T.C. Memo. 2012-360
UNITED STATES TAX COURT
JOHN J. NORMAN, JR., AND M. ELIZABETH NORMAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14289-09. Filed December 27, 2012.
Helen E. Marmoll, for petitioners.
Scott A. Hovey and Anne W. Bryson, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
THORNTON, Chief Judge: Respondent determined deficiencies of $16,042
and $5,090 in petitioners’ Federal income tax for 2005 and 2006, respectively, and
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[*2] an accuracy-related penalty of $1,018 pursuant to section 6662 for 2006.1
Respondent having conceded the penalty, the issue for decision is whether
petitioners are entitled to deduct, as investment interest, certain amounts of
mortgage interest that do not constitute qualified residence interest under section
163(h)(3), on the ground that their mortgage loan is properly allocated between
residential property and nonresidential investment property.
FINDINGS OF FACT
The parties have stipulated some facts, which we so find. When they
petitioned the Court, petitioners resided in Virginia.
Background
Petitioner John J. Norman, Jr., is the principal in Norman Realty, Inc., a
commercial brokerage firm. In early 2003, when they were living in Alexandria,
Virginia, petitioners began looking for a home in Warrenton, Virginia, where Mr.
Norman had grown up.
On October 27, 2003, petitioners entered into a contract to purchase for
$1,040,000 a house on 1.29 acres in the Old Town area of Warrenton. After a
1
Unless otherwise noted, all section references are to the Internal Revenue
Code (Code) in effect for the years at issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure.
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[*3] home inspection, however, petitioners learned that the house had significant
structural defects, and for that reason they terminated the purchase contract.
The Yorkshire Property and the Sellers’ Development Plans
Petitioners later became interested in a historic residence on Winchester
Street in the Old Town area of Warrenton (Yorkshire property). The Yorkshire
property was a single-family residence on 9.875 acres. The house, which was then
being rented out, was in disrepair. In December 2003 Mr. Norman toured the
Yorkshire property with Virginia Farrar, who was one of three coowners of the
property and who spoke for all three owners in connection with any matters
concerning the property.
During this tour Ms. Farrar explained to Mr. Norman that she and the other
Yorkshire property owners had investigated the possibility of selling only the
house and about three acres, leaving the remaining acreage for development in
conjunction with acreage in an adjoining property (Yonder Lea property). The
Yonder Lea property consisted of a single-family residence on about 11 acres and
was owned by Yonder Lea, LLC, the managing partner of which was Ms. Farrar’s
cousin, who was also one of the three coowners of the Yorkshire property. Both the
Yorkshire property and the Yonder Lea property had zoning for quarter-acre lots,
but use of that development right was subject to the creation of an access road
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[*4] satisfactory to the Town of Warrenton. In preparing for a possible
development project, the owners of the Yorkshire and Yonder Lea properties had
retained a development consultant and an architect to develop plans for villas on the
back part of the properties (i.e., the part of the properties most remote from
Winchester Street) after placing a conservation and preservation easement on the
properties, so as to allow for lots larger than the quarter acre permitted by the
applicable zoning laws. The property owners had not yet proceeded with these
development plans, however, because they had been unable to convince the Town
of Warrenton to allow access to the proposed development from Winchester Street.
Negotiations To Buy the Yorkshire Property
According to Mr. Norman’s testimony, it was during his initial tour of the
Yorkshire property in December 2003 that Ms. Farrar, having explained the
owners’ development plans for the Yorkshire and Yonder Lea properties, stated
that the price for the Yorkshire residence and three acres was $1 million.
Consistent with Ms. Farrar’s explanation of the owners’ development plans, it was
anticipated that the Yorkshire property would be subdivided before petitioners
purchased the house and three acres and that petitioners would buy just the front
portion of the property that bordered Winchester Street. Also according to Mr.
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[*5] Norman’s testimony, in February 2004, after making two more visits to the
Yorkshire property, Mr. Norman called Ms. Farrar and told her that petitioners
would buy the house and three acres for $1 million. But by that time the sellers had
apparently reconsidered; in any event, the deal did not move forward on those
terms. In an effort to persuade her to go forward with the deal, Mr. Norman offered
Ms. Farrar the benefit of his real estate expertise and prepared for her some
financial analyses showing how she might profitably develop the Yorkshire and
Yonder Lea properties after selling the house and three acres to petitioners for $1
million. Nevertheless, in August 2004 Mr. Norman learned that the Yorkshire
property owners would not sell the house and only three acres to petitioners; instead
the owners offered to sell them the entire property for $1.8 million.
