Interest on residential property debt not deductible as investment interest.

• Author: Jang, Jaclyn

In Norman, T.C. Memo. 2012-360, the Tax Court held that taxpayers who purchased a residence with the intention to treat part of the tract as investment property could not deduct any of the interest on indebtedness as investment interest. The Tax Court agreed with the IRS that the taxpayers failed to properly prove an allocation between residential property and investment property. Consequently, the taxpayers were allowed to deduct only the interest attributable to $1.1 million of the debt as qualified residence interest.

Facts

The taxpayers in late 2004 entered into an agreement to purchase a historic single-family residence on 9.875 acres in the Old Town area of Warrenton, Va., (the York-shire property) for $1.8 million. When the taxpayers had initially approached the sellers about purchasing the property in 2003, the sellers had indicated that they would sell the house and three acres for $1 million, but later the sellers reconsidered and offered the entire tract for $1.8 million. The taxpayers agreed and planned to recover $800,000 of the purchase price by subdividing the property into several lots and developing them.

The purchase agreement did not provide for an allocation of the purchase price into subparcels, and the parties to the agreement did not discuss an allocation. The purchase agreement provided for a 90-day study period, during which the taxpayers could investigate the property further before closing. During this period, the taxpayers contracted a civil engineering firm to study the property and provide a feasible plan of subdivision.

Some months after entering into the purchase agreement, the sellers placed the Yorkshire property onto a state historic registry and the National Register of Historic Places without notifying the taxpayers. The sellers consequently refused to allow the taxpayers to add an addendum to the purchase agreement that would have allowed the taxpayers to divide the property into two parcels, one including the residence with three acres, and the other consisting of the remainder of the property. In May 2005, the taxpayers settled on the Yorkshire property for $1.8 million. At closing, the loan documents stated that the bank agreed to make a loan of $2,310,000, which represented $1,760,000 to acquire the property and $550,000 to renovate the house.

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The taxpayers began extensive renovations on the Yorkshire property shortly after closing with an advance from the bank to cover...