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Mortgage Expense

GENERAL REQUIREMENTS REGARDING DEDUCTIBILITY OF INTEREST

(a) INTEREST DEFINED

A payment must be interest to be deductible as interest. The case law
defines interest as the amount that one has contracted to pay for the use,
forbearance, or detention of money. It is not necessary for a payment
to actually be called interest to be treated as interest, nor does
labeling a payment as interest make it so. See Court Holding Co. v.
Commissioner, 2 T.C. 531 (1943). If a payment is, in fact, for the use or
forbearance of money, it qualifies as interest. It is also not necessary
for interest to be stated as a specific percentage of the sum loaned or
computed at a rigid, stated rate, as long as the sum is definitely
ascertainable.

Thus, for example, payments of "dividends" on preferred stock were treated
as interest when the stock was issued to avoid usury laws, required fixed
dividend payments regardless of corporate earnings, and was redeemable at
par on a fixed date. Arthur R. Jones Syndicate v. Commissioner, 23 F.2d
833 (7th Cir. 1927). On the other hand, payments of "interest" on an
indenture were not treated as interest because in substance they
represented principal payments on the loan.

In Rev. Rul. 69-290, 1971-1 C.B. 55, a lender charged an annual premium
charge of one-half of one percent for granting a loan (in addition to
stated interest). Because the borrower had separately and fully
compensated the lender for its services for the loan, the IRS ruled that
the premium charge was compensation for the use or forbearance of money
and qualified as interest.

Payments made to compensate a lender for services performed in connection
with a loan do not qualify as interest. Rev. Rul. 69-189, 1969-1 C.B. 55.
Charges made for closing costs are not for the use or forbearance of
money and hence are not interest.  Interest also does not include
separate charges made for investigating a prospective borrower, any
security for a loan, closing costs of the loan and papers drawn in
connection therewith, or fees paid to a third party for servicing and
collecting a particular loan. However, the amount of a "service charge"
intended to raise the lender's yield on a low interest loan and unrelated
to the value of any services provided by the lender was treated as
interest. Blitzer v. United States, 684 F.2d 874 (Ct. Cl. 1982).

Points, loan origination fees, and loan processing fees are interest if
paid solely for the use or forbearance of money, and not as a charge for
services. Similarly, a bank charge of 2 percent for each cash advance
and 1 percent for each new check and overdraft advance are interest, even
though interest is also charged directly, unless the charges are for
services and not for the use of the money. Rev. Rul. 77-417, 1977-2 C.B.
60.

A payment for the use or forbearance of money is interest, even where
excessive (Dorzback v. Collison, 195 F.2d 69 (3d Cir. 1952)) or usurious.
A prepayment penalty, a penalty for paying off an obligation before
its due date, also is interest.


(b) VALID, EXISTING INDEBTEDNESS REQUIRED

(b)(1) In general

Code Section 163(a) permits a deduction for interest paid "on
indebtedness." The term "indebtedness" implies an existing,
unconditional, and legally enforceable obligation to pay. State law is
controlling on the issue of whether a debt is legally enforceable. A
taxpayer proves the existence of valid indebtedness by means of notes,
other written evidence of indebtedness, books and records, and the
testimony of interested parties. Bernstein v. Commissioner, T.C. Memo.
1975-253.

There are several factors to consider in determining whether a valid
indebtedness has been created: whether the parties intended to create a
debt obligation, the presence or absence of bona fide negotiated
terms, whether any payments of principal have been made, and
whether any effort has been made to enforce the obligation. For
example, no debt existed where a taxpayer had originally made a personal
loan to a friend to help him with the operation of his automobile
dealership. Shortly thereafter, when the friend requested additional
loans, the taxpayer was given a controlling interest in the dealerships.
The dealerships were not held merely as security because no promissory
notes were given, no maturity dates were fixed, and any repayment depended
upon the success of the dealerships. Personal liability or the lack
thereof is not a factor. For example, a non-recourse purchase-money
obligation is treated as valid indebtedness if the value of the property
equals or exceeds the amount of the debt. Reg. Section 1.163-1(b).


If an indebtedness is contingent on the occurrence of an event and the
event does not occur, there is no valid indebtedness. A valid
indebtedness only arises after the occurrence of the contingency.
Guardian Inv. Co. v. Phinney, 253 F.2d 326 (5th Cir. 1958).

