It is not uncommon for individuals to loan money to relatives to help them buy a home. In those situations, it is also not uncommon for a loan to be undocumented or documented with an unsecured note, and the unintended result that the homebuyer can’t claim a tax deduction for the interest paid to their helpful relative. The tax code describes qualified residence interest as interest paid or accrued during the tax year on acquisition indebtedness or home equity indebtedness with respect to any qualified residence of the taxpayer. It also provides that the term "acquisition indebtedness" means any indebtedness that is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by such residence.
There are also limits on the amount of debt and number of qualified residences that a taxpayer may have for purposes of claiming a home mortgage interest tax deduction, but those details are not covered in this article, which focuses on the requirement that the debt be secured.
Secured debt means a debt that is on the security of any instrument (such as a mortgage, deed of trust, or land contract):
(i) that makes the interest of the debtor in the qualified residence-specific security of the payment of the debt,
(ii) under which, in the event of default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated, and
(iii) that is recorded, where permitted, or is otherwise perfected in accordance with applicable state law.
In other words, the home is put up as collateral to protect the interest of the lender.
Thus, interest paid on undocumented loans, or documented but unsecured notes, is not deductible by the borrower but is fully taxable to the lending individual. The IRS is always skeptical of family transactions. Don’t get trapped in this type of situation.
Take the time to have a note drawn up and recorded or perfected in accordance with state law. In California it’s pretty easy. You can usually have the note created and recorded by escrow and/or title companies and they’re very inexpensive.
Finally, the terms of the note between family members should be at arm’s length, what a non-related lender would offer/provide to the borrower. For example, if the going mortgage interest rate based on the borrower’s credit score, down payment and finances is 5% but the family member is charging 2%, there could be a tax issue. This is beyond the scope of this article.
The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.
David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him at firstname.lastname@example.org or visit www.saacpa.com or www.SilkRoadRealtyInc.com. Thank you.