Wednesday, March 06, 2013

ADDING ACCRUED INTEREST TO PRINCIPAL BALANCE DOES NOT GENERATE A DEDUCTION

Cash basis taxpayers may deduct “qualified residence interest” when paid. Qualified resident interest is generally interest on a loan taken out to purchase a qualified residence, or to refinance it within certain dollar limits.

In a recent Tax Court case, a taxpayer accrued interest on his home mortgage. Per an adjustment clause under the mortgage a portion of the interest was paid, and a portion was added to the principal of the mortgage. The taxpayer deducted all of the accrued mortgage interest, including the portion that was not paid but was added to the mortgage. The IRS contested the deduction for the capitalized portion of the interest.

The Tax Court ruled for the IRS. Other precedent provides that the delivery of a promissory note to satisfy an interest obligation is not payment of the interest obligation. The reasoning for such a rule is that the note may never be paid, and if it is not paid, the taxpayer has not parted with anything (other than his or her promise to pay). Unable to distinguish that situation from adding interest to the principal amount of a mortgage, the Court held the capitalized interest amount was not deductible.

Philip C. Smoker, TC Memo 2013-56

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