Help - Land Mortgage - Built Residence - Deductible?

[LivinInUSA]

I can't find a straight answer. Since another thread here was as close to an answer as I've found, I thought I'd discuss.

So, I buy unimproved land with a Rural Land Site Loan (stating intention to build a home in the future). I immediately build a cabin on the land within 3-4 months and move there as my primary residence. I have the intention of building an even bigger home in a few years and rolling it all into a standard mortgage, but until I begin construction on the bigger home, is the interest on the land site loan considered deductible? I am living there, but the loan is not originally "secured" by the residence. Please help. Thanks.

P.S. I called the IRS "hotline" to see what they said, and the guy said the loan was secured by the land and not the house, but he didn't really sound like he knew what he was talking about. He was just reading off a form.

[Luis Mopeo]

That's an interesting question. There might not be a direct answer to your specific situation in tax authority.

I'd say yes, interest on the land is deductible if you build a house on it and the house is your primary residence (assuming the land isn't so vast as to pose a question of whether it's all used as your primary residence). Here's why.

The confusion comes from the intermingling of the terms "residence" and "property." IRC section 163(h)(3) allows a deduction for personal interest for a qualified residence. Section 163(h)(4) defines a qualified residence as "the principal residence (within the meaning of section 121) of the taxpayer..."

Section 121 uses the term "property" in relation to a residence, using the phrase "such property has been owned and used by the taxpayer as the taxpayer's principal residence..."

In more conventional situations, land is included as part of the "principal residence" for purposes of the mortgage interest deduction. There is no provision that says the land is not part of the principal residence.

There are provisions that allow for exclusion of gain from the sale of land adjacent to a principal residence even if the land is broken up in to parcels and sold at different times. The land is considered part of the principal residence and is not excluded from consideration because there isn't a house on it.

Opinion is probably the best you're going to do with this question, and my opinion is that the land under your house is part of the residence. Interest on the land would be interest on a principal residence, and would be treated no differently than interest on the structure. Home mortgage interest, deductible.

[sea-tax]

I would say that the interest is not deductible in regards to sch a home mortgage interest. However you may be able to deduct it under investment interest if all standards are met.

I will concede that I have never heard of a Rural Land Site Loan, therefore I may be wrong.
Let us see what others have to say.

[LivinInUSA]

Thank you. I feel like it SHOULD be, since I couldn't have built the house if not for the money for the land mortgage, and it is my primary residence. The land cost me about what 2 lots would cost, even though it is more acres than normal (80 acres). However, the way the rules are written are indeed confusing.

So, what happens if I deduct the interest, and then the IRS decides to disagree with me. What happens?

[Luis Mopeo]

So, what happens if I deduct the interest, and then the IRS decides to disagree with me. What happens?

That's the practical question. The deduction could be a flag, since it likely will not come on a standard 1098 mortgage interest form. You'd deduct it on Schedule A specifically as "not reported on Form 1098." Just keep in mind that how it's reported shouldn't (theoretically) determine the true nature of the transaction.

It's a calculated risk that you may have to argue with some IRS agent down the line. The thought of that gives lots of people the heebie geebies (including some of the tax preparers I know). My approach would be to deduct it if you reasonably believe it's deductible. Just because a front-line revenue agent might try to disallow it isn't the end of the world. If you do get audited, you have the choice of how far to go to fight it. There's always appeals and even tax court.

I know lots of folks won't take a tax benefit even if they believe it's reasonable because they don't want to get a letter to come downtown to discuss it. That gives me the heebie geebies. It's easy to make a return "audit proof," in fact that's what the IRS would love to have everybody do. Guess who comes out ahead on an audit-proof return.

If you get audited, RULE NUMBER ONE. DO NOT GO TO AN AUDIT WITHOUT REPRESENTATION. You'll get rolled if you do that.

What happens? You set up a meeting with an agent, who will probably be polite and respectful, not an ogre (but don't fool yourself into thinking their job is to protect your rights). If the revenue agent doesn't like the deduction, he or she will say so. Hopefully you and/or your representative have substantial authority to argue your side of the issue. If the revenue agent doesn't buy it, you can talk to a supervisor, go to appeals, or even take it to court. If you decide at some point it's not worth it, they'll write an audit report that refigures your tax and adds some interest and maybe some underpayment penalty amounts. Unless the amount is substantial, there shouldn't be huge damage financially. No water torture, no harrassment, just a bill if you don't win out.

I'm just saying look at the merits of your position and make the decision based on that. Don't make your decision based on being intimidated by the IRS or fear of what a revenue agent might think off the top of his or her head.

[Corduroy Frog]

Too Much Land

Too much land for ALL of this loan to be deductible if you are Livin'inUSA.. What do you intend to do with the land that is NOT your residence? (Remember, if your answer is "nothing" then that is STILL an answer).

Depending on the "lay of the land" I would take maybe 10 acres max as my residence. This is a subjective number, but I seriously doubt more than 10 acres would be mowed and/or secluded as part of your house and lot.

In your case, if you bought 80 acres with borrowed money, and used some of the borrowed money to build a residence, then your part of the interest deductible would be:
1) Funds used to build the residence, plus
2) 1/8 of the remaining funds deemed to be funds spent on the land.
All of this would be divided by the total loan principle.

