March 5, 2015

The Qui Van Phan Tax Court Case: Favorable Outcome for Mortgage Interest Paid

By Stephen Gilman - Partner, Tax & Business Services

The Qui Van Phan Tax Court Case: Favorable Outcome for Mortgage Interest Paid

A recent small tax court case had a favorable outcome for the taxpayer. In this case, the taxpayer was able to deduct home mortgage interest paid during a year in which he neither owned the home, nor was he listed as liable on the mortgage debt.

Home mortgage interest is deductible if it is qualified residence interest. A “qualified residence” is the taxpayers’ principal residence, and one other residence (second home.) Qualified residence interest includes interest on up to $1 million of acquisition indebtedness. This is interest incurred in acquiring, constructing, or improving a qualified residence and is secured by that residence. Qualified residence interest also includes home equity indebtedness which is any indebtedness other than acquisition indebte­­dness, secured by the qualified residence. The limit on home equity indebtedness is $100,000. There are further limitations for married filing separate taxpayers.

The background of the Qui Van Phan case is as follows:

  1. In 2008, the taxpayer moved into a house in California to help his mother who was unable to care for property.
  2. Phan lived in the property from 2008 to 2010 during at which time his mother was in process of divorcing his father who had moved out prior to 2008.
  3. As a result of the divorce settlement, Phan’s mother paid his father for his interest in the property and she became the sole owner.
  4. In 2011, Phan’s sister and sister-in-law refinanced the mortgage loan for the property. Taxpayer was unable to obtain financing at that time, but entered into an oral agreement with mother and siblings that he would pay mortgage loan and property taxes and these payments would increase his equity in the home.
  5. In 2013, Phan’s name was added to the legal title to the property which was previously titled to his parents and brother.
  6. Since 2010, Phan paid the monthly mortgage payments from his own bank account, and deducted $35,880 in home mortgage interest.  The mortgage was not in the taxpayer’s name.
  7. In April, 2013, Phan received notice of deficiency disallowing the home mortgage interest deduction and an accuracy-related penalty was imposed.

In order to treat interest as “qualified residence interest”, the indebtedness generally must be an obligation of the taxpayer, and not an obligation of another. However, there is a rule within the Internal Revenue Regulations which provides that even if a taxpayer is not directly liable on a bond or note secured by a mortgage, the taxpayer may deduct the interest paid if the taxpayer is the legal or equitable owner of the property subject to the mortgage.

Under California law, an individual can be considered an equitable owner by showing there is an agreement or understanding with the parties evidencing an intent which is different than the deed.
Since Phan had an oral agreement with his family, in addition to paying all the home expenses while living in the home and then ultimately being added to the deed, the Tax Court held that he was treated as being an equitable owner, and therefore, allowed to deduct the home mortgage interest.

Although this case had a favorable outcome for the taxpayer, it cannot be relied upon as precedent for any other case, however, it does allow us to revisit the rules on what constitutes qualified residence interest.

This is an interesting and favorable case. If you have question about mortgage interest, contact your Marcum Tax professional.