T.C. Memo. 2014-226
UNITED STATES TAX COURT
CHARLES COPELAND AND ARLENE COPELAND, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 5605-13. Filed October 30, 2014.
Charles Copeland and Arlene Copeland, pro se.
Sebastian Voth, for respondent.
MEMORANDUM OPINION
LAUBER, Judge: The Internal Revenue Service (IRS or respondent)
determined a deficiency in petitioners’ Federal income tax for 2010. After
concessions,1 the sole remaining issue is whether petitioners are entitled to a
1
Petitioners conceded that unemployment compensation of $3,133 received
(continued...)
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[*2] mortgage interest deduction under section 163(a) and (h)(2)(d)2 for interest
that was capitalized into the principal of their mortgage note but not actually paid
during 2010. We hold that they are not so entitled.
Background
This case was submitted fully stipulated under Rule 122. The stipulated
facts and the related exhibits are incorporated by this reference. Petitioners
resided in California when they petitioned this Court.
Petitioners are cash basis taxpayers. In 1991 they purchased a residential
property in Yucaipa, California, for $334,000. They financed this purchase with a
$300,000 mortgage loan secured by the property. Petitioners have occupied this
property as their home since 1991. In 2007 petitioners refinanced the Yucaipa
property with a $600,000 loan from Gateway Funding Diversified Mortgage
Services (GFDMS). This loan was likewise secured by a mortgage on the
property. Bank of America subsequently acquired the GFDMS mortgage loan.
1
(...continued)
in 2010 was includible in taxable income. Respondent conceded that a health
savings account distribution of $2,400 received in 2010 was not includible in
taxable income.
2
All statutory references are to the Internal Revenue Code as in effect for the
taxable year in issue. All Rule references are to the Tax Court Rules of Practice
and Procedure. We round all monetary amounts to the nearest dollar.
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[*3] In 2010 petitioners applied for a loan modification with Bank of America.
This application was granted, and the terms of petitioners’ mortgage loan were
permanently modified. The modifications included a reduction of the interest rate,
a change in the payment terms, and an increase in the loan balance. Immediately
before the modifications, the outstanding loan balance was $579,275; after the
modifications, the new balance was $623,953. The difference (equal to $44,678)
resulted from adding the following amounts to the loan balance: past due interest
of $30,273, servicing expense of $180, and charges for taxes and insurance of
$14,225.
Bank of America issued petitioners Form 1098, Mortgage Interest State-
ment, reporting that it had received from them during 2010 interest of $9,253 with
respect to the Yucaipa property. On their timely filed 2010 tax return, petitioners
claimed a deduction of $48,078 for home mortgage interest. The IRS issued peti-
tioners a notice of deficiency disallowing $38,825 of this deduction, namely, the
amount by which it exceeded the interest that Bank of America had reported on
Form 1098. Petitioners have conceded that $8,552 of this deduction was properly
disallowed. They contend, however, that they are entitled to the remainder of the
claimed deduction, or $30,273. This represents the past-due interest that petition-
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[*4] ers did not pay during 2010 which was capitalized into the principal of their
modified mortgage loan.
Discussion
Deductions are a matter of legislative grace, and the burden is on the tax-
payer to prove entitlement to the deductions claimed. INDOPCO, Inc. v. Commis-
sioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435,
440 (1934). This case was submitted fully stipulated under Rule 122. Since there
remain only legal issues, the burden of proof is irrelevant. See, e.g., Nis Family
Trust v. Commissioner, 115 T.C. 523, 538 (2000).
Section 163(a) generally allows a deduction for interest. However, section
163(h)(1) provides that “[i]n the case of a taxpayer other than a corporation, no
deduction shall be allowed * * * for personal interest paid or accrued during the
taxable year.” Nondeductible “personal interest” is defined to exclude several
categories of interest, including “any qualified residence interest.” Sec.
163(h)(2)(D), (3). The parties agree that during 2010 the Yucaipa property was a
“qualified residence” and that petitioners paid some “qualified residence interest.”
They disagree as to whether the amount deductible as “qualified residence inter-
est” includes the $30,273 that was capitalized into the principal of the Bank of
America loan.
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[*5] Petitioners are cash basis taxpayers. It is well settled that “[a] cash-basis
taxpayer ‘pays’ interest only when he pays cash or its equivalent to his lender.”
