Tax Court denies investment interest deduction.

• Author: Beavers, James A.
• Position: 2012 memorandum decision in Norman v. Commissioner

The Tax Court held that the taxpayers were not entitled to take an investment interest deduction for any of the mortgage interest they paid on property they had purchased because they failed to substantiate their claimed allocation of the mortgage debt.

Background

John Norman, a real estate broker who lived in Alexandria, Va., decided to purchase a house to use as a personal residence in his hometown of Warrenton, Va. Norman found a suitable house in the old town area of Warrenton that was located on 9.875 acres (the Yorkshire property). However, Norman only wished to purchase the house and some of the land. Initially, the owners of the Yorkshire property were interested in selling the home and three acres and developing and subdividing the rest of the land in conjunction with an adjoining parcel (the Yonder Lea property). According to Mr. Norman, one of the owners of the Yorkshire property said they would sell Norman the house and three acres of the land for $1 million.

The owners later decided that they would only sell the entire property to Norman and offered it to him for $1.8 million. After making some financial analyses, Norman decided he could purchase the entire property and recover the additional $800,000 by developing part of the land himself. On May 4, 2005, Norman and his wife settled on the Yorkshire property for $1.8 million with the intent to develop about seven acres.

At the closing, the Normans 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, and the bank agreed to make "a loan in the principal amount" of $2,310,000. Of this amount, the Normans and the IRS agreed that $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 the Normans' existing Alexandria residence, which they had listed for sale.

On July 13, 2005, the Normans 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. As of that date, the bank had advanced the Normans $326,635 to cover renovation costs. They subsequently took additional draws against the line of credit to cover additional renovation costs; the draws for renovation costs ultimately totaled $549,761. The Normans moved into the Yorkshire...