The United States Tax Court has considered whether the Internal Revenue Service (“IRS”) properly denied a taxpayers’ mortgage interest deduction for the period during which the taxpayers prepared the property for construction of a residence.

Thomas and Cheryl Rose (“Taxpayers”) purchased a parcel of land on a Florida beach in 2006.  They planned to construct a vacation house on the property, so the purchase contract required the removal of the house on the property, which was completed prior to closing.  The Taxpayers received a loan of $1,260,000 to help facilitate their purchase.

In order to build a residence on the property, the Taxpayers needed to obtain a construction permit from the Florida Department of Environmental Protection “(“Department”).  The Department’s permitting process had multiple steps because the property was located on the beach, such as demonstrating the property met hurricane and flood standards.  As part of the process, they had to perform numerous tests on the property.  The Taxpayers also began working with various building professionals while they were preparing their permit applications in order to develop the construction and site plans for the property.

In June 2007, the Taxpayers filed their application for a permit.  It took the Taxpayers over a year to gather the necessary information to apply for a permit.  Following the permit submission, the Taxpayers signed a building a contract with a homebuilder.  In September 2007, the Department told the Taxpayers that their application was complete; however, the Department still had additional questions about the application and so the Taxpayers’ construction plan was not approved until February 2008, or almost two full years after they purchased the property. 

Due to the collapse of the financial and real estate markets in 2008, the Taxpayers were not able to obtain a loan to complete their purchase and so eventually sold the property for a loss in 2009 without ever building the planned vacation home.

The Taxpayers filed joint tax returns in 2006 and 2007, and they deducted a total of $160,000 in mortgage interest for those two years from the loan for the purchase of the vacation property.  The IRS disallowed the deductions, determining that the Taxpayers did not qualify for the deduction because the Taxpayers had never completed the construction of the home.  The Taxpayers appealed.

The United State Tax Court ruled in favor of the Taxpayers and allowed them to take the mortgage interest deduction.  The tax code allows a taxpayer to deduct mortgage interest from a qualified residence.    A “qualified residence” is either the taxpayer’s principal residence or another residence selected by the taxpayer for the taxable year that is also used as a residence.  In order for the second residence to qualify for the deduction, it must be used for the greater of either 14 days or 10 percent of the number of days during the taxable year for which the unit is rented at a fair market value.  However, if the unit is not rented, then it may be treated as a residence qualified for the mortgage interest deduction.

The Taxpayers never completed the construction of the vacation home, but had taken steps over the two year period to prepare for constructing the home by creating a building plan and applying for permits.  In addition, they had caused the removal of the prior residence on the property.  Previous cases have disallowed deductions for vacant lots, but have allowed deductions of mortgage interest during the construction phase of a home for a 24-month period. 

Looking at the facts, the court found that the Taxpayers’ efforts to receive the necessary permits qualified the residence as being under construction and so entitled them to the mortgage interest deduction.  The court rejected the IRS’s arguments that the deduction should be disallowed because construction was never completed, stating that the court examines each tax year individually and so it is irrelevant what happened in later years.  Therefore, the court ruled that the Taxpayers were entitled to claim the mortgage interest for those two years.

Rose v. Comm’r, 15061-10S, 2011 WL 4582434 (T.C. Oct. 4, 2011).   [This is a citation to a Westlaw document.  Westlaw is a subscription, online legal research service.  If an official reporter citation should become available for this case, the citation will be updated to reflect this information].

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