After making some financial analyses, Mr. Norman decided that he could
purchase the Yorkshire property for $1.8 million and recover the additional
$800,000 by developing part of the property after subdividing it into at least seven
additional lots. In September 2004 petitioners hired a civil engineering firm,
Dewberry & Davis, LLC (Dewberry), to provide a limited feasibility study for a
development project involving the combined Yorkshire and Yonder Lea properties.
They later requested a separate limited feasibility study for developing only the
Yorkshire property.
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[*6] Purchase Agreement for the Yorkshire Property
On December 7, 2004, petitioners signed an agreement to purchase the
Yorkshire property for $1.8 million. The purchase agreement makes no allocation
of the purchase price between subparcels, and the parties to the transaction never
discussed any such allocation. The purchase agreement provided for a 90-day
study period, during which petitioners could investigate the property and
determine whether to go forward with the purchase. The agreement also provided
that to facilitate financing and development, petitioners could elect before
settlement to subdivide “the residential structure and approximately three (3) acres
from the balance of the Property and take ownership of the two resulting parcels as
separate parcels”. Petitioners did not elect to subdivide the property, because they
were unsure how they would configure the three acres until they knew for sure
what access could be provided for the acreage to be developed.2 The purchase
agreement also stated that before settlement the sellers wished to place on the
property a historic conservation easement that would limit the number of
residential units on the property to eight, including the existing residence. In the
2
There were at least three possible means of access: (1) from Winchester
Street, if the safety concerns of the Town of Warrenton could be satisfied; (2) from
a right of way at the back of the property; and (3) through a connection into a
subdivision to the south of the Yorkshire property.
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[*7] purchase agreement petitioners and the sellers acknowledged that “this deed
restriction has a significant impact on the value of the Property and that Seller shall
have all rights to claim any tax credits or other benefits derived from the diminution
of value.”
Over the next several months, petitioners explored subdividing the Yorkshire
property. On January 10, 2005, they contracted with Dewberry to provide a refined
version of the limited feasibility study of a portion of the property and a conceptual
layout plan for a subdivision. Between January and March 2005, Dewberry created
a number of plats showing drainage feasibility, available sewer hookups, and ingress
and egress onto Winchester Street.
On March 16, 2005, without petitioners’ knowledge, Ms. Farrar submitted
an application to the Virginia State Historic Preservation Officer to have the
Yorkshire property listed on the State registry and the National Registry of
Historic Places; the property was accepted into the registries shortly thereafter.
Petitioners discovered the listings on March 22, 2005. Concerned about the
listings’ impact on the property’s development potential, petitioners attempted to
negotiate an addendum to the purchase agreement that would divide the Yorkshire
property into two parcels, one consisting of the residence and approximately three
acres and the other consisting of the rest of the property with 75 feet of frontage
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[*8] on Winchester Street. The sellers did not accept the addendum. Eventually,
the sellers waived the provision in the purchase agreement that a historic
conservation easement be placed on the property. This waiver convinced petitioners
to proceed with the purchase because it positively affected the property’s value.
In preparing for the closing, petitioners obtained from Dewberry an area
tabulation allocating three acres to the residence and the rest of the acreage to the
back portion of the property, but configured in such a way that both parcels had
frontage on Winchester Street. Petitioners also contracted with Dewberry to
perform a boundary check of the property, plot a subdivision creating two parcels,
and set pipes for the new lots as needed.
Purchase of the Yorkshire Property
On May 4, 2005, petitioners settled on the Yorkshire property for $1.8
million. They purchased the Yorkshire property intending to continue the
development process that the sellers had started to develop about seven acres. At
the closing petitioners executed a credit line deed of trust note, whereby they
agreed to pay “the principal sum” of $2,310,000 plus interest at a stated rate. The
loan agreement similarly states that the bank agreed to make “a loan in the
principal amount” of $2,310,000. The parties have stipulated that of this amount,
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[*9] $1,760,000 was for the acquisition of the Yorkshire property (the house plus
the 9.875 acres) and the remaining $550,000 was for renovation costs anticipated
for the house. Security for the loan included the Yorkshire property as well as
petitioners’ existing Alexandria residence, which was listed for sale.
On July 13, 2005, petitioners closed on the sale of their Alexandria residence,
applying $462,000 of the proceeds as a partial payoff of the mortgage loan on the
Yorkshire property.3 As of that date, the bank had advanced petitioners $326,635 to
cover renovation costs. Petitioners subsequently took additional draws against the
line of credit to cover additional renovation costs; the draws for renovation costs
ultimately totaled $549,761. Petitioners moved into the Yorkshire house in August
2005 after completing renovations.
On October 17, 2006, having made certain payments on the Yorkshire
property loan in addition to the payoff resulting from the sale of their Alexandria
3
An internal bank email dated July 11, 2005, indicates that after the partial
release of $462,000, the “maximum loan balance”--which we interpret to refer to
the limit of the credit line--was $1,848,000. A computer printout showing the
disbursement and repayment history for the bank loan shows that the $462,000
payoff on July 15, 2005, reduced the then-outstanding principal balance due from
$2,066,635 to $1,624,635.
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[*10] residence, petitioners refinanced their mortgage for a new principal amount of
$1,860,000.4
Purchase Agreement for Yonder Lea Property
On June 15, 2005, petitioners entered into an agreement to purchase the
Yonder Lea property for $1.8 million. The purchase agreement provided for a study
period and several option periods. Petitioners coordinated with Larry Doll, a
developer, who was primarily responsible for handling the potential joint
development of portions of the Yorkshire and Yonder Lea properties. On August 1,
2005, petitioners hired Wetland Studies & Solutions, Inc., to conduct an
environmental study with respect to the proposed development of the properties. By
October 3, 2005, petitioners received approval from the U.S. Army Corps of
Engineers of the wetlands delineation on the project planned for the property and
the adjacent property. Over the next several months, petitioners and Mr. Doll
continued to actively pursue the Town of Warrenton’s approval to develop the two
properties. On January 11, 2006, a deposit was made on the purchase of the
Yonder Lea property pursuant to the purchase agreement.
4
At this time, the original mortgage had an outstanding principal balance of
$1,847,761.
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[*11] At some point it became apparent that Mr. Doll did not want to proceed with
the development. In a letter dated May 5, 2006, to the sellers and their attorney,
Mr. Norman stated that “it has become apparent that the process of obtaining
permits and approvals for development of portions of the Yonder Lea and Yorkshire
properties would be a long and difficult process” and that “The Town is resolute in
their desire to limit access from Winchester Street”. In the letter Mr. Norman
requested an amendment to the purchase agreement that would allow him to pursue
with the town a deal that would permit the owners of the Yorkshire and Yonder Lea
properties to transfer their development rights. The letter stated that, “There is
really no way to quantify the values” of the development rights to be transferred
until the town had taken certain actions and negotiated for the transfer of the
development rights. The sellers did not accept the proposed amendment, and on
July 14, 2006, the parties released the purchase agreement. At this point, Mr.
Norman considered either transferring some of the Yorkshire property’s
development rights, granting a conservation easement on the property, or donating
part of the property to the town. Mr. Norman ultimately did not undertake any of
these actions.
As of the date of trial, petitioners had not subdivided the Yorkshire
property.
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[*12] Petitioners’ Tax Returns
On their 2005 joint Federal income tax return, petitioners claimed an $88,507
home mortgage interest deduction with respect to the Yorkshire property. They
reported no net investment income and claimed no investment interest deduction.
On their 2006 joint return, petitioners claimed an $85,174 home mortgage interest
deduction and a $17,951 investment interest deduction with respect to the Yorkshire
property.5
Respondent’s Determinations
Respondent determined that for 2005 petitioners’ home mortgage interest
deduction was limited to $42,673, the amount paid with respect to $1.1 million of
indebtedness. Respondent further determined that for 2006 petitioners were
entitled to a home mortgage interest deduction of $86,816 (which was slightly
more than petitioners had claimed on their 2006 return) for interest paid on $1.1
million of indebtedness. Respondent disallowed the investment interest deduction
that petitioners had claimed for 2006, however, on the ground that it was paid on
debt in excess of $1.1 million to acquire their residence.
