Joint ownership of real estate is very common (as is joint payment of mortgage interest and taxes). Normally, with married couples, the deductions relating to property taxes and mortgage interest for the property are taken on the couple’s joint return. With unmarried co-owners, usually each owner pays half of the taxes and mortgage, and each takes half of the deductions. But what happens if joint owners pay these expenses other than proportionally to their ownership in the property? Do they each still split the deductions, or does the deduction follow the payor?
For the rest of this post, let’s assume that Joe and Mary, unmarried, own a home together. They are listed as joint tenants with right of survivorship, meaning they each hold a 50% interest in the property. Joe pays 100% of the taxes and interest on the property. Can Joe deduct 100% of the mortgage interest and taxes?
Let’s begin with property taxes. In order to take a deduction for property taxes, the taxpayer must both have the tax imposed upon him, and also actually pay the tax. Treas. Reg. 1.164-1(a). Joe easily fulfills the second prong, as he has paid all of the taxes. However, in New Jersey and most other states, real estate taxes are “imposed” against the property, not the taxpayer. See N.J.S.A. 54:4-1. How can he then fulfill the first prong of the test?
In Powell v. Commissioner, T.C. Memo 1967-32, an owner of one-sixth of a property paid 100% of the property taxes. The Tax Court ruled that when the tax is not “imposed” on a person but rather against the property, the tax is considered “imposed” against any person who would would forfeit his property in the event the tax went unpaid. In so holding, the court relied upon Treas. Reg. 1.164-6(c)(3), which addresses apportionment of taxes between a buyer and seller of real estate. Rev. Rul. 71-268 reached a similar conclusion where two co-owners had joint and several liability for payment.
In our hypothetical, if Joe only pays half of the property taxes on the property, and the other half go unpaid, he loses all of his real estate (not just half) in a tax sale. As a result, it certainly seems 100% of the tax is considered “imposed” on Joe, and he is therefore entitled to 100% of the deduction.
Mortgage interest has a different standard for deductibility. To deduct the interest, it must be paid by the taxpayer, have been used to acquire the property (or be “home equity indebtedness”), and be secured by the taxpayer’s residence. IRC 163(h)(3). There is no mention in the statute about any personal liability for payment being “imposed” on the taxpayer. Under this test, Joe would seem to easily clear both prongs and be entitled to a full deduction. [This doesn’t address any gift tax consequences relating to the principal portion of the payments, which will be addressed in a future post.]
This analysis is particularly important for couples using disclaimer credit shelter trusts in New Jersey. With our $675,000 estate tax threshold, fully funding a credit shelter trust at the death of the first spouse is particularly important. Most of my clients have the bulk of their net worth in IRAs in today’s times. Because IRAs are poor assets for funding into a credit shelter trust (due to the loss of future income tax deferral), clients will often fund a deceased spouse’s portion of the primary residence into the credit shelter trust. This creates a situation where the surviving spouse co-owns the home with the trust. In this scenario, documents I draft typically impose a duty on the surviving spouse to pay ongoing property taxes in order to continue living on the property. As can be seen from this analysis, the surviving spouse should be entitled to deduct 100% of the real estate taxes paid. [Further, with careful drafting of a separate “residential credit shelter trust”, IRC 678 can also permit deductibility, as well as preