Mortgage loan modification with capitalized delinquent interest

[appelman]

Are there circumstances under which a taxpayer can deduct delinquent mortgage interest that is capitalized as part of a loan modification?

Evan Appelman, EA

[Maribeth]

If you capitalize interest on a loan modification, you have in effect borrowed additional sums from the lender in order to pay the interest. The interest is paid and may be deductible depending on what type of interest it is.

Maribeth

[David1980]

On the other hand, if this was cancellation of debt income and there was an amount included in the cancellation of debt for interest, the interest would not be deductible but also would not be taxable income.

An interesting question. Obviously they never really paid it, but is it considered paid and added to the cancellation of debt income, which is assumedly being excluded from income with a 982?

I would lean towards not deducting the never paid mortgage interest. Under the reasoning that if it was a foreclosure, they wouldn't have been able to deduct the interest from the COD income.

[appelman]

An interesting analysis.

An interesting analysis. However, I would think that once the delinquent interest has been capitalized, it would no longer be broken out as "interest" on a 1099-A or 1099-C.

Evan Appelman, EA

[BHoffman]

I'll vote for Maribeth's answer. I think the interest was actually paid as soon as it was rolled into the principal balance. If it qualifies in all other ways, I would say it is deductible.

[Snaggletooth]

Example

Not sure I'm certain what it is discussed Johnny Appleseed...
I'll reveal my ignorance, and see if I'm on the right track.

Jimmy and Janine borrow $300,000 on a new home @5%. After paying a couple payments, Jimmy is laid off, and doesn't find work for six months. During this time, payments accumulate to a $22,000 delinquency, of which $15,000 would have been interest.

Prior to foreclosure, Jimmy gets hired making big money at a tax preparation firm (right). With his new salary, the bank decides he qualifies for a new loan. They loan him the $322,000 to cover all accumulated indebtedness and start his payments all over again.
Jimmy makes prompt payments thitherthence. (thitherthence??)

Interest on which of the amounts is now deductible?
a. $300,000 (original loan principle)
b. $307,000 (original plus delinquent loan principle)
c. $315,000 (original plus interest that WOULD have been deductible)
d. $322,000 (total amount of new loan)

[Regardless of your answer, the bank cannot double up the delinquency on the $7000 unpaid principal - The new loan should have only been $315,000] My answer is c.

[David1980]

That makes sense to me. I had an incorrect idea of what a loan modification actually was, the $15k in that example should be deductible.

(Still creates an interesting tax strategy. If you know you're going to lose the home, try to get the bank to perform a loan modification to get the $15k deductible and then allow them to foreclose after. You get an extra $15k deduction you otherwise wouldn't have.)

[Snaggletooth]

Only if you pay

You would have to actually PAY the extra $15K in order to deduct it.

Interest accrued or billed without being actually paid is not deductible.

[David1980]

But that is the essence of this thread, right? If it's capitalized onto the loan, it is considered paid right? Then allow the home to foreclose. $15k deduction for free. Or am I missing something?

[Gretel]

I would think that the interest is deemed to be paid. Since there was no cash flow, maybe the interest needs to be amortized? If treated the same as points then this interest would not be deductible at all.

[Earl]

Capitalized Interest

This compares to Student Loan Interest in that unpaid interest is capitalized into loan. When student makes payment on loan all of the payment is considered first applied to the capitalized interest for purposes of deducting student loan interest. When capitalized interest is completely paid off then only interest applied to original loan is deducted.

However, don't know whether this would apply to the above scenario.

[OtisMozzetti]

recovery of amount of itemized deduction

If a mortgage loan is modified with delinquent interest not paid in cash but just added into the new loan balance, I myself would not consider that an allowable itemized deduction. I wouldn't want to be in the position later of defending that deduction with the IRS.

However, if the interest which is capitalized instead of actually paid were indeed considered an allowable itemized deduction; then if the capitalized interest were subsequently part of a debt which is cancelled, the deducted interest paid would have been recovered and would then have to be included in income. (recovery of an itemized deduction)

[MRPLOW]

I have a client with this exact situation from a loan modification. Been searching for some clarity but have not found any.

1098 from the bank has the interest on it, but taxpayer did not make any payments. The amount due was tacked on to the principal in a loan modification refinanace agreement.

Any clarity on this issue?

[MRPLOW]

Just bringing this message to the top.

[Corduroy Frog]

Clear-Cut Distinction

No authoritative answer from me, but obvious from all the replies above that the answer is totally contingent on whether the delinquent interest is deemed to be "paid" by virtue of its inclusion in a new loan.

My opinion is "no" because of the restrictions on the deductibility of interest even for an accrual basis taxpayer. It is required to be actually PAID.

However, other deductions that are not paid but are wrappable into a loan are in fact considered "paid."

Hope there's more discussion from this, Plowboy. Welcome to the board.