I hope you tax gurus can help with this family scenario…
I just learned that a family member, “Bob” bought a house for his son, “Mike”.
Mike could not qualify for a mortgage because he had a foreclosure and recent divorce on his record. Mike was homeless, so…
Father Bob qualified for the new mortgage and his name only is on the deed. But he let his son, Mike, live there alone, make the payments AND deduct the mortgage interest on Mike’s tax returns.
I heard about this and little red flags started popping up all over my brain.
Now the house is being sold for a profit (southern California) and due to close escrow.
Won’t Bob owe capital gains on Mike’s house?
Won’t the IRS be notified of profit at closing?
Will the IRS be concerned about Mike’s interest deductions on a home he didn’t actually own?
Will the monthly mortgage payment made by Mike be construed as taxable rental income on Bob’s returns should he be audited?
Mike will re-pay Bob the downpayment and accrued downpayment deferred interest after closing. A promissory note is the only written documentation of their intent.
How should this be handled now? Did they really mess up by not having an attorney help them with the transaction? Gulp.
The home mortgage interest deduction on Schedule A can only be taken by the person who is liable for the loan but only if that person actually makes the loan payments. Since only Bob is liable for the loan but Mike actually made the loan payments, it seems that neither is entitled to the home mortgage interest deduction.
At the time of sale a 1099-S should be filed with the IRS.
While it would appear that Mike will owe capital gains on the sale of the house, the presence of a promissory note between Bob and Mike could be construed as an installment sale but whether the IRS actually takes that position is anyone’s guess. While Bob and Mike may have had an agreement that Mike would take the home mortgage interest deduction, it is not really an issue if Mike took the standard deduction instead of itemizing deductions.
I am curious to see Mark Wagner’s take on this situation.
Wouldn’t it be Bob (Dad) who would owe capital gains on the house rather than Mike (son, occupant)?
How is an installment sale beneficial, tax-wise, other than the seller only has to pay capital gain taxes on principal when received…as I understand it.
Yes, the father would owe the capital gains taxes, unless unless the agreement between father and son is construed as an installment sale, If that happens, then I would argue that the son rightfully gets all the home mortgage interest deductions, AND, section 121 capital gain exclusion applies to the son’s profit on the sale.
Sorry, I got mixed up between the father and son. Thanks for the catch.
I let whoever makes the payments take the deduction. Facts and circumstances over form. As long as nobody double dips, usually the IRS doesn’t care.
Since Bob is on the deed, Bob will receive the proceeds from the sale and the capital gain.
One way around this is to have Bob pay Mike “commission” on the sale equal to the capital gain. Title co writes a check to Mike. Bob’s gain is zero. Mike gets a 1099 for commission income. The downside is that Mike will pay ordinary income tax, which is higher than capital gain. Depending on the math, this may not matter much in actual dollars.
I’d also do the math on the installment sale. Just to cover all the bases.
A 1099 may or may not be issued at closing. Some title companies do and some don’t. If there’s no 1099, just treat it as if Mike sold it. But keep damn good records.
Thank you, mcwagner and Dave T for the advice. I believe that those family members were going to check with the IRS for an opinion so that they wouldn’t be caught later with having to pay capital gains, etc.
Now I wonder if it is a good idea or will that flag their tax return?
Ask two different IRS employees and you’re likely to get two completely different answers. Hell, ask the same guy on two different days and get a different answer. And neither of them will match what the regs say. And none of those will match what the auditor says. And nobody will ever put anything in writing.
and THAT’s when I use the super-secret CPA hotline staffed by IRS people who supposedly know what they’re doing.
oh… and now they’re in charge of your healthcare.
and there are no such things as “flags.”
I generally agree with Mark that the IRS probably won’t make an issue over who takes the deduction as long as it is claimed only once. However when you ask the IRS the question, if the IRS person asked the question actually reads the IRS Pub on home mortgage interest deduction, the family member will be told that no one is entitled to the deduction.
The home mortgage interest deduction on Schedule A can only be taken by the person actually liable for the loan and only if that person actually made the loan payments. Contrast this with a business interest deduction on Schedule C where the interest can be deducted by the person actually making the loan payments without regard to who is liable for the loan.