Can I deduct Interest paid toward family loan used to bought my primary resident?

[curious_panda]

Earlier this year my parents lend me $750k to buy a house. From what I read I can deduct interest from my income but do I need to file any documentations for the IRS? A few potential complications

- My parents are not U.S. citizens, and they don't live in the U.S. so they won't be able to report interest income I paid them since they don't file U.S taxes 

- I rent out a portion of my house...I am not sure if this is related.

I just want to be prepare to ensure I have everything I need so I can claim my deduction at the end of the year.

[NCperson]

did you provide them a lien so that the loan is collateralized by the home or was this just a personal loan from your parents? 

[Curious_panda1]

No I did not provide the lien. But I can prove the funds are used to purchase my current primary resident. I also have a loan contract between my parents and I. 

would I need to provide them a lien in order for me to deduct interest from my income? 

[NCperson · Accepted solution]

Bottom of page 3 

https://www.irs.gov/pub/irs-pdf/p936.pdf

You can deduct your home mortgage interest only if your mortgage is a secured debt. A secured debt is one in which you sign an instrument (such as a mortgage, deed of trust, or  land contract) that:
• Makes your ownership in a qualified home security for payment of the debt;
• Provides, in case of default, that your home could satisfy the debt; and
• Is recorded or is otherwise perfected under any state or local law that applies.

debt if you put your home up as collateral to
protect the interests of the lender. If you can't
pay the debt, your home can then serve as payment to the lender to satisfy (pay) the debt. In
this publication, mortgage will refer to secured
debt.

[Curious_panda1]

so if I provide my parents a lien so that the loan is collateralized by the home then I can deduct the interest I paid toward the loand?

Does the fact that my parents are not U.S citizens and don't file US tax return matters in this case?

[Opus 17]

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@Curious_panda1 wrote:

so if I provide my parents a lien so that the loan is collateralized by the home then I can deduct the interest I paid toward the loand?

Does the fact that my parents are not U.S citizens and don't file US tax return matters in this case?

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The loan must be secured by the home.  Usually this means a lien that is recorded against the property in the county clerk's office, or wherever such records are kept in your location.

However, the IRS also follows a doctrine of substance-over-form.  That is, a transaction is judged by its result, rather than the paperwork.  A transaction may be improper if the result is improper, even if the steps to achieve that result are individually legal. 

While you could, on paper, qualify to deduct a loan taken out to buy a home as a qualifying mortgage if you gave your parents a lien and recorded it with the county clerk, if you were audited, the IRS might ask if this was a real lien or only for show.  Would your parents really foreclose and take your house if you couldn't make the payments?

Furthermore, if this is a loan, then your parents are expected to charge you interest, at the applicable federal minimum interest rate (or higher), and they must report this interest as US taxable income, and file a US non-resident tax return to report the interest and pay US income tax on it.  (Interest is taxable US income if the payer is a US person, even if the lender is not a US person).  Even if your parents don't charge interest, they are required to report as taxable income and pay tax on the interest they could have received if they charged the applicable federal rate.

https://www.irs.gov/individuals/international-taxpayers/nonresident-aliens-source-of-income

So, bottom line, if you want to deduct this interest as a qualifying mortgage interest,

a. You must give your parents a lien and record it with the proper authorities where you live (you will need a lawyer for this, probably).

b. Your parents must report the interest as US taxable income and pay US income tax on it (form 104NR).

c. You must be prepared to prove, if audited, that your parents really do intend to foreclose on the home, kick you out, and sell it to someone else, if you stop making payments. 

[Anonymous_]

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@Opus 17 wrote:

....You must be prepared to prove, if audited, that your parents really do intend to foreclose on the home, kick you out, and sell it to someone else, if you stop making payments. 

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To the best of my knowledge, this "requirement" is found nowhere in Section 163, the Regulations promulgated thereunder, or anywhere else in the Code. 

Even assuming there is such a requirement, proof would be almost impossible to provide other than a notarized letter (e.g., affidavit) stating that the lenders really would foreclose if the terms of the loan were violated which, in a very real sense, is a tautology (the recorded mortgage (or security agreement) states exactly the same thing).

[Opus 17]

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@Anonymous_ wrote:

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@Opus 17 wrote:

....You must be prepared to prove, if audited, that your parents really do intend to foreclose on the home, kick you out, and sell it to someone else, if you stop making payments. 

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To the best of my knowledge, this "requirement" is found nowhere in Section 163, the Regulations promulgated thereunder, or anywhere else in the Code. 

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The question is one of substance-over-form, combined with the principle that all deductions are matters of legislative grace and must be proved by the taxpayer.  In other words, if the IRS audits the taxpayer over the interest deduction, the taxpayer is guilty unless they can prove themselves innocent.  

My concern is that, if audited, the IRS could allege that the lien is a sham designed to create an interest deduction.  How could the taxpayer rebut that?  I agree the lien would create a defense, but I'm a pessimist in this situation, and perhaps you are an optimist.  Most taxpayers are never audited, but the risk is there, I think.

The conclusion that this is a sham would be even stronger if the parents don't report US taxable income on a 1040NR.  Of course, if the parents do report taxable interest income, they will probably pay more income tax than the value of the deduction to their child//borrower, so maybe the IRS won't care, as long as the parents pay the tax.  

[Anonymous_]

The language in your post indicates that this scenario presents some sort of criminal liability ("guilty until they can prove themselves innocent") which is simply wrong; the standards and burden here are entirely different.

In the event of an issuance of a notice of deficiency, the Commissioner's position is initially presumed correct, but that presumption is rebuttable. The taxpayer merely needs to present any credible evidence to rebut the presumption and, if the taxpayer does so, the burden would shift back to the Commissioner per Section 7491.

The Commissioner would then have the burden of going forward which would entail producing and presenting evidence to the contrary of that presented by the taxpayer. A bald allegation that the Commissioner is correct at this point would be ineffective to overcome the taxpayer's evidence to the contrary. What might the Commissioner introduce? Simply stating that the Commissioner is still correct would be insufficient to overcome the taxpayer's evidence. Provided the taxpayer has complied with the procedure (written document (lien), perfection thereof, and paying interest at the market rate), the Commissioner's position is now a loser. 

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@Opus 17 wrote:

....I'm a pessimist in this situation, and perhaps you are an optimist. 

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Actually, I am not an optimist, not in the least. However, I do have a formal legal and tax education, hold professional licenses, and have represented taxpayers before the IRS in the past. You, on the other hand, appear to be adept at using internet search engines and rely on information written on various random web sites, with some being reasonably accurate, some being misleading or ambiguous, and some containing information and legal positions that are simply erroneous. Regardless, you have, in the past, misapprehended and misinterpreted the Code and Regs, apparently fail to understand the basics, such as the order of precedence, and use terms, legal and otherwise, incorrectly, to wit:

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@Opus 17 wrote:

The conclusion that this is a sham would be even stronger.........

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There is no "conclusion" here unless and until a court of competent jurisdiction renders a verdict on the issue(s) presented.