If the above calculation is, for example, 45%, then 45% of your annual interest would be deductible on Schedule A. It follows that 55% of the interest would attach to the remaining 70 acres of land. It's possible that the 55% could also be deductible, depending upon how the land was used. If not used in a farm or business operation, it probably would qualify for a deduction as "investment interest", Form 4952. The 55% is another discussion, so I'll stop there.

You don't have to have a 1098 to deduct mortgage interest on a Schedule A, but it will be helpful if you receive one from the lending agency. If they used the land for collateral, they are supposed to give you one.

You did ask what would happen if the IRS didn't agree with you. You find a tax practitioner.

[Bees Knees]

There is no limit on acres that define a principal residence. Nothing in the code says how much land you need, or how much land is too much. You could buy the 800 acres in Central Park, NY, and live on a park bench, and as long as that is your principal residence, the interest is deductible.

[erchess]

Hmmmm

My parents live on 40 acres of mountainside in an old log cabin. The land is mostly too steep to use for anything except forest land. There is a naturally flat area that once housed a barn but it was torn down before I was born because it was in bad shape and the caretaker's mules died and were not replaced. There is a garage that will eventually meet a similar fate. And aside from the cabin there is about two acres of grass that we keep mowed. We do a selective timbering of the wooded area every ten years or so. I do my parents' returns and I do claim their mortgage interest. (The place was inherited and there has never been a forest service survey of its value. My parents still don't understand why I refuse to claim any basis in the timber.)

However, Bees please tell me that you don't really mean that a park bench can be a residence. A residence has always had to have some sort of cooking, sanitary, and sleeping facilities. Has something changed?

[Bees Knees]

However, Bees please tell me that you don't really mean that a park bench can be a residence. A residence has always had to have some sort of cooking, sanitary, and sleeping facilities. Has something changed?

Well, generally yes,, but in NYC, people who live on park benches use them for all that other stuff too.


just kidding....

[Corduroy Frog]

Disagree

There is no limit on acres that define a principal residence. Nothing in the code says how much land you need, or how much land is too much.

Here is a rare disagreement with the Bees. He is correct that there is no limit specified. But many times the code and regulations are silent on an issue because IRS does not want to create a "safe harbor." My knowledge of clients and others is that IRS examiners will always attempt to restrict the gain on residence if there is a substantial amount of acreage sold with it.

But I think Bees is correct with respect to the original question. Mortgage interest is still mortgage interest, and deductible to the extent of basis and the $1MM cap -- without bounds of whether the personal residence is limited or not.

[LivinInUSA]

Thanks all for sharing your knowledge. I guess until something exactly like this is taken to court and the court decides, then there will never be a clear answer. I think I will get a form 1098. I will also call the mortgage company after I get it built, and make sure that the cabin is put up as collateral on the loan (they know it's there). Again, thanks all, you've been a big help.

[jainen]

Courts HAVE answered this question

>>until something exactly like this is taken to court and the court decides, then there will never be a clear answer<<

Courts HAVE answered this question from time to time. You have to go all the way back to 1961 to find a court accepting even as much as 65 acres. More recently (TC Memo 1997-37) 43 acres was allowed on the principle that a residence can include land used for "“appreciating nature, living in open spaces, hiking, horseback riding, and enjoying unobstructed views of the countryside.” The parcel in question was larger but the court ruled the rest of it was NOT used as a home.

It's a matter facts and circumstances, but 80 acres is such a large area that I doubt you could show it is ALL actually used as a home.

EDIT: Obviously Section 121 is not that old and these rulings are about a similar question under Section 1034. It is a mistake to think that there can not be a clear answer "until something exactly like this is taken to court."

As for the land loan, I have no problem with it being qualified home acquisition debt (to the extent of the home acreage). If the bank forecloses on the property it won't leave the cabin behind!

[Bees Knees]

Again, I stand by my statement. Even 800 Acres would work.

The key is, what are you doing with it? Obviously if you are farming some of it as a business, that won't cut it. But if you have 80 million acres you use as your principal residence with no other investment or business tied to it, there is nothing in the code that says its too big. Its a facts and circumstances thing.

Having said that, yes, the IRS would probably say 79.9 million of those 80 million acres are being used for investment purposes and not as your principal residence.

[LivinInUSA]

Thanks for the court info. 25 acres is pasture, and yes we bought it just for the view. The other 55 is wooded and would be used for recreational purposes (hunting, horse riding, etc.).

I really never thought of there being a problem with the pretty cheap 80 acres. My main question was just whether a land mortgage would be deductible if you built a home on it out of pocket within 3-4 months of closing on the loan, even though the loan wasn't originally "secured by the home".

[Corduroy Frog]

Mortgage Interest

Let me revisit what I said about having to prorate the interest deduction in proportion to the land value.

I do not believe all of this property is your principle residence, and am confident some sort of split would be proper should you sell this property. However, mortgage interest is mortgage interest, and people do claim mortgage interest on properties that are not their principle residence -- and it is quite common. People deduct mortgage on lake houses, condos, second houses, adjoining land, etc. very commonly on Schedule A, and NONE of the foregoing would be their principle residence.

I believe you have the right to claim all of it by special rules which allow the deduction on Schedule A as long as the principle does not exceed basis or $1MM limitation.

However, you may wish to explore 4952, as I believe the non-residence portion would qualify for this. On the surface, this may not appear attractive but you may wish to consult a tax practitioner. There are situations where you may want to roll the deduction into years where you have higher income, or you may want to deduct interest that does not phase out with higher income levels. This is where a tax man or lady can help.