5
Petitioners attached a Form 4952, Investment Interest Expense Deduction, to
their 2006 return, reporting $58,653 in investment interest paid and $17,951 in net
investment income. Petitioners limited their investment interest deduction to
$17,951 for 2006 and reported $40,702 as disallowed investment interest expense to
be carried forward to 2007.
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[*13] OPINION
I. Burden of Proof
In general, the Commissioner’s determinations in a notice of deficiency are
presumed correct, and the taxpayer has the burden of proving that the
determinations are in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933). In particular, deductions are a matter of legislative grace, and the taxpayer
bears the burden of proving entitlement to any claimed deductions. INDOPCO, Inc.
v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292
U.S. 435, 440 (1934). The taxpayer bears the burden of substantiating the amount
and purpose of each expense claimed as a deduction. See Higbee v. Commissioner,
116 T.C. 438, 440 (2001); Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975),
aff’d per curiam, 540 F.2d 821 (5th Cir. 1976).
Section 7491(a)(1) provides that if, in any court proceeding, a taxpayer
introduces credible evidence with respect to any factual issue relevant to
ascertaining the taxpayer’s proper tax liability, the Commissioner shall have the
burden of proof with respect to that issue. Credible evidence is evidence the Court
would find sufficient upon which to base a decision on the issue in the taxpayer’s
favor, absent any contrary evidence. See Higbee v. Commissioner, 116 T.C. at
442.
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[*14] Petitioners argue that pursuant to section 7491(a) the burden of proof has
shifted to respondent and that uncertainty on any issue in this case should be
resolved in their favor. We disagree. As discussed in more detail infra, the issue for
decision is whether petitioners are entitled to deduct, as investment interest, certain
amounts of mortgage interest that do not constitute qualified residence interest under
section 163. Petitioners have failed to introduce sufficient evidence on which we
could base an allocation of the mortgage debt between petitioners’ residence and
other property. Because petitioners have failed to offer credible evidence to
substantiate the disputed interest deductions in amounts greater than respondent has
allowed, section 7491(a) does not operate to shift the burden of proof to respondent.
Accordingly, the burden of proof remains with petitioners.
II. General Principles of Applicable Law
As a general rule, individuals may not deduct personal interest. Sec. 163(h).
Limited exceptions to this general rule permit individuals to deduct investment
interest and qualified residence interest. Sec. 163(h)(2).
For noncorporate taxpayers, investment interest is deductible only to the
extent of the taxpayer’s net investment income for the taxable year.6 Sec.
6
Investment interest disallowed under this limitation is treated as investment
interest paid or accrued by the taxpayer in the succeeding taxable year. Sec.
(continued...)
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[*15] 163(d)(1). Investment interest generally means “any interest * * * which is
paid or accrued on indebtedness properly allocable to property held for investment.”
Sec. 163(d)(3)(A). Investment interest excludes qualified residence interest. Sec.
163(d)(3)(B)(i).
Section 163(h)(3)(A) defines qualified residential interest as any interest paid
or accrued during the taxable year on:
(i) acquisition indebtedness with respect to any qualified residence of
the taxpayer, or
(ii) home equity indebtedness with respect to any qualified residence of
the taxpayer.
Acquisition indebtedness is debt used to acquire, construct, or improve a
“qualified residence” and that is secured by that residence. Sec. 163(h)(3)(B)(i).
The aggregate amount treated as acquisition indebtedness for any period cannot
exceed $1 million ($500,000 for a married individual filing a separate return).
Sec. 163(h)(3)(B)(ii). Acquisition indebtedness includes debt incurred in
refinancing acquisition indebtedness, insofar as the new debt does not exceed the
refinanced debt. Sec. 163(h)(3)(B) (flush language). Home equity indebtedness is
the first $100,000 of debt ($50,000 for a married taxpayer filing separately), other
6
(...continued)
163(d)(2).
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[*16] than acquisition indebtedness, secured by a “qualified residence” so long as
the debt does not exceed the fair market value of the residence reduced by the
qualified acquisition indebtedness. Sec. 163(h)(3)(C). As relevant here, “qualified
residence” means the taxpayer’s “principal residence” within the meaning of section
121. Sec. 163(h)(4)(A)(i).
Section 121 does not define the term “principal residence” but, subject to
various limitations, allows for the exclusion of gain on the sale or exchange of
property “owned and used by the taxpayer as the taxpayer’s principal residence”.
