joelgilb Posted December 15, 2007 Report Share Posted December 15, 2007 I have a client that wants to refinance her home to get rid of a Jumbo loan and convert to a standard mortgage with better rates. To this she will need to borrow money from her father and have him put a second on the house. In order to get the funds to lend my client (his daughter), father will need to borrow the money against his home to lend to his daughter. I am trying to see if anyone has any thoughts on how to structure this so that the income from loan to daughter can be offset wit the loan from the bank/mortgage company. Problem I see is that the interest from the loan on dad's house is a schedule A itemized deduction and will most likely not fully offset the schedule B interest income from daughter. Anyone have any thoughts? Thanks Joel Quote Link to comment Share on other sites More sharing options...
RJM Posted December 16, 2007 Report Share Posted December 16, 2007 You can elect to have the dad's mortgage interest expense be reclassed as investment interest expense. Then will be deductible 100%. Quote Link to comment Share on other sites More sharing options...
joelgilb Posted December 18, 2007 Author Report Share Posted December 18, 2007 Won't investment interest also flow through to the schedule a? And if on sched a, I still have the same problem, his standard deduction will wipe out at least a portion of the deduction. Or will the election let me run it through the Schedule E? And if so, do I still show the interest income on schedule B or on schedule E to offset? Joel Quote Link to comment Share on other sites More sharing options...
RJM Posted December 18, 2007 Report Share Posted December 18, 2007 My understanding is that investment interest is one of several Sch A deductions which is excluded from the itemized deduction limitation calculation. Medical and Casualty Loss are also excluded. So, you get 100% of the deduction. I think the place to put the interest income is Sch B. Quote Link to comment Share on other sites More sharing options...
OldJack Posted December 18, 2007 Report Share Posted December 18, 2007 My understanding is that investment interest is one of several Sch A deductions which is excluded from the itemized deduction limitation calculation. Medical and Casualty Loss are also excluded. So, you get 100% of the deduction. I think the place to put the interest income is Sch B. I don't believe you could classify this mortgage interest as investment interest excludable from the limitation since the loan does not qualify as a "buying investment property". For a recap of what is investment property read 2006 Quickfinder 1040, page 5-7 and 5-8. Quote Link to comment Share on other sites More sharing options...
joelgilb Posted December 18, 2007 Author Report Share Posted December 18, 2007 First I agree that OldJack is correct and I can't call this investment interest even with an election. Also, RJM, there is no question that the interest income must be on schedule B, that is where it has to go. As for avoiding the limitation, maybe I did not make myself clear. Father is someone that has taken the standard deduction in past years. Even if he can now itemize due to the interest on this loan, he will lose some of the benefits of the interest deduction as to get benefit from itemized deductions, it has to be more than his standard deduction. Now I do think in my case he will be over, but the increased itemized deduction over the standard will not give him a full offset to the schedule B interest income he has to pick up. I had hoped there was a way to use something like a schedule E to take the interest expense deduction, rather than schedule A. Although I guess I am really stretching here. Maybe there is no alternative and this is just the result though. Anyway. Thanks for the ideas. Joel Quote Link to comment Share on other sites More sharing options...
jainen Posted December 18, 2007 Report Share Posted December 18, 2007 >>the interest from the loan on dad's house is a schedule A itemized deduction and will most likely not fully offset the schedule B interest income from daughter.<< That would only be true if she paid the interest to him and he paid the bank. Why not have the daughter co-sign and list her home as additional security on the father's loan? Then the daughter can pay that mortgage directly and report the interest on her own Schedule A. Quote Link to comment Share on other sites More sharing options...
joelgilb Posted December 18, 2007 Author Report Share Posted December 18, 2007 >>the interest from the loan on dad's house is a schedule A itemized deduction and will most likely not fully offset the schedule B interest income from daughter.<< That would only be true if she paid the interest to him and he paid the bank. Why not have the daughter co-sign and list her home as additional security on the father's loan? Then the daughter can pay that mortgage directly and report the interest on her own Schedule A. Not sure if they will b able to do that , but it does seem like the best way to do this. Thx Joel Quote Link to comment Share on other sites More sharing options...
RJM Posted December 18, 2007 Report Share Posted December 18, 2007 Jainen, I like your very creative solution ! Old Jack, in Pub 550 investment property is defined as: "Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business." So, the interest on the investment in a mortgage security qualifies. It is directly comparable to margin interest on a securities account. I know this to be true because I have 2 clients who have done the interest election under Regs S 1.163-10T(o)(5) for several years, with full disclosure of the tax treatment in attached statements. -Bob Quote Link to comment Share on other sites More sharing options...
jainen Posted December 18, 2007 Report Share Posted December 18, 2007 >>property that produces interest<< I would consider treating daughter's payments as investment interest, but I'm not comfortable with it because of the substance-over-form doctrine, specifically the question of economic substance. If the father is simply passing the money through at the same rate as he is paying, there is no true investment. I don't have a ready citation, but it is such a general principle that I'm sure it can be backed up. It might be expressed as a below-market or gift loan, since the market rate for the daughter's second mortgage would not equal the father's first mortgage terms. Which of course is the very reason why they are doing this! Quote Link to comment Share on other sites More sharing options...