Wilkerson v. Commissioner, 655 F.2d 980, 982 (9th Cir. 1981), rev’g 70 T.C. 240
(1978); Davison v. Commissioner, 107 T.C. 35, 41 (1996), aff’d, 141 F.3d 403 (2d
Cir. 1998); Smoker v. Commissioner, T.C. Memo. 2013-56. The delivery of a
promissory note to satisfy an interest obligation, without an accompanying dis-
charge of the note, is a mere promise to pay, not a payment in cash or its equiva-
lent. Don E. Williams Co. v. Commissioner, 429 U.S. 569, 577-578 (1977);
Wilkerson, 655 F.2d at 982; Davison, 107 T.C. at 41; see United States v. Clardy,
612 F.2d 1139, 1151 (9th Cir. 1980) (“It is undisputed that if a new note is given
to satisfy an interest obligation by a debtor on a cash basis, the interest has not
been ‘paid.’”). The rationale for this rule is that “the note may never be paid, and
if it is not paid, ‘the taxpayer has parted with nothing more than his promise to
pay.’” Don E. Williams Co., 429 U.S. at 578 (quoting Hart v. Commissioner, 54
F.2d 848, 852 (1st Cir. 1932), aff’g in part, rev’g in part 21 B.T.A. 1001 (1930)).
The same rule applies to a discounted loan. Where a lender withholds a sum
as interest from the face amount of a loan, the borrower is not regarded as having
“paid” that interest. See Davison, 107 T.C. at 41; Menz v. Commissioner, 80 T.C.
1174, 1186 (1983). Whether interest is subtracted from the loan proceeds or
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[*6] added to the loan principal, the economic reality is the same. In each case,
the borrower is able to postpone paying the interest until some time in the future,
over the life of the loan or as part of a balloon payment at maturity. See Heyman
v. Commissioner, 70 T.C. 482, 485-487 (1978), aff’d, 652 F.2d 598 (6th Cir.
1980); Rubnitz v. Commissioner, 67 T.C. 621, 627-628 (1977); Smoker, T.C.
Memo. 2013-56.
Through the loan modification agreement, the $30,273 in past-due interest
on petitioners’ mortgage loan was added to the principal. No money changed
hands; petitioners simply promised to pay the past-due interest, along with the rest
of the principal, at a later date. Because petitioners did not pay this interest during
2010 in cash or its equivalent, they cannot claim a deduction for it for 2010. They
will be entitled to a deduction if and when they actually discharge this portion of
their loan obligation in a future year. See Smoker, at *11-*12.
Against this backdrop of settled caselaw, petitioners ask us to recharacterize
their loan modification transaction. Instead of having modified the terms of their
existing loan, petitioners say they should be treated as if they had obtained a new
loan from a different lender and used the proceeds of that loan to pay both the
principal of the Bank of America loan and the past-due interest. Cf. Wilkerson,
655 F.2d at 984 (stating that if a separate loan from a third party is used to pay
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[*7] interest, “a deduction may be appropriate because the obligation between the
borrower and the original lender has not merely been postponed, it has been
extinguished”).
Contrary to petitioners’ “substance over form” argument, the transaction
they hypothesize is not economically equivalent to the transaction in which they
engaged. For one thing, petitioners have supplied no reason to believe that they
could have obtained a $623,952 loan from a different lender, given the economic
environment prevailing in 2010. In any event, it is well established that taxpayers
must accept the tax consequences of the transaction in which they actually
engaged, even if alternative arrangements might have provided more desirable tax
results. See Don E. Williams Co., 429 U.S. at 579-581; Noble v. Commissioner,
79 T.C. 751, 767 (1982); Smoker, at *12.3
In sum, a taxpayer is not “entitled to mortgage interest deductions for
amounts capitalized into the principal of a mortgage note but not actually paid.”
3
Alternatively, petitioners say they should be treated as if they had obtained
a new loan from Bank of America and used the new loan proceeds to discharge the
old loan and the past-due interest. But petitioners would not be treated as having
“paid” the interest in this event either. Rather, they would be regarded as having
postponed payment of that interest by giving Bank of America a note, as they did
through the loan modification arrangement in which they actually engaged. Wil-
kerson, 655 F.2d at 984; Battelstein v. Commissioner, 631 F.2d 1182, 1184 & n.3
(5th Cir. 1980); Davison, 107 T.C. at 41-51.
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[*8] Smoker, at *2. We accordingly conclude that petitioners cannot deduct for
2010 the $30,273 of past-due interest that was not paid for 2010 but postponed by
being added to the loan balance.
To reflect the foregoing,
Decision will be entered under
Rule 155.