Huntsman v. Commissioner

91 T.C. No. 57, 91 T.C. 917, 1988 U.S. Tax Ct. LEXIS 141

• Court: United States Tax Court
• Decided: November 17, 1988
• Docket: Docket No. 5883-87
• Status: Published

Opinions

OPINION

TANNENWALD, Judge:

Respondent determined a deficiency of $8,020 in petitioners’ 1983 Federal income tax. After concessions, the sole issue is whether petitioners are entitled to deduct in the year paid, as interest expense, loan origination and loan discount fees (points) paid in connection with refinancing their principal residence.

The facts have been fully stipulated. The stipulation of facts and attached exhibits are incorporated herein by reference.

Petitioners resided in Stillwater, Minnesota, at the time that they filed their petition. They timely filed a joint Federal income tax return on a cash basis for 1983.

In January 1981, petitioners purchased a principal residence in Stillwater, Minnesota. The residence was partly financed by a loan, secured by a mortgage on the property, in the amount of $122,000. The note was payable in monthly installments with the balance to be paid in January 1984. In July 1982, petitioners financed a home improvement with a loan of approximately $22,000, secured by a second mortgage on the property.

On September 16, 1983, petitioners refinanced their residence with a 30-year loan, the proceeds of which were used to pay off the notes secured by the existing first and second mortgages. This loan was also secured by a mortgage on their residence. As part of the refinancing, petitioners paid points from their own funds. The points consisted of a loan origination fee of $1,480 and a loan discount fee of $2,960, for a total of $4,440. They deducted this amount as interest expense.

Section 163(a)¹ generally allows a deduction for all interest paid within a taxable year on indebtedness. That section must be read in conjunction with section 461. Zidanic v. Commissioner, 79 T.C. 651, 653 (1982). Section 461(g) sets out the general rule that a cash basis taxpayer is to treat prepaid interest in the same manner that an accrual basis taxpayer would — that is, he is allowed a deduction in the year during which the interest represents a charge for the use or forbearance of money.²

Section 461(g)(2) contains an exception to this general rule for certain points paid in connection with certain loans secured by mortgages on principal residences. That paragraph provides:

(2) Exception. — This subsection shall not apply to points paid in respect of any indebtedness incurred in connection with the purchase or improvement of, and secured by, the principal residence of the taxpayer to the extent that, under regulations prescribed by the Secretary, such payment of points is an established business practice in the area in which such indebtedness is incurred, and the amount of such payment does not exceed the amount generally charged in such area.

The parties agree that the points paid as part of the refinancing transaction meet all the criteria for deductibility in the year paid except whether the debt was incurred “in connection with the purchase or improvement” of petitioners’ principal residence. Petitioners contend that that phrase encompasses a refinancing transaction such as the one that they consummated, so that the points they paid are immediately deductible. Respondent contends otherwise, and argues that the points may only be deducted ratably over the life of the loan.³ We agree with respondent.

We have not had occasion to interpret the meaning of “in connection with the purchase or improvement” as used in section 461(g). We note, however, that in other cases dealing with the exception in section 461(g)(2), we have construed the terms used therein narrowly, requiring taxpayers to comply with all requirements for the exception therein to apply. See Schubel v. Commissioner, 77 T.C. 701 (1981).⁴ We think that, in light of the legislative history of section 461(g), a limited reading of the term “in connection with the purchase or improvement” is appropriate here and therefore sustain respondent’s position.

The legislative history does not deal directly with the treatment under section 461(g)(2) of points paid in refinancing transactions. The House report, however, provides that: “A loan will not qualify under this exception * * * if the loan proceeds are used for purposes other than purchasing or improving the taxpayer’s principal residence.” H. Rept. 94-658, at 101 (1975), 1976-3 C.B. (Vol. 2) 695, 793. Identical language is contained in the Senate report and the Staff of the Joint Committee on Taxation’s General Explanation. See S. Rept. 94-938, at 105 (1976), 1976-3 C.B. (Vol. 3) 49, 143; Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1976, at 102 (1976), 1976-3 C.B. (Vol. 2) 1, 114.

By using this language, we think that Congress meant to limit the application of the exception in section 461(g)(2) to points paid in respect of financing the actual purchase of a principal residence or financing improvements to such residence. In this connection, we think it of some significance that when Congress dealt further with the deductibility of home mortgage interest in the Revenue Act of 1987, it saw fit to treat with specificity the refinancing of such a mortgage. Pub. L. 100-203, sec. 10102(a), 101 Stat. 1330-384 (now codified át section 163(h)(3)). Cf. Dunn Trust v. Commissioner, 86 T.C. 745, 755 n. 4 (1986).

In a refinancing transaction, the funds generated by the loans generally are used not to purchase or improve a principal residence but to pay off the loan that is already in existence and thereby lower the interest costs incurred or achieve some other financial goal not connected directly with home ownership. Therefore, we hold that the exception to section 461(g)(1) set forth in section 461(g)(2) does not apply to points paid on refinancing transactions and that, if such points are otherwise deductible, they are deductible ratably over the life of the loan.⁵

Our conclusion herein is not changed by the facts that the final principal payment on petitioners’ purchase money loan was due in January 1984 and that the proceeds of the refinancing loan were used to make that payment. Both the structure of the original financing and the means to meet the obligation under that note were at least in part of petitioners’ choosing, and neither is directly related to the actual acquisition of the principal residence.

To reflect the foregoing, and concessions by the parties,

Decision will be entered under Rule 155.

Reviewed by the Court.

Nims, Chabot, Korner, Cohen,. Jacobs, Wright, and WHALEN, JJ., agree with the majority opinion. Whitaker, Swift, Gerber, Parr, Williams, and WELLS, JJ., did not participate in the consideration of this case.

1 Unless otherwise indicated, all section references are to the Internal Revenue Code as amended and in effect during the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

2 Sec. 461(g)(1) provides:

(1) In general — If the taxable income of the taxpayer is computed under the cash receipts and disbursements method of accounting, interest paid by the taxpayer which, under regulations prescribed by the Secretary, is properly allocable to any period—

(A) with respect to which the interest represents a charge for the use or forbearance of money, and

(B) which is after the close of the taxable year in which paid,

shall be charged to capital account and shall be treated as paid in the period to which so allocable.

3 Respondent’s position herein is reflected in Rev. Rul. 87-22, 1987-1 C.B. 146, which does not, however, constitute substantive authority for that position. Stark v. Commissioner, 86 T.C. 243, 250-251 (1986). Respondent has made no attempt to deal separately with the points representing the loan origination fee and the points representing the loan discount fee (see p. 918, supra); he deals with both fees in the context of interest for the purposes of applying sec. 461. We do the same. See Rev. Rul. 67-297, 1967-2 C.B. 87. See also Noble v. Commissioner, 79 T.C. 751, 776 n. 22 (1982).

4 See also Cathcart v. Commissioner, T.C. Memo. 1977-328.

5 We do not herein decide that all types of refinancing of a principal residence fall outside the exception of sec. 461(g)(2). An example may be the building of a residence with a construction loan replaced upon completion with a permanent mortgage loan. Another example may be a “bridge” loan, depending upon the circumstances. Since the record herein does not permit the conclusion that the instant case falls within either category, we do not reach the questions involved.