Real Estate - Interest on Construction Loan paid by Builder - I reimburse prior to possess

[hamulcahy]

Builder wanted me to do a construction to perm loan and I said no. This is a spec home he has built many times in a subdivision, so not a custom home. He wants me to reimburse him for the interest he will pay on the construction loan. He wrote it as a change order (Financing) - Payable prior to possession - financing costs payable to builder. My question is, do I need him to supply me with a 1098 to make this tax deductible to me on my taxes next year when I pay him and take possession of the home? He is financing with a local bank and he will get a 1098. I am not sure if the amount he is asking me to pay will even match the 1098, but that will be in his name anyways. Hoping someone can help answer how I need to handle this. If I pay for the financing cost, he shouldn’t get to deduct it.

[rjs]

Just my opinion, with no special expertise:

You didn't take out a loan, and you are not paying any interest, so you have no deduction for interest. The change order just increases the total price that you pay for the home. The additional amount is included in your cost basis. The fact that the builder intends it to cover his financing cost is irrelevant.

The builder cannot give you a 1098 because he did not make a loan to you and you are not paying interest to him.

There is nothing for you to report on your tax return for the year that you purchase the home.

Other people may have different opinions.

[Opus 17]

Whatever you pay him is the price for the house, it doesn't matter how he calculates it.  It's not tax deductible to you because it is not a mortgage in your name that you are obligated to pay.  Whatever you pay for the house is your cost basis, and paying a higher cost will reduce your taxable capital gains when you sell.  But this is not a tax deduction for you.  

And he does get to deduct it as business expense, because he is paying for it.

Think about a new car.  The sticker price is $35,000 and the dealer will sell it to you for $33,000.  What you don't know, because it happens behind the curtain, is that the dealer paid the factory $30,000 for the car, but the dealer borrowed the money and is paying $300 per month interest to the bank until they sell the car. That's why dealers are often ready to make a deal at the end of the month (before the next interest payment) and why they often make better deals on cars that have been sitting on the lot a long time (because the interest is adding up).  But you don't pay $30,000 for the car plus $900 for interest plus $2100 dealer profit, you just pay $33,000 and that's your cost.

So with your house, you are buying a house for an agreed price.  It makes no difference to you how much the builder paid for wood, cement, nails, shingles, pipes, wires, or labor.  It also makes no difference to you how much money the builder borrowed or what his interest rate was.  Normally, you never even see those details, you just agree on a price.  Here, the builder seems to have found a tactic to persuade you to pay a higher price.  But it doesn't matter what the tactic was, all that matters is that you will pay some agreed on final price for the house and that is your price.  You are not the loan borrower, and you are not the owner of the property at the time the interest is being paid, so this is not a deductible expense for you.  It's just part of the overall price of the house and it doesn't matter how that price was added up. 

[hamulcahy]

Thanks for your input. He has written a separate change order saying that I am paying him outside the purchase price of the house for reimbursing him for the interest he is paying for the construction loan. I thought since it is separate and he has written it as such, that it would be deductible to me. I keep getting conflicting information. I already asked a real estate tax accountant who said the way it was written and not included in purchase price as clearly states it is for interest on construction loan it was deductible. Now I am not sure what to believe.

[rjs]

The builder can't change the tax laws. As a general rule, it doesn't matter what he calls it. What matters is the actual substance of the transaction.

I suggest that you consult a tax lawyer (not accountant). If the lawyer says you can deduct it as mortgage interest, ask for a written opinion so that you have solid backup if the IRS questions it. And keep in mind that if you deduct it now, you cannot include it in your basis. It's one or the other.

[Opus 17]

I agree.  No matter that the builder wrote it as two documents, you are paying one price for the home, not interest and a lower price for the home.

I will concede there is room for a clever attorney -- there almost always is.  But I still don't think it's enough.  Mortgage interest is deductible if you are the "legal or beneficial owner" of the home, and you are the person who actually pays the interest.  (Technically, you don't have to be the borrower on the note.)  There are still 3 objections to this theory.

1. You would have to pay the interest directly to the bank, not to the builder.

2. A beneficial owner is someone who has the responsibilities and benefits of ownership without being on the title.   I previously reviewed 2 Tax Court cases on the topic.  In one case, brother A bought a house for his brother B to live in, because B was a recent immigrant with no credit history.  B lived in the home with his family, paid all the bills, performed all maintenance and chores common of homeowners, and planned to put the home in his own name when he had credit and could get a loan.  B was allowed to deduct the mortgage interest even though A's name was on the title.  In the other case, C was an elderly man who invited his adult son D to move in with him.  D paid all the bills, performed all maintenance and chores common of homeowners, and planned to inherit the home when his father died.  The court allowed D to deduct the mortgage interest even though the loan was in C's name.

Here, however, the builder owns title, and is still building the home.  You don't live there, and you have none of the burdens or benefits of home ownership.  I don't think you are a beneficial owner.

3. A construction loan is not a deductible mortgage unless it is converted to a mortgage when the home is completed.  Here that can't happen, since the borrowers would be different people.   You can't convert the construction loan in the builder's name to a mortgage in your name, you have to get a new loan (assuming you even get a loan).  So it's not a mortgage, even if you somehow meet the beneficial owner rule and pay the bank directly.

[hamulcahy]

Thanks for your comment. I should have prefaced that my attorney is both real estate and a tax attorney (CPA). My attorney wrote me a 6 page written opinion citing legal cases that support me being able to deduct, since I am reimbursing him for the cost. Thanks again.

yes, thanks again for comment about deducting now and cost basis. Appreciate all the help!