Sec. 121(a). A principal residence includes both the dwelling unit and associated
land. See Gates v. Commissioner, 135 T.C. 1, 8-10 (2010). In various
circumstances, courts have found a principal residence to include considerable
acreage surrounding the dwelling unit. See, e.g., Bogley v. Commissioner, 263 F.2d
746, 748 (4th Cir. 1959) (holding that the taxpayers’ sale of 10 acres of unimproved
land, less than a year after the sale of the dwelling unit and surrounding 3 acres from
the original 13-acre parcel, qualified as a sale of the taxpayers’ principal residence),
rev’g 30 T.C. 452 (1958); Schlicher v. Commissioner, T.C. Memo. 1997-37
(holding that 43.5 of 51 acres of the taxpayer’s property was his principal residence
for purposes of the nonrecognition of gain provision of former section 1034).
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[*17] III. Summary of the Parties’ Positions
The parties agree that the Yorkshire property (or some portion of it) was
petitioners’ principal residence during the years in issue. There is no dispute that
the debt giving rise to the disputed deductions was used (at least in part) to acquire
and improve petitioners’ principal residence and that the fair market value of this
residence exceeded the amount of the associated outstanding debt. The parties
agree that the first $1 million of the debt constitutes acquisition indebtedness and
that petitioners are entitled to mortgage interest deductions for interest attributable
to this portion of the debt. Respondent concedes that petitioners may also deduct
interest attributable to an additional $100,000 of home equity indebtedness. The
primary issue for decision, then, is whether petitioners may deduct interest
attributable to more than $1.1 million of the debt.
A. Petitioners’ Position
Petitioners contend that they paid $1.8 million for the Yorkshire property,
of which $1 million was for the dwelling unit plus three acres and $800,000 of
which was for “investment property” consisting of the other 6.875 acres.
Consequently, they contend, the interest on $1 million of the mortgage debt is
deductible as qualified personal residence interest, and the interest on the
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[*18] remaining $800,000 of the mortgage debt is deductible as qualified investment
interest.7
B. Respondent’s Position
Respondent’s position is that petitioners may deduct, as qualified residence
interest, (1) interest attributable to the first $1 million of acquisition indebtedness
and (2) interest attributable to an additional $100,000 of home equity
indebtedness. Respondent contends that petitioners are not entitled to deduct any
additional amounts of interest paid with respect to the mortgage secured by the
Yorkshire property. Respondent concedes that petitioners intended to subdivide a
significant portion of the Yorkshire property at some future date. But respondent
contends that, as a legal matter, petitioners may not allocate any part of the
mortgage to investment property because they did not actually subdivide the
property or use it for any business purpose enumerated under section 280A.8
Respondent further contends that even if petitioners were not legally precluded
7
As discussed in more detail infra, the evidence does not support any premise
that the amount of the mortgage debt was exactly $1.8 million at any relevant time.
8
As a general rule, sec. 280A(a) denies deductions with respect to the use of a
dwelling unit that the taxpayer used as a residence during the taxable year. Sec.
280A(c)(1)(A), however, permits the deduction of expenses allocable to a portion of
a dwelling unit that a taxpayer used exclusively and on a regular basis as the
principal place of business for the taxpayer’s trade or business.
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[*19] from allocating part of their mortgage to investment property, they have
nevertheless failed to substantiate their claimed allocation. Furthermore, respondent
contends, petitioners may not deduct any investment interest for 2005 because they
reported no net investment income for that year.
IV. Analysis
A. Petitioners’ 2005 Taxable Year
On their 2005 joint income tax return, petitioners reported no net investment
income and claimed no investment interest deduction. In this proceeding they
contend that a portion of the amount that they claimed as a mortgage interest
deduction should be reclassified as investment interest deductible under section
163(h)(2). Because petitioners reported no net investment income for 2005,
however, they are not entitled to deduct any amount as investment interest for that
year. See sec. 163(d)(1).
B. Petitioners’ 2006 Taxable Year
For 2006 petitioners claimed a $17,951 investment interest deduction, which
equaled the net investment income they reported for 2006. This deduction is
predicated on their claim that the Yorkshire property mortgage debt should be
allocated between $1 million of debt for their primary residence and $800,000 of
debt for investment property. For the reasons discussed below, we agree with
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[*20] respondent that petitioners have failed to substantiate this claimed allocation
or to provide any adequate evidentiary basis to support such an allocation.
