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When we were building our house in 2005, we paid to the builder $10,000 in upfront interest for financing our construction loan. We deducted this on our 2005 taxes as Mortgage Interest Deduction. Now we're being queried. Does anyone know if this is, indeed, a real deduction? What documentation do we need to send to the IRS?
You can deduct the points in full in the year they are paid, if all the following requirements are met:
Your loan is secured by your main home (your main home is the one you live in most of the time).
Paying points is an established business practice in your area.
The points paid were not more than the amount generally charged in that area.
You use the cash method of accounting. This means you report income in the year you receive it and deduct expenses in the year you pay them.
The points were not paid for items that usually are separately stated on the settlement sheet such as appraisal fees, inspection fees, title fees, attorney fees, or property taxes.
You provided funds at or before closing, that were at least as much as the points charged, not counting points paid by the seller. You cannot have borrowed the funds from your lender or mortgage broker in order to pay the points.
You use your loan to buy or build your main home.
The points were computed as a percentage of the principal amount of the mortgage, and
The amount is clearly shown on your settlement statement.
If you did not get a 1098, that is ok, but you have to explain it (i.e. a statement or some sort of an indication on who was the recipient of the $10,000)
FYI: Point is interest that is paid ahead of time in – generally – a larger sum than the monthly payment.
The answer to your question can get considerably more involved than you might expect.
First, as a procedural matter... note the IRS runs a document-matching compliance program on all tax returns filed. If you deducted mortgage interest on 2005 Schedule A, Line 10 (Home Mortgage interest and and points reported to you on Form 1098), the program will look to match up amounts reported on that line to amounts reported on Form 1098 as filed by the mortgagee. Banks and mortgage companies routinely file these forms, but a construction outfit may not. If you deducted your interest on this line and no Form 1098 was filed... resulting in a $10k discrepancy between what you deducted and what was reported to the IRS, they WILL query you about the deduction. Had you reported such amount on the next line, line 11, for home mortgage interest not reported on Form 1098, chances are much smaller they would be asking you about a $10k deduction.
Now that they are asking about the deduction, however, you need to read the requirements very carefully... it can get complicated fast. Basically, you can deduct interest you paid during the year on a principal residence or a second home that qualifies as interest paid on acquisition indebtedness or equity indebtedness.
I am not going to go into a big, long discussion on each of these points, but from what you have posted thusfar, I would be most concerned with these points:
1. Was what you paid interest. The Internal Revenue Code ("Code") does not define the word "interest." A general definition has evolved through court decisions that can be concisely stated as follows: "Interest is the amount which one has contracted to pay for the use, forbearance, or detention of money." [Old Colony R.R. Co. v. Comr., 284 U.S. 552 (1932)]. So the question is... was the $10,000 paid for the use of money, or was it for some service the contractor provided? If it was for the use of money, then some reasonable interest rate should be able to be computed based on $10k paid divided by indebtedness and multiplied by number of days debt is outstanding divided by 365. In other words, lenders lend money for a reasonable rate of interest. If, by using the formula, the interest rate comes out unreasonably high (like 20% interest), the IRS will have a pretty good case for saying some of that must have been for other services rendered... or a price adjustment on the cost of the house itself, but not just for the use of the money. Similarly, if the interest rate comes out unreasonably low (like under 5%), the IRS is likely to argue that lenders don't lend for 2% or 3% when they could loan for 7% or 8%.... and, in that case, the whole amount paid may get reclassified as some sort of other cost, but not interest as defined.
2. Next, was the debt secured by the residence? In order to be deducted as mortgage interest, the debt needs to be secured by the house itself. Just a blanket "all assets of the borrower" is not good enough. If the jurisdiction allows for registering the mortgage with the registry of deeds, or whatever, then that should have been done as well. If the builder just charged you $10k for *something* and called it interest and never secured the debt by a mortgage, you're going to have a hard time showing the interest was paid on acquisition indebtedness or equity indebtedness.
3. Construction period interest, btw, will generally be classified as acquisition indebtedness, so I'll assume that's what it would have to qualify as to be deductible.
4. Next, was the property YOURS on which the mortgage interest was paid? If the builder retained title to the property during construction and just charged you "interest" to help cover HIS cost of borrowing, this would not be YOUR interest you paid, but part of the cost of building the home.... title to which you did not have yet. YOu can only deduct interest paid on indebtedness secured by property you OWN and have TITLE to.
5. After getting through all of that, if you still think you have a deduction, then you just need to make sure you're under the indebtedness limits for acquisition indebtedness or equity indebtedness. Basically, you can deduct interest on up to $1 million of acquisition indebtedness. That's TOTAL acquisition indebtedness. So if you're paying interest on a home you're living in during construction, that debt counts, too. And you can count your principal residence and a second home. So if you're building a home, living in a home, and have a vacation home, and have less than $1 million acquisition debt between all 3, you'll count your principal residence (where you normally live) and interest on debt for either the home under construction or the vacation home, but not both.
Thank you, shuke, for taking the time to write all that out, and in layman's language too. Based on what you wrote, we're now thinking that we might as well just pay IRS instead of sending them documentation. At the time, we did NOT own the property. The builder owned the property and he charged us $10,000 to carry the finances until closing. Thank you so much for shedding clarity on the matter.
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