Real Deductions for an Imaginary Beach House

Originally Published on forbes.com on October 7th,2011

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In the good old days, you could pretty much deduct any interest that you paid as long as you did not use the proceeds to buy tax free bonds.  Then came the Tax Reform Act of 1986 (25th birthday coming up on October 22).  In exchange for lower rates some deductions had to go.  Interest expense was one of the things affected.  Although the Act did make some things simpler it made interest deductions much more complex.  Interest has to be classified first of all by a tracing rule.  The tracing rule, which has some really complicated regulations, will have you divide your interest expense into trade or business, investment interest, interest associated with passive activities and personal interest.  The first three are deductible subject to limitations and the last is not deductible at all.  It does not matter what is securing the debt, it matters how the debt proceeds trace.  Then there is residence interest.  Interest on home equity indebtedness up to a loanbalance of  $100,000 is debt secured by a personal residence.  It is deductible as an itemized deduction (Alternatively you could deduct that interest based on how the proceeds traced).  Finally there is residence acquisition indebtedness.  That is deductible as an itemized deduction up to a loan balance of $1,000,000.  It must be spent on acquiring a residence and secured by that residence.

What about  the interest expense that you incur while you are building your dream house ?  That can be deducted as residence acquisition interest for up to 24 months provided that you actually use the house as your residence.  The case of Thomas and Cheryl Rose raises an interesting question.  What happens to your deductions, if the dream turns into a nightmare from which you wake up screaming ? Here is the story:

In late 2005 petitioners began searching for property along the Florida coastline upon which they could build a vacation house. In January 2006 petitioners entered into a contract for the purchase of beachfront property in Fort Myers Beach, Florida, for $1,575,000 (property). At the time that petitioners entered into the contract there was an existing house on the property. Petitioners purchased the property in order to build a new house on the lot and not because they intended to make use of the existing house. The purchase contract provided that the existing house would be torn down and completely removed from the property before the closing date.

Petitioners borrowed $1,260,000 from Fifth Third Mortgage Co. to facilitate their purchase of the property. The loan was secured bya mortgage on the property. On March 6, 2006, the parties closed on the purchase of the property. At the time of closing, the demolition work had been completed and the property consisted of a vacant lot.

Building a beach house involves a lot of permitting and preparatory work:

In order to build a new house on the property, petitioners were required to obtain a construction permit from the Florida Department of Environmental Protection (department). The department requires thecompletion of a lengthy permitting process whenever someone seeks to build on beachfront property. The process requires that applicants exhibit that the proposed building meets hurricane and flood standards, among other requirements. As part of this lengthy process, petitioners were required to submit numerous items to the department, including detailed survey work and core drilling samples. During 2006 after the existing house had been demolished, petitioners had the required survey work done and core samples taken. Additionally, during 2006 petitioners began working with a team of building professionals that included architects, engineers, and designers. That work continued during the time petitioners were readying their permit application.

As John Lennon said “Life is what happens, while you are busy making plans.”  Life in this case was the Florida real estate market, which around this time went on sale.  (According to my friend Daryl Carter of Maury L Carter and Associates in Orlando, the state is still on sale by the way).  So when the Roses went for construction financing for the fully permitted fully planned dream beach house, they found:

…. the residential real estate market in Florida had changed significantly between the time that petitioners purchased the property and the date on which the construction permit was granted. Due to the realities of a constrained credit market, petitioners were unable to secure financing that would allow them to proceed with the completion of their plan to build a residence on the property.

In 2009 the Roses sold the property taking an $850,000 loss.  They had deducted about $170,000 of residence interest in 2006 and 2007.  The IRS essentially said “What residence ?” and assessed them a little over $40,000.  They petitioned the Tax Court which framed the issues as follows:

The issues we must decide are: (1) Whether the residence was “under construction” during the taxable years at issue, and, if so, (2) whether the fact that events occurred after the taxable years in issue that prevented the completion of construction of a qualified residence should disqualify the interest deduction for prior years.

The Court found for the taxpayers on both issues.  On the issue of “under construction”:

The record indicates that in early 2006 petitioners purchased the property and caused the demolition of the existing house. Although the house was leveled and the lot was cleared before petitioners received legal title to the property in March 2006, the work would not have occurred had petitioners not bargained for it in the purchase and sale agreement. For all practical purposes, petitioners were responsible for the demolition work, and it came about as a direct result of their purchasing the property. The fact that petitioners did not hold legal title to the property at the time that the work occurred does not negate its relevance to our inquiry, especially given the real property laws of the State of Florida.  At the time the actual demolition and cleanup work took place with respect to the property, petitioners were possessors of equitable title. As such, petitioners were the beneficial owners of the property when the demolition of the existing house took place. Therefore, we find that by causing an entire house to be demolished and by clearing the lot so that it would be suitable for a new residence, petitioners undertook significant steps in the process of constructing their vacation house, as early as January 2006. Such steps have been recognized as the beginning of construction

It is interesting to not that if this were a profit making construction project, the IRS and the taxpayer would have switched sides since “construction period interest” has to be capitalized.  I think the IRS might have shot themselves in the foot if they had won this case, although arguably those are different regulations. (Also it is a Summary Opinion, which limits its value as precedent).

On the second issue the Court referred to the principle that each tax year stands on its own and that there is now way that the taxpayer could have known in 2006 and 2007 that the residence would never be completed:

 In evaluating each year on its own, it would be impossible for petitioners or the Internal Revenue Service to have known that the proposed residence would never become ready for occupancy.  The appropriateness of the deductions petitioners claimed should be evaluated on the basis of the facts and circumstances as they existed in 2006 and 2007. Events beyond petitioners’ control occurred in subsequent years and prevented petitioners from completing a residence