Accordingly, it is unnecessary for us to decide, and we do not decide, whether, as
respondent also contends, petitioners are precluded from allocating any part of the
mortgage to investment property because they did not actually subdivide the
property or use it for any business purpose enumerated under section 280A.
The purchase agreement for the Yorkshire property makes no allocation of
the purchase price between subparcels, and the parties to the transaction never
discussed any such allocation when they entered into the purchase agreement.
Some months after entering into the purchase agreement petitioners attempted to
negotiate an addendum that would have divided the Yorkshire property into two
parcels, one consisting of the residence and approximately three acres and the other
consisting of the rest of the property with 75 feet of frontage on Winchester Street.
The sellers did not accept the addendum.
Petitioners arrive at their proffered allocation of the mortgage largely on the
basis of their claim that Ms. Farrar originally offered to sell them the Yorkshire
house and three acres for $1 million. They observe that they expressed a
willingness to pay $1.8 million only after the sellers insisted that the sale should
include all 9.875 acres of the Yorkshire property. Consequently, they contend,
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[*21] they paid the additional $800,000 for the extra 6.875 acres with the intention
of developing this acreage. Accordingly, they conclude, $800,000 of the mortgage
should be allocated to investment property, and interest associated with this portion
of the mortgage should be deductible as investment interest under section
163(d)(3)(A) and not subject to the limitations on deductibility of qualified
residence interest.
We disagree with petitioners’ analysis. In the first instance, even assuming
that the conversations with Ms. Farrar occurred as Mr. Norman testified, such
conversations would not amount to a meeting of the minds as to any definite
agreement. To the contrary, the evidence shows that when petitioners sought,
three months after this alleged conversation with Ms. Farrar, to negotiate the deal on
these terms, the sellers were no longer interested. Even if Ms. Farrar’s initial
comments should be construed as an offer, the sellers had the right to withdraw it at
any time before acceptance, see Hoffstot v. Dickinson, 166 F.2d 36, 40 (4th Cir.
1948), and did so by insisting on selling the entire Yorkshire property for $1.8
million. Consequently, Ms. Farrar’s alleged conversations with Mr. Norman in
December 2003 do not adequately support petitioner’s claimed basis for allocating
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[*22] the mortgage debt as of the time that the purchase agreement was finally
executed a year later.9
Moreover, the purchase agreement contained terms and restrictions not
necessarily contemplated in Mr. Norman’s alleged initial conversations with Ms.
Farrar about selling the house and three acres for $1 million. In particular, the
purchase agreement provided that the sellers intended to place on the Yorkshire
property a historic conservation easement that would limit the number of
residential units that could ultimately be built on the property. The purchase
agreement expressly acknowledges that such a deed restriction would have a
“significant impact on the value of the Property” and that any resulting tax
benefits would accrue to the sellers. Ultimately, the sellers waived this provision,
but only after they had, without petitioners’ foreknowledge, placed the Yorkshire
property on the State registry and the National Registry of Historic places--actions
9
As corroboration for Mr. Norman’s testimony about Ms. Farrar’s purported
oral offer, petitioners also point to various financial summaries that Mr. Norman
prepared while petitioners were considering whether to go forward with the
purchase of the Yorkshire property. But these summaries reflect only unproven
assumptions about the purported investment property’s value. Similarly, we reject
petitioners’ suggestion on brief that their attempt to purchase another house in
Warrenton for $1,040,000 before purchasing the Yorkshire property is indicative of
the value of the Yorkshire dwelling unit plus three acres.
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[*23] that also presumably affected the property’s investment potential and the
allocation of value among any subparcels.
Petitioners have submitted no expert witness testimony to support the values
upon which they seek to predicate an allocation of the mortgage debt. Making
accurate valuation even more difficult is the fact that the boundaries of any actual
geographic division between the Yorkshire house and the purported investment
portion of the parcel remain unclear. Different plans for the Yorkshire property over
time show different parts of the land being used, depending upon various factors that
became known between the time petitioners entered into the purchase agreement
and the time that they settled on the Yorkshire property. For instance, the
addendum to the purchase agreement that petitioners proposed (and that the sellers
rejected) specified that both the approximately three acres surrounding the dwelling
unit as well as the additional acreage (which petitioners contend was investment
property) would have frontage on Winchester Street. After the town of Warrenton
refused to grant access rights from Winchester Street to the proposed development
site, however, it became necessary to change the configuration of the proposed
development to allow for other access.
