Cash-basis Taxpayers Must Pay Mortgage Interest to Deduct It

December 3, 2014

The US Tax Court denied taxpayers a deduction for mortgage interest that was capitalized into part of the principal of their new loan.

The mortgage interest was never actually paid in the year at issue.

This case involved Charles and Arlene Copeland (Charles Copeland and Arlene Copeland v. Commissioner, US Tax Court, T.C. Memo 2014-226, Oct. 30,2014). They purchased a residential property in Yucaipa, Calif., in 1991 for $334,000. They have occupied this property as their main home since 1991.

In 2007, the Copelands refinanced this property.

Due to some financial issues, the Copelands reworked the loan again in 2010. Bank of America agreed to reduce the interest rate, change the payment terms and increase the loan balance.

The bank agreed to roll $30,273 of past-due interest and $14,405 of taxes, insurance and service charges into the new loan balance. The outstanding loan balance increased from $579,275 before these adjustments to $623,953 after them.

Bank of America had sent the Copelands a Form 1098, Mortgage Interest Statement, in 2010 for $9,253. This was the amount of interest the bank had received during the year on the Yucaipa property.

The Copelands had claimed a mortgage interest deduction on their 1040 return of $48,078. This amount represented the $9,253 of mortgage interest that was actually paid to the bank plus most of the past-due amounts that were rolled into the new loan.

After some back and forth with the IRS, the Copelands agreed that the amount at dispute was the $30,273 that represented past-due interest rolled into the new balance of the loan. They included the past-due taxes and insurance in the amount they had originally claimed as a deduction.

The Copelands agreed with the IRS that the past-due taxes and insurance were not a valid mortgage interest deduction.

The problem with including the $30,273 of mortgage interest as part of their mortgage interest deduction was that this amount of interest was actually never paid. Most individuals are cash-basis taxpayers, so to deduct an item on their tax return, they actually had to have paid it.

Unfortunately for the Copelands, a lot of case law deals with this issue. “It is well settled that a cash-basis taxpayer pays interest only when he ‘pays’ cash or its equivalent to his lender” is a statement resulting from a number of different court cases.

The signing of a new promissory note does not satisfy an interest obligation without discharging or paying the note. A promise to pay is not the same thing as paying the note. A lot of case law also deals with this issue.

Having past-due interest added onto the balance of a new loan is not looked at in the court’s eyes as paying the interest. For this reason, the taxpayers are able to deduct only the $9,253 as mortgage interest.