View Full Version : Allocation of Interest, Schedule A or F ?
05-31-2007, 05:33 PM
Scenario:Taxpayer purchases a farm including principal residence, farm
buildings and land. Obtains a first and second mortgage on the property
Total financing: 1st: $800,000, 2nd: $200,000 just within the
1,000,000 limits. Then refinances 2nd of $200,000 and replaces with a
2nd of $350,000. Pays off some personal debt with cash from proceeds
of new 2nd and then purchases approx $100K in business assets. I'm
trying to allocate interest.
Can the taxpayer prorate interest between schedule A and C based on
assets purchased on either of these loans? I've always allocated
interest on mixed use loans but some reading of Pub 535 and other
information has led me to question the legitimacy of the allocation.
From 535 "If the property that secures the loan is your home, you
generally do not allocate the loan proceeds or the related interest.
The interest is usually deductible as qualified home mortgage
interest, regardless of how the loan proceeds are used. For more
information, see Publication 936." Pub 936 goes on to deal with
mortgages exceeding 936 and allocating them.
If this property were sold it wouldn't all be eligible for the principal residence election, is it therefore correct to allocate all the interest to the principal residence? In this case isn't the property that secures the loan the taxpayers principal residence AND farm property?
For 2006 the average loans secured by the residence do not exceed the
$1,000,000 limit (this was all done in the fall). I've run through the
tables in pub 936 and unless I'm doing something wrong it appears that
all the interest will need to go on Schedule A.
05-31-2007, 06:22 PM
In cases where no line is drawn between home and farm land with buildings, I find it very helpful to request info with details of number of acres on farm and size of residence lot.
This gives me a visual so I know what to ask next.
If TP bought 20 acres of poor soil with 2 old shelters and a huge 6 bedroom home fit for a king - I would agree - Sch A.
However, if TP bought 400 acres of good land for $3,000 per acre and a modest home on a one half acre lot - I would get a signed release from TP, allowing me to speak to lender and gather appraisal info and how lender handled the loan. You may also need to request USDA Farm Service acreage reports (to show actual farm property). Actually the TP should know. If the farm land has a higher FMV than residence (at time of loan), you could use those percentages to prorate the interest.
Unless the residence has a separate deed and is recorded separately, I doubt the lender could keep from placing a lien on the home. I don't think you should keep that from a proper proration for the mortgage interest deduction.
I hope this helps.
Jeannie Allen EA
05-31-2007, 07:35 PM
Yes that's what I try to do. In this case it's really a mixed bag. Very well maintained buildings, taxpayer is converting to riding stable, constructing indoor arena, using pasture etc.
Per appraisal at least 50% of the value is in the land and farm buildings. Homestead while nice is over 150 years old.
I have always prorated the interest because I doubt on the way out if the IRS would let the taxpayer treat all as principal residence so it would seem contrary to say the interest must be deducted on Schedule A and not prorated.
I will continue with my ways unless someone comes up with something that shows that this interpretation is in error.
05-31-2007, 09:22 PM
Farm or business interest nearly always provides a stronger deduction. (i.e. lower taxes than Sch A interest). Someone may cite regulations which prove me wrong, but I believe the $1MM ceiling applies to residence only, so if you have a 50% allocation, the ceiling was never really approached.
The passage from Pub 535 is not realistic in cases of business loans, and I don't believe practitioners treat proceeds used for business the same as residential interest. Usually when someone takes exception with the Pubs, another board member will want to send them to the electric chair, so expect someone else to post and portray me as giving you bad direction.
In order to split hairs, you have to understand the plight of farmers/businessmen who apply for bank loans to use in their business operation. Even though the funds are used for business, the bank is not interested in that kind of collateral. They want hard collateral, such as a house, land, etc. They are not willing to take wheat futures, business inventory, prepaid advertising or anything else they can't securely convert into cash. So the borrower is forced to put up their house or land for collateral, and this therefore becomes a "mortgage secured by home" even though the funds are used differently. I believe this interest is properly reported as a deduction on Schedule F, Schedule C, or Schedule E.
Deductibility as business interest, however, implies there is a business operation. If this land is lying fallow during ownership, there is no operation, and the interest never leaves the Schedule A, and you're back is again against the wall with respect to limits.
However, one observation you made in your initial question may come back to haunt you.
If this is later sold, and only 50% of the value is for personal residence, I believe half of the sale should be reported as farmland - possibly on a schedule D or 4797 - maybe even section 1252 if there has been work done on the land. Furthermore, I believe if your client has been deducting half the interest against a farm operation, then the IRS has a prima facia case that half of the value is NOT personal residence. They might prevail even if interest has never been taken on a schedule F or even if the land was never used for a farm during ownership.
06-02-2007, 02:39 PM
If all the interest of a property is deemed to be Schedule A interest because of Pub 535 -then would the taxpayer be eligible to claim principal residence election on the the entire property upon eventual disposition?
This client in particular only has a small acreage with improved farm buildings. Value of land/farm buildings is equal to 50% of purchase price.
I see two options:
a) Say the whole property is personal property, claim interest and property taxes on Schedule A. Do not depreciate the buildings as this is personal. On the eventual sale claim the entire property as principal residence.
b) Allocate 50% of the interest to Schedule F, and depreciate the buildings. On eventual sale include portion attributable to farm as 4797/Schedule D income.
So which one do you think is correct?
06-02-2007, 07:50 PM
Does he sell farm products? Or Christmas Trees? Or Hay? This means he has a farm operation whether he treats the interest as personal or not.
I would say with 50% of the value non-residential, I don't believe he has the option of calling all of this property his personal residence if he sells it. It follows that if he files a farm operation, he no longer has 100% of his value as a residence. The reverse, however, is NOT necessarily true. If he does not file a farm operation, then it does NOT necessarily follow that 100% of his value IS a residence.
Equinecpa, this is just the way I see it. I hope others will post and give you a balanced opinion. Your client does not need to be blindsided with incorrect ideas about what happens if he sells.
06-03-2007, 09:55 AM
This is just one of those cases that is not cut and dry. The business is actually a riding school - which I'm actually reporting on Schedule C ( I asked about F because that's probably the more common scenario).
The client has since added more improvements to the property such as an indoor arena, outside arena, barn improvements etc.
Argument for treating property personally: Potential for principal residence exemption on eventual sale, less expenses reported on Schedule C so more likely to be a profitable endeavor (being a horse operation will be subject to hobby loss scrutiny). Note is secured by whole property so supports this action. I think the taxpayer would be safe in arguing that they purchased this property and since they had the facilities to run a business, do so. Insurance policy is currently one policy covering the whole property, not a separate business policy.
Arguments against treating as personal: Facts are assets will be used in a business. Lose depreciation on buildings, can't claim interest on business schedule. Potential additional SE taxes. If the business is not profitable lose the potential argument for capital appreciation on assets (which can be a BIG argument).
In the past I've always gone with the latter but I just got to thinking on this one and reading the pubs etc...and now I'm not so sure.
06-03-2007, 11:50 AM
Equine, while you're researching, you may want to look at "depreciable" doctrine.
Essentially forces depreciation recapture for amounts "depreciated or depreciable." Assumes depreciation if taxpayer was "entitled to the depreciation," whether he actually takes the depreciation or not...