Moreover, petitioners have failed adequately to account for the fact that the
purchase of the Yorkshire property was financed with a single credit line deed of
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[*24] trust note of $2,310,000, representing $1,760,000 for acquisition costs and
$550,000 for renovation costs. Petitioners suggest that the $550,000 was a
separate “bridge loan” that was extinguished upon the sale of their former
Alexandria, Virginia, residence and consequently that it should be disregarded.
This view is difficult to square with the evidence. Both the credit line deed of
trust note and the loan agreement indicate that there was a single loan rather than
separate loans. Petitioners’ sale of their Alexandria residence in July 2005
resulted in a partial mortgage payoff of $462,000, even though as of that time the
bank had advanced them only $326,635 for renovation costs. Clearly, a payoff
that exceeded the funds advanced for renovation costs is not properly viewed as
merely extinguishing a separate subloan for renovation costs, as petitioners
suggest. Rather the evidence shows that the payoff was applied to the then-
outstanding principal balance of the entire loan, which decreased from $2,066,635
to $1,624,635.10
10
Petitioners subsequently made additional draws for renovations, which
ultimately totaled $549,761. These additional draws were added to the principal
amount due.
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[*25] On October 17, 2006, petitioners refinanced their mortgage for a new
principal amount of $1,860,000.11 This refinanced debt gave rise to new
acquisition indebtedness for purposes of determining the limitation of petitioner’s
qualified residence interest deduction. This refinanced debt--like the original
mortgage--was secured both by the dwelling unit, which by that time had been
improved by over one-half million dollars of petitioners’ renovations, and the
9.875 acres of the Yorkshire property. Any allocation of either the original or the
refinanced mortgage loan would need to take into account the value-enhancing
renovations to the Yorkshire house.12 In deciding what portion, if any, of the
11
At that time the principal balance on the original mortgage loan was
$1,847,761. This outstanding balance was paid off, presumably from the
refinancing proceeds, on October 24, 2006.
12
Respondent contends on brief that because the $550,000 renovation
portion of the loan was used to improve the Yorkshire house, it must be included
in the amount of the acquisition indebtedness. See sec. 163(h)(3)(B)(i) (defining
acquisition indebtedness as indebtedness “incurred in acquiring, constructing, or
substantially improving any qualified residence of the taxpayer” which is “secured
by such residence”). This position seems inconsistent with respondent’s
determination in the notice of deficiency, which respondent has not otherwise
sought to repudiate in this proceeding, that petitioners are entitled to deduct
interest attributable to $100,000 of home equity indebtedness. This determination,
unlike respondent’s position on brief, is consistent with Rev. Rul. 2010-25, 2010-44
I.R.B. 571, which holds that if a loan that otherwise would be acquisition
indebtedness exceeds the $1 million cap, the excess may be treated as home equity
indebtedness. This Court has held that sec. 163(h) restricts the residential
mortgage interest deduction to interest paid on $1 million of acquisition
(continued...)
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[*26] acquisition indebtedness should be allocated to investment property, we
cannot simply ignore, as petitioners would seem to have us to do, the extensive
renovations to the house, the various draws and repayments on the note, and the
ultimate refinancing of the note.
In sum, petitioners have provided no adequate evidentiary basis to support
their claimed allocation, or any other allocation, of their mortgage loan between
residential property and purported investment property. Accordingly, petitioners are
not entitled to deduct interest expenses for 2006 greater than respondent has
allowed.
To reflect the foregoing,
An appropriate decision
will be entered.
12
(...continued)
indebtedness and that excess amounts that otherwise would be acquisition
indebtedness cannot be treated as home equity indebtedness. Pau v.
Commissioner, T.C. Memo. 1997-43; see also Catalano v. Commissioner, T.C.
Memo. 2000-82, rev’d on other grounds, 279 F.3d 682 (9th Cir. 2002). Given
respondent’s concession of the issue in this case, we need not address it, see
Bronstein v. Commissioner, 138 T.C. __, __ (slip op. at 7 n.6) (May 17, 2012), nor
is the resolution of this matter material to our analysis supra.