Interest Deductions When Interest Added to Principal Balance

A cash basis taxpayer owes interest and principal to a lender on a home mortgage loan. The taxpayer goes to another lender, borrows additional money against the residence, and uses the loan proceeds to pay off the accrued interest on the first loan. Such an interest payment should be deductible (assuming the interest is otherwise deductible under the Code).

Now look at a similar factual situation. Here, the taxpayer does not borrow money from a new lender, but modifies his existing loan with the existing lender to add the accrued interest to the principal balance. When such accrued interest is eliminated via an increased principal loan balance, can the taxpayer likewise treat that as a deductible interest payment?

Notwithstanding that the taxpayer is in a similar economic situation in both circumstances, the Tax Court has ruled that no interest deduction is allowed in the second circumstance. This is based on the settled principle that a cash basis taxpayer can deduct interest only when paid, and the delivery of a promissory note to satisfy an interest obligation is not treated as payment. In the second circumstance, “the borrower is able to postpone paying the interest until some time in the future, over the life of the loan or as part of a balloon payment at maturity...No money changed hands; petitioners simply promised to pay the past-due interest, along with the rest of the principal, at a later date.”

So while the economics of these two situations is similar, sometimes form over substance matters!

Copeland, TC Memo 2014-226