OldJack Posted December 18, 2007 Report Share Posted December 18, 2007 >>It is directly comparable to margin interest on a securities account<< I disagree that father could have investment interest. Father may not even qualify for mortgage interest expense (or may be limited) since the mortgage proceeds he took out was not used for improvements to his owned home. The margin interest is investment interest because it is based upon actual ownership of investment property in the account. This loan to his daughter is a "personal loan" and it is not an investment loan; he has no investment property attributes; or even an underlying investment property for his personal loan. 2006 Quickfinder Handbook, page 5-8, lists interest expense that is not included in investment interest: 1) Qualified residence interest 2) Interest expense from a passive activity 3) Interest expense that is capitalized 4) Interest expense related to tax-exempt interest income and 5) interest expense on life insurance policy loans. I expect you would have trouble getting past item #1 and/or item #2. Quote Link to comment Share on other sites More sharing options...
RJM Posted December 18, 2007 Report Share Posted December 18, 2007 Jainen, since individuals can get around the jumbo rate bumps by splitting their mortgages into 2 separate mortgage loans, I believe there is no substance over form issue with respect to a bargain interest rate on the father's loan to the daughter. This of course assumes that the father's loan to the daughter is at a market interest rate. Family mortgage arrangements are not uncommon in my experience, and I have never seen a problem with deductibility from the IRS. Old Jack, investing in mortgages is one of the oldest forms of fixed income investment, and the tax treatment I believe is quite settled and common. The loan to the daughter is a securities investment, and the mortgage borrowing on the father's part is debt incurred for investment purposes. There is no issue with deductibility of mortgage interest by the father, because he elects to treat the mortgage borrowing as investment borrowing per Section 1.163-10T(o)(5). The fact that the collateral for the father's loan is his home, has nothing to do with the tax treatment. Rather, the tax code imputes deductibility of a loan to the use of the proceeds. Mortgage borrowing is ordinarily presumed to support either acquisition, improvement, or home equity debt, except when specifically exempted under 1.163-10T as the proceeds are applied to a different use. Quote Link to comment Share on other sites More sharing options...
OldJack Posted December 18, 2007 Report Share Posted December 18, 2007 >>Old Jack, investing in mortgages is one of the oldest forms of fixed income investment, and the tax treatment I believe is quite settled and common.<< Under your opinion there is no such thing as a personal loan to a related party. Quote Link to comment Share on other sites More sharing options...
jainen Posted December 18, 2007 Report Share Posted December 18, 2007 >>Family mortgage arrangements are not uncommon in my experience, and I have never seen a problem with deductibility from the IRS.<< I agree there is no problem with the daughter deducting her interest payments (provided, of course, that her second mortgage can be construed as replacing acquisition debt). The problem is the father's deduction. He can NOT elect "to treat the mortgage borrowing as investment borrowing per Section 1.163-10T(o)(5)." The election is only to not treat it as qualified home equity debt. Facts & circumstances determine whether it is investment borrowing. Since (I assume) he is not trying to make any money off the loan to his daughter, the fact is that he is not investing in anything in this circumstance. He is simply using his equity temporarily for a personal purpose. What you call "one of the oldest forms of fixed income investment" does not apply because he has no expectation of net income. Quote Link to comment Share on other sites More sharing options...
lbbwest Posted December 18, 2007 Report Share Posted December 18, 2007 >>Old Jack, investing in mortgages is one of the oldest forms of fixed income investment, and the tax treatment I believe is quite settled and common.<< Under your opinion there is no such thing as a personal loan to a related party. It's amazing...hours, days, weeks, months can go by and I still almost always agree with "Old Jack" Substance over form differentiates tax law from State law; original poster stated taxpayer wanted to refinance his home so that his daughter could get a "better interest rate" In my never humble opinion refinancing one's own home to allow one's child to use the equity to obtain a better interest rate is not an investment, but up here in the far North newfangled ideas don't get to us much. lbb Quote Link to comment Share on other sites More sharing options...
OldJack Posted December 19, 2007 Report Share Posted December 19, 2007 >>almost always agree with "Old Jack"<< Obviously I just happen to post before you as you are always right. LOL Quote Link to comment Share on other sites More sharing options...
joelgilb Posted December 19, 2007 Author Report Share Posted December 19, 2007 Looks to me like both Old Jack and lbbwest are right and lbbwest, that is exactly what I had asked! Joel Quote Link to comment Share on other sites More sharing options...
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