Many of us have taken out a home loan. It is not uncommon for individuals to loan money to relatives to help them buy a home. In those situations, it is also not uncommon for a loan to be undocumented or documented with an unsecured note. The unintended result is that the home buyer cannot claim a tax deduction for the home loan interest paid on the loan given by their helpful relative.
The tax code describes qualified residence interest as interest paid or accrued during the tax year. This is on acquisition indebtedness or home equity indebtedness with respect to any qualified residence of the taxpayer. It also provides that the term “acquisition indebtedness” means any indebtedness that is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by such residence. There are also limits on the amount of debt and number of qualified residences that a taxpayer may have for purposes of claiming a home mortgage interest tax deduction. For the purchase of this article, those details are not covered. This article focuses on the requirement that the debt be secured.
Secured debt means a debt that is on the security of any instrument. These include a mortgage, deed of trust, or land contract:
- that makes the interest of the debtor in the qualified residence-specific security of the payment of the debt,
- under which, in the event of default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated, and
- that is recorded, where permitted, or is otherwise perfected in accordance with applicable state law.
In other words, the home is put up as collateral to protect the interest of the lender.
Thus, interest paid on undocumented loans, or documented but unsecured notes, is not deductible by the borrower. Yet it is fully taxable to the lending individual. The IRS is always skeptical of family transactions. Do not get trapped in this type of situation. Take the time to have a note drawn up and recorded or perfected in accordance with state law.
Do you have questions about Home Loan Interest?
If you have questions related to this situation or other issues related to the deduction of home mortgage interest, please give call our office at 781-849-7200.