Payments made before any indebtedness exists are not deductible as
interest. For example, standby charges paid by a prospective borrower
to a prospective lender are paid for the acquisition of the right to
borrow money. Rev. Rul. 81-160, 1981-1 C.B. 312. This loan commitment fee
is similar to the cost of an option, which becomes part of the cost of
the property acquired upon exercise of the option. If the right is
exercised, the commitment fee becomes a cost of acquiring the loan,
deducted ratably over the term of the loan. If the right is not
exercised, the taxpayer may be entitled to a loss deduction under Code
Section 165 when the right expires. However, this amount is not deductible
as interest because it was not a payment for the use or forbearance of
money, but rather for the right to use the money.


(b)(2) Sham transactions and the business purpose requirement

The two major approaches that the courts have taken to deny an interest
deduction for lack of a valid, existing indebtedness are the sham
transaction doctrine and the business purpose doctrine. Under the business
purpose doctrine, interest is deductible only if the indebtedness and
related transactions have an economic purpose apart from any tax savings.
See Knetsch v. United States, 364 U.S. 361 (1960).

Under the sham transaction doctrine, interest is not deductible if a
transaction lacks substance and, therefore, should be ignored for tax
purposes. Goodstein v. Commissioner, 267 F.2d 127 (1st Cir. 1959). This
doctrine generally is relied on only where the steps taken by a taxpayer
do not, in fact, create the legal relationship that they purport to
create. See Knetsch v. United States, 364 U.S. 361 (1960). The test for
the existence of a sham transaction, as stated in Rothschild v. United
States, 407 F.2d 404 (Ct. Cl. 1969), is to determine whether the parties
are in the same position after the transaction occurs as they were before
entering into the transaction, or whether there was any significance to
the parties' dealings, by examining the nature of the transaction in its
entirety.

The most prominent application of the sham transaction doctrine is
Goodstein v. Commissioner, 267 F.2d 127 (1st Cir. 1959). In Goodstein,
the taxpayer, in an effort to secure an interest deduction, ordered an
agent to purchase $10 million of treasury notes on the taxpayer's
account. The taxpayer paid $15,000 down, giving a note to Seaboard
Investment Corp. (which was owned by the agent's brother) in the amount
of approximately $9.9 million. The note was secured by the treasury
notes. The treasury notes bore interest at the rate of 1 3/8 percent. The
agent sold the notes back to the original seller, despite the taxpayer's
order to deliver the treasury notes to Seaboard. The taxpayer prepaid
substantial amounts of interest to Seaboard, and Seaboard shortly
thereafter loaned identical amounts back to the taxpayer. The court
characterized the entire scheme as a sham that never involved the actual
purchase of notes by the taxpayer or the creation of a true indebtedness
for the purchase funds. The court agreed that some legal relationship was
created between the taxpayer and Seaboard, but not that of a debtor and
creditor. The court held that the legal relationship that the transaction
purported to create did not in fact exist and the interest deduction was
disallowed.

The best comparison of the business purpose and sham transaction doctrines
is provided by Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966),
cert. denied, 385 U.S. 1005 (1967). In Goldstein, the taxpayer, after
winning the Irish Sweepstakes, borrowed approximately $465,000 at 4
percent interest from a bank in order to purchase treasury notes having a
face value of $500,000 and paying 1.5 percent interest. The taxpayer
prepaid part of the interest in an attempt to shift income to the next
year to avoid application of high marginal rates to the entire prize. The
court refused to treat the transaction as a sham because a true
debtor/creditor relationship existed and the creditor was an independent
financial institution in the business of making loans. However, the
court held that the interest was not deductible because no business
purpose existed for the transaction, apart from the generation of an
interest expense deduction. According to the court, the only reason the
taxpayer entered into the transaction (which was almost certain to lose
money) was to offset her winnings for tax purposes.

The Supreme Court appears to have combined the two approaches in Knetsch
v. United States, 364 U.S. 361 (1960), although it did not do so
explicitly. In Knetsch, the Court held that a purported loan was a sham,
but on the grounds that "there was nothing of substance to be realized
... from this transaction beyond a tax deduction" (a business purpose
requirement). In so holding, the Court refused to examine the taxpayer's
motivation (a sham transaction doctrine requirement).

