applying $462,000 of the proceeds as a partial payoff of the mortgage loan on the Yorkshire property. As of that date, the bank had advanced the Normans $326,635 to cover renovation costs. They subsequently took additional draws against the line of credit to cover additional renovation costs; the draws for renovation costs ultimately totaled $549,761. The Normans moved into the Yorkshire house in August 2005 after completing renovations. On Oct. 17, 2006, having made certain payments on the Yorkshire property loan in addition to the payoff resulting from the sale of their Alexandria residence, the Normans refinanced their mortgage for a new principal amount of $1,860,000.
On June 15, 2005, the Normans also entered into an agreement to purchase the Yonder Lea property. After entering the agreement, Mr. Norman made preliminary efforts to begin developing the Yonder Lea and Yorkshire properties, including attempts to obtain necessary permits from the city. However, during the ensuing year, it became apparent that it would be difficult to obtain the permits, leading Mr. Norman to reconsider his plan. In July 2006, the purchase agreement for the Yonder Lea property was released.
At this point, Mr. Norman considered several other options, including transferring the development rights to the Yorkshire property, granting a conservation easement on it, or donating part of the property to Warrenton. The Normans ultimately did not take any of these actions.
The Normans’ Tax Returns
On their 2005 joint federal income tax return, the Normans claimed an $88,507 home mortgage interest deduction with respect to the Yorkshire property. They reported no net investment income and claimed no investment interest deduction. On their 2006 joint return, they claimed an $85,174 home mortgage interest deduction and a $17,951 investment interest deduction with respect to the Yorkshire property.
The IRS determined that for 2005 the Normans’ home mortgage interest deduction was limited to $42,673, the amount paid with respect to $1.1 million of indebtedness. It further determined that for 2006 the Normans were entitled to a home mortgage interest deduction of $86,816 (slightly more than the Normans claimed on their 2006 return) for interest paid on $1.1 million of indebtedness. The IRS disallowed the investment interest deduction that the Normans had claimed for 2006.
The Normans challenged the IRS’s determination in Tax Court. They claimed that $1 million of the loan on the Yorkshire property was attributable to the house on it and three acres of the land, which was their personal residence, and that $800,000 of it was attributable to the rest of the land, which was investment property. Consequently, the interest on $800,000 of the loan was deductible as qualified investment interest. The IRS argued that while the Normans could deduct interest paid on $1.1 million of the mortgage loan as acquisition indebtedness and home equity indebtedness, they could not deduct the rest of the interest. According to the IRS, the Normans could not allocate any part of the mortgage to investment property because they did not actually subdivide the property or use it for any business purpose under Sec. 280A. The IRS further contended that even if the Normans were not legally precluded from allocating part of their mortgage to investment property, they nevertheless had failed to substantiate their claimed allocation.
The Tax Court’s Decision
The Tax Court held that the Normans were not entitled to an investment interest deduction because it found that they failed to substantiate the claimed allocation of the mortgage debt between debt on residential property and debt on investment property or provide any evidentiary basis to support the allocation. In making its decision, the Tax Court considered whether the purchase agreement and mortgage loan for the property supported the Normans’ claims.
The Tax Court first looked at the purchase agreement for the Yorkshire property and the circumstances that led to the final agreement. It pointed out that the purchase agreement made no allocation of the purchase price and that the Normans based their allocation on the owners’ original tentative offer to sell the Normans the home and three acres separately for $1 million. Even assuming that the owners made this offer, the court stated, it did not amount to a meeting of the minds that resulted in a definite agreement, and the owners’ subsequent conduct supported this conclusion. Also, the offer was only an offer, and the owners had subsequently revoked it. Furthermore, the eventual purchase agreement for the house contained terms and restrictions not contemplated in the initial offer. Thus, the Tax Court determined that the initial offer did not provide an adequate basis for allocating the mortgage debt.
The Tax Court also pointed to the lack of any other evidence supporting the values on which the Normans predicated their allocation of the mortgage debt. The Normans had not provided any expert testimony to support the valuations. The court also found that the geographic division of the Yorkshire property between residential property and investment property remained unclear due to the different plans that John Norman had developed over time, making an accurate valuation difficult.
Finally, the Tax Court considered the mortgage loan, draws and payments the Normans made on it, and its refinancing. The court pointed out that the original loan was a single line of credit made in part for acquisition costs and in part for renovation costs for the house. The Normans argued that the part of the loan for renovation costs was a separate loan tied to the sale of their house in Alexandria, which was extinguished when the house was sold and the proceeds from the sale were used as a partial mortgage payoff, and should be disregarded. The court disagreed, stating that the evidence showed that the partial payoff applied to the entire loan and not to a separate subloan. The court also noted that when the Normans refinanced the loan, it became new acquisition debt, and any allocation of it must take into account the value-enhancing renovations to the house, which was security for the refinanced loan. The court stated, “[i]n deciding what portion, if any, of the acquisition indebtedness should be allocated to investment property, we cannot simply ignore, as petitioners [the Normans] would seem to have us to do, the extensive renovations to the house, the various draws and repayments on the note, and the ultimate refinancing of the note” (Norman at *25–*26).
For all these reasons, the Tax Court found that the Normans had failed to substantiate their allocation of the mortgage debt. Because the Normans had failed to substantiate the allocation, the court found that it was not necessary to determine whether they were precluded from allocating any part of the mortgage to investment property because they did not actually subdivide the property or use it for any business purpose under Sec. 280A.
The taxpayers might well have been able to prevail on the substantiation issue if they had provided credible expert testimony regarding the allocation of the mortgage debt. Practitioners should warn clients who are determined to take their case to court that while vague evidence or self-serving testimony will rarely be found adequate to substantiate the value of property or an allocation based on the value of property, the testimony of a credible expert often will.
Norman, T.C. Memo. 2012-360