Non-recourse loans also may run afoul of the sham transaction or business
purpose doctrines if the amount of the loan significantly exceeds the fair
market value of the underlying property at the time that the loan is made.
In this situation, non-recourse debt creates only potential, not actual,
indebtedness. Until the property appreciates, the interest is not
deductible.

The Tax Court has applied the sham transaction doctrine, in the context of
tax shelters, to disregard purported indebtedness if the taxpayer did not
have both a bona fide intention and a realistic possibility of earning a
profit (aside from tax benefits). <22> The Fourth Circuit held that while
the portion of the transaction that was a sham could be disregarded, an
enforceable recourse note that was a genuine debt could not be
disregarded. Rice's Toyota World v Commissioner, 752 F.2d 89 (4th Cir.
1985). The Tax Court has subsequently agreed with this view.

Other circuits consider the two-part Tax Court approach as factors to
consider, rather than as a rigid rule.


(b)(3) Loans between related parties

Transactions between related parties, such as a husband and a wife
(Commissioner v. Park, 113 F.2d 352 (3d Cir. 1940)), a parent and a
child, <25> or between brothers and sisters <26> may or may not create a
valid indebtedness. Due to the potential for manipulation and abuse, debt
arrangements between related parties are subject to a higher level of
scrutiny. See Dorzback v. Collison, 195 F.2d 69 (3d Cir. 1952).

Indebtedness between related parties must meet the same requirements as
loans between unrelated parties; that is, there must be a real obligation
to pay money, which is provable, unconditional and enforceable. See
Hudspeth v. Commissioner, 509 F.2d 1224 (9th Cir. 1975). The parties must
have intended to create a debt, shifting dominion and control over the
proceeds of the loan. See Goldsmith v. Sturr, 241 F.2d 797 (2d Cir.
1957). The business purpose and sham transaction doctrines also apply.
See Knetsch v. United States, 364 U.S. 361 (1960). Similarly, court
decisions dealing with intra-family loans have applied several of the
same factors in determining if a loan is in fact a bona fide debt as
those used in non-family situations; that is, whether a specific rate of
interest was charged for the use of money, whether there is a specific
date for repayment, whether a written instrument evidences the debt,
whether the borrowers had a legitimate purpose for obtaining the loan,
whether the borrower intended to repay the debt, and whether the loan has
economic substance.

A number of cases and rulings have found a lack of a bona fide
indebtedness on "loans" between related parties. For example, in
Guaranty Trust Co. v. Commissioner, 98 F.2d 62 (2d Cir. 1938), a husband
transferred funds to his wife, who put the money in a trust with herself
as trustee. The trust then purported to loan the money back to the
husband. The court held that the loan was not a valid indebtedness. In
reaching this result, the court concluded that the husband did not intend
to divest himself of complete dominion and control over the funds because
this prearranged agreement restricted the use of the funds to one purpose
(i.e., to establish a trust that would loan the money back to him).
The court found that the transfer of funds to the wife was an incomplete
gift, and the husband's note as no more than an unenforceable, gratuitous
promise to make a gift, based neither on money nor money's worth.

In Rev. Rul. 82-94, 1982-1 C.B. 31, the IRS, relying on a similar
analysis, denied a deduction for interest payments made by a parent to a
child. In this ruling, the parents of a full-time college student loaned
him $50,000 in return for his interest free demand note. The student
immediately loaned the identical sum to his parents at 17 percent secured
by a real estate mortgage. The student used the interest payments he
received to pay his college expenses. The IRS ruled that the transaction
was no more than an attempt to deduct the child's college expenses by
disguising them as interest expenses, and the transaction had no economic
reality. Accordingly, the IRS concluded that no true debtor/creditor
relationship even existed. Similarly, in Rev. Rul. 87-69, 1987-2
C.B. 46, the IRS ruled that where taxpayers gave money to their children
as a purported gift, and under a prearranged plan, immediately borrowed
it back, the arrangement did not have any economic reality and did not
create valid debtor/creditor relationships.


(c) WHO IS ENTITLED TO THE DEDUCTION?

Only a taxpayer who is liable for an indebtedness may deduct interest
payments. Arcade Realty Co. v. Commissioner, 35 T.C. 256 (1960), acq.,
1961-2 C.B. 3. However, the legal or equitable owner of real estate
encumbered by a mortgage or deed of trust may deduct interest even though
there is no personal liability (e.g., when the taxpayer's property is
serving as collateral security for someone else's indebtedness). <30>

The equitable owner of a personal residence can deduct the interest on the
mortgage payments if he is obligated to the legal owner of the residence
to make the payments. For example, when a taxpayer's poor credit rating
barred him from obtaining a mortgage, and his brother purchased the home
and allowed him and his family to live in it, the taxpayer was held to be
entitled to the interest deduction, because he was the equitable owner of
the residence because he was required to make the mortgage payments to the
bank. Usher v. Commissioner, T.C. Memo. 1997-551.

PRACTICE TIP: This should enable a son or daughter whose parents
purchase a house for them to deduct the interest payments where they
are responsible for making the mortgage payments directly to the
bank.

A taxpayer is not entitled to deduct interest paid on the debts of
another. Therefore, parents may not deduct the interest they pay on
the debts of their children. If a child actually borrows money from a
third party that is subsequently repaid by his parent, the child, and not
the parent, is entitled to the interest expense deduction. Similarly,
a spouse who pays the interest on the other spouse's debt generally is not
entitled to deduct the interest on the debt because the paying spouse is
acting as the agent of the other spouse.

On the other hand, where two or more persons are jointly and severally
liable for a debt, each is primarily liable on the debt and each is
entitled to deduct the interest that he pays (if the other requirements
for a deduction have been satisfied). Arrigoni v. Commissioner, 73 T.C.
792 (1980), acq., 1980-2 C.B. 1. For example, the IRS ruled that a father
was allowed to deduct the interest he paid on a note for a student loan
that he co-signed with his son. Rev. Rul. 71-179, 1971-1 C.B. 58. The Tax
Court held that a father was allowed to deduct mortgage interest he paid
on property held in common with his daughter, even though he had recently
temporarily conveyed legal title to his daughter to avoid creditor's
claims. Conroy v. Commissioner, T.C. Memo. 1958-6.

In the divorce context, a spouse who gives up her interest in the marital
home but remains obligated to pay the mortgage is entitled to an interest
deduction (if the other requirements for a deduction have been satisfied).


A guarantor or courtesy endorser cannot deduct interest paid on the
guaranteed debt until default because a guarantor has only a contingent
liability on the indebtedness until that point. See Norwood v.
Commissioner, T.C. Memo. 1983-755, aff'd without published opinion, 756
F.2d 883 (11th Cir. 1985). The guarantor becomes liable for the principal
and unpaid interest upon the primary debtor's default. Although the
guarantor may not deduct any payment of the previously unpaid interest,
the guarantor may deduct payment of interest that accrues after default
because the guarantor has become primarily liable.

Whether a taxpayer in bankruptcy may deduct interest paid in a foreclosure
of his residence requires a determination as to whether the taxpayer or
the bankruptcy estate bore the tax consequences of the foreclosure.
Reversing the Tax Court, the Ninth Circuit has held that a taxpayer in
bankruptcy can not deduct any accrued but unpaid mortgage interest when
the lender forecloses on a bankrupt taxpayer's residence. Catalano v.
Commissioner, 279 F.3d 682 (9th Cir. 2002), rev'g T.C. Memo. 2000-82. The
Tax Court had found that the bankruptcy court's grant of relief from the
automatic stay to the lender (allowing the foreclosure) was tantamount to
an abandonment by the bankruptcy estate causing the property (and the tax
consequences thereof) to effectively revert to the taxpayer. However,
the Ninth Circuit reversed the Tax Court, finding that the release of the
property from the automatic stay did not constitute an abandonment of the
property. Consequently, according to the Ninth Circuit, the taxpayer was
not entitled to deduct any mortgage interest that had accrued (and deemed
to have been paid from the proceeds of the foreclosure) when the lender
foreclosed on the residence. Catalano v. Commissioner, 279 F.3d 682
(9th Cir. 2002). The tax consequences of the abandonment of property by
a bankruptcy estate are discussed in Section 151.9(b).


(d) YEAR IN WHICH INTEREST IS DEDUCTIBLE

(d)(1) In general

A taxpayer's interest expense deduction for a taxable year is determined
by his method of accounting. Under the cash receipts and disbursements
method of accounting, a taxpayer generally is entitled to deduct interest
in the year it is actually paid. An accrual basis taxpayer is
entitled to deduct interest in the year in which all events have occurred
that determine the fact of the liability, the amount thereof can be
determined with reasonable accuracy, and economic performance has
occurred. <37> Since most individual taxpayers use the cash receipts and
disbursements method of accounting, the following discussion only
considers the cash method of accounting with respect to interest paid.


(d)(2) Discounted loans

Where all or a portion of interest is withheld, or discounted, from the
proceeds of a loan, a cash basis taxpayer may not claim a current
deduction for the withheld amount, but can deduct a portion of the
withheld interest as each loan payment is made.

EXAMPLE 1: Peg, a cash basis taxpayer, signed a note for $1,200 at 12
percent interest on March 1. Peg agreed to repay it in twelve equal
monthly installments beginning on April 1. The interest ($1,200 x 12
percent = $144) was subtracted from the face value of the note and
Peg received $1,056. Under the cash method of accounting, the
interest is considered to be repaid in twelve installments of $12
each. Since Peg made nine payments during the year, her interest
deduction for the year is $108 (9 x $12).

If, however, a taxpayer repays an obligation issued at a discount in a
lump sum, the manner in which the loan discount is deductible as interest
depends upon the size of the loan and whether the lender and borrower are
individuals or corporations. If both the lender and borrower are natural
persons, the lender is not in the trade or business of making loans, the
amount of the loan (increased by any outstanding prior loans) does not
exceed $10,000, and tax avoidance was not one of the principal purposes of
the loan, the borrower is permitted an interest deduction only when
interest is actually paid.

EXAMPLE 2: On November 1, 1997, Meg, a cash method taxpayer, borrows
$10,000 from Peg at 12 percent interest. The loan is due and payable
on November 1, 1998. Peg discounted the obligation and gave Meg
$8,800. Meg repays Peg $10,000 on November 1, 1998. Meg's interest
deduction for 1997 is $0, since she paid no interest in such year. In
1998, Meg is entitled to an interest deduction of $1,200, the full
amount of interest paid.

In any other circumstances, such as if either the borrower or the lender
is a corporation, if the lender is in the business of making loans, or if
the amount of the loan (increased by any outstanding prior loans) exceeds
$10,000, the loan is subject to the original issue discount rules, and
interest is deductible as it accrues, regardless of when it actually is
paid. The accrued interest is the "aggregate daily portion" of the
original issue discount for the days in the taxable year the loan is
outstanding. Code Section 163(e)(1).

Original issue discount is interest, the payment of which is deferred,
usually until maturity, instead of being paid to the lender currently. The
original issue discount rules apply where the debt instrument's stated
redemption price at maturity (as defined in Code Section 1273(a)(2))
exceeds the instrument's issue price (as defined in Code Section
1273(b)), and the excess is the amount of the original issue discount.



(d)(3) Interest paid with a note or increase in principal

A cash method taxpayer may not deduct interest paid with a note because he
has not actually made payment of interest during the taxable year.
While a cash basis taxpayer may deduct interest paid with funds borrowed
from a third party, a deduction generally is not permitted if the
taxpayer borrows from the same lender because this is not considered the
payment of interest.

EXAMPLE 1: On November 1, 1997, Moe, a cash method taxpayer, borrows
$10,000 from Curly at 12 percent interest. The loan is due on
November 1, 1998. In 1997, Moe pays no interest and thus is not
entitled to an interest deduction. In November 1998, Moe borrows an
additional $11,200 from Curly in order to pay the $10,000 loan plus
the $1,200 of interest due. Moe may not claim an interest expense
deduction for 1998 because he has not, in fact, paid any interest.

EXAMPLE 2: Assume the same facts as Example 1, except that in
November 1998 Moe borrows $11,200 from a bank to pay Curly. Moe is
entitled to an interest deduction of $1,200 in 1998.

A cash basis taxpayer may deduct interest on a loan paid with funds
borrowed from the original lender if the proceeds of the second loan
become subject to her unrestricted control. This requires that the
funds actually pass into her hands or bank account and be commingled with
her other funds. However, this exception does not apply if the purpose of
the second loan is to obtain funds to pay the interest, as where there is
a prearranged transfer of funds in a step transaction designed to create
an interest deduction for the taxpayer, when, in fact, no interest has
been paid with the taxpayer's funds.

PRACTICE TIP: Whether the effect of the transaction is to postpone,
rather than pay, the interest depends on several factors: whether the
relevant transactions were simultaneous, whether the borrower had the
funds in her account to pay interest, whether the funds are
traceable, and whether the borrower had any realistic choice to use
the borrowed funds for any other purpose. Once it is determined that
the borrowed funds were the same funds used to satisfy the interest
obligation, a cash basis taxpayer is not entitled to the interest
deduction. Davison v. Commissioner, 141 F.3d 403 (2d
Cir. 1998).


(d)(4) Prepaid interest

In general, a taxpayer cannot take a current deduction for prepaid
interest. Prepaid interest must be charged to a capital account and
is treated as paid in the period in which it represents a charge for the
use of forbearance of money.

The amount of interest that is allocable to a year is determined
economically, using a single rate of interest equal to the yield to
maturity. The yield to maturity is the interest rate that yields the
issue price when applied to compute the present value of all payments.
This rate is applied to the principal balance during each of the loan's
"accrual periods" and, if unpaid, this interest is added to the principal
balance for the computation for the next period. Interest for an accrual
period that straddles two taxable years is allocated ratably between the
years, based on the number of days of the accrual period in each. Rev.
Rul. 83-84, 1983-1 C.B. 97.

The accrual period for a loan generally corresponds with payment or
accrual dates. For example, the accrual period for a typical mortgage that
requires equal monthly payments is one month, while an obligation that
calls for semiannual or quarterly interest payments would have a six-month
or three-month accrual period, respectively.

EXAMPLE 1. On November 1, 1997, Larry, a cash method taxpayer,
borrows $10,000 from Curly at 12 percent interest. The note is due
and payable on November 1, 1998. If Larry pays the $10,000 note and
$1,200 interest on November 1, 1998, the interest deduction for 1997
is $0, since no payment was made during 1997. The interest deduction
for 1998 is $1,200, the amount paid in such year.

EXAMPLE 2: Assume the same facts as Example 1, except that Larry pays
the $1,200 interest on December 31, 1997. Larry's interest deduction
for 1997 is $201 computed as follows: The accrual period is one year
because only one payment is required, one year after the loan is
made. The $1,200 of interest for the accrual period is allocated on a
daily basis to 1997, so that (61/365) is deductible. His deduction
for 1998 is $999, the amount of prepaid interest attributable to
1998.

EXAMPLE 3: Assume the same facts as Example 1, except that Larry must
make equal monthly payments, such that principal and interest will be
paid by November 1, 1998. A portion of each payment is considered to
be interest and a portion is principal. Larry makes one payment in
1997 on December 1. He is entitled to an interest deduction of $120
(12 percent x $10,000 x 1/12) for 1997.

POINTS: The prepaid interest rules generally apply to points paid by a
taxpayer on a loan. As long as the points are interest, i.e., they are
paid for the use or forbearance of money and not for specific services,
they may be deducted as prepaid interest over the term of the loan (if the
other requirements for a deduction have been satisfied).

Exceptions to this rule requiring prepaid interest to be capitalized are
extended to taxpayers paying "points" on loans secured by a residence. If
the points otherwise qualify as interest, a current deduction for points
paid is allowed if:

(1) The debt is incurred in connection with the purchase or
improvement of, and secured by, the taxpayer's principal residence;

(2) the payment of points is an established business practice in the
area in which the debt is incurred; and

(3) the amount of the points does not exceed the amount generally
charged in such area. Code Section 461(g)(2).

To the extent that the proceeds of a loan are not used to purchase or
improve the taxpayer's principal residence (e.g., refinancing loans or
loans to purchase or improve a second home), the points paid may not be
currently deducted. Rather, they may be deducted only for the period to
which they are allocable under the general rules of Code Section
461(g)(1). However, as a matter of administrative convenience, the points
may be allocated ratably over the indebtedness period, as opposed to
being allocated under principles of economic accrual. <48>

When a construction loan and permanent financing are considered as one,
withheld "interest points" will be deductible over the term of both the
construction loan and permanent financing. <49> This result is most
likely to occur when the construction and permanent mortgages are
represented by a single set of documents. However, when the taxpayer
separately negotiates a construction loan and permanent loan from
different lenders, the appropriate fees normally will be amortized over
their respective periods. Francis v. Commissioner, T.C. Memo 1977-170.
From a tax planning perspective, it will prove easier to establish the
existence of two independent loans when separate lenders are involved.
However, if the taxpayer can clearly establish that independent loans are
intended, separate amortization of fees over the construction phase and
the permanent phase will be permitted even when the same lender is
involved. Buddy Schoellkopf Products, Inc. v. Commissioner, 65 T.C. 640
(1975), acq. 1977-1 C.B. 1, nonacq. 1981-1 C.B. 2.

RULE OF 78s: The rule of 78s is a method of allocating interest on a loan
among time periods during the term of the loan. Under this method, the
amount of interest allocable to each period is determined by multiplying
the total interest payable by a fraction, the numerator being the number
of periods remaining on the indebtedness at the time of the calculation
and the denominator being the sum of the periods' digits for the term of
the indebtedness. Rev. Rul. 83-84, 1983-1 C.B. 97. Because the rule of
78s method accrues interest at a faster rate than the permitted economic
accrual method, the rule of 78s method is no longer an acceptable method
of accounting for federal income tax purposes. Rev. Proc. 98-60, 1998-2
C.B. 761. Previously, the rule of 78s had been a permissible method of
determining the taxpayer's interest expense deduction in certain
short-term consumer loan transactions; the excess amount was treated as
prepaid interest <50> and was deductible when economically accrued or
when the loan was paid in full. Rev. Rul. 86-42, 1986-1 C.B. 82.


(d)(5) Capitalized interest

Interest paid on debt that is allocable to the production of certain
property must be capitalized rather than deducted in the year paid. <51>
Property is subject to this rule if it has a long useful life, an
estimated production period exceeding two years, or an estimated
production period exceeding one year and a cost exceeding $1 million. <54>
This rule does not apply to any qualified residence interest. Code
Section 263A(f)(2)(B).

Interest is required to be capitalized during the production period.
Code Section 263A(f)(1). Interest may be deducted after the production
period of the property ends (if the other requirements for a deduction
are satisfied). Reg. Sections 1.263A-8(a), 1.263A-9(a), and
1.263A-12(c).

COMPLIANCE TIP: In Rev. Proc. 95-19, the IRS provided guidance on
changing the method of accounting for interest costs subject to Code
Section 263A(f). Rev. Proc. 95-19, 1995-1 C.B. 664. If
a taxpayer complies with the requirements of Rev. Proc. 95-19,
automatic consent will be granted to a change to comply with Code
Section 263A(f). Rev. Proc. 95-25 allows a taxpayer to obtain
automatic consent to make a historic absorption ratio election to
determine the additional Code Section 263A costs that must be
capitalized. Rev. Proc. 95-25, 1995-1 C.B. 701.

A taxpayer may also elect to capitalize annual taxes, mortgage interest,
and deductible carrying charges on unimproved and unproductive real
property. This election only applies to the year in which made; the
election must be made for each year if the taxpayer desires to capitalize
these expenses for more than one year. Reg. Section 1.266-1(c)(2)(i).


A taxpayer engaged in the development of real estate or in the
construction of an improvement to real estate can elect to capitalize
certain items relating to the project: interest on loans, deductible taxes
(including state and federal unemployment taxes, social security taxes and
state and local sales taxes), and other necessary charges including fire
insurance premiums, commitment fees, and standby charges on the mortgage.


A taxpayer may elect to capitalize any or all types of qualifying expenses
for each development or project. No consistency is required among expenses
relating to one project or among more than one project. Reg. Section
1.266-1(c)(1). However, within a single project, a taxpayer must treat all
expenditures of the same type consistently.

A taxpayer may also elect to capitalize interest on a loan to finance the
purchase, transportation, and installation of machinery and other personal
property, disallowed deductible state and local taxes (such as sales or
use taxes on the purchase, transportation, use, or other consumption of
the property, state and federal unemployment taxes, and federal social
security taxes on the wages of employees engaged in transportation and
installation of the personal property). Reg. Section 1.266-1(b)(1)(iii).
Once the election is made to capitalize one type of tax or carrying
charge, the same type of expenditure must be capitalized up to the date
of the later of installation or the property first being put into use.
Reg. Section 1.266-1(c)(2)(ii)(b).

The election to capitalize is made by filing a statement with the
taxpayer's original return for the time period for which the election is
to be effective. This statement must indicate the items that the taxpayer
elects to capitalize. Reg. Section 1.266-1(c)(3). Merely capitalizing the
expenses on the taxpayer's books is not an effective election, but the
filing of schedules with the return indicating an intent to capitalize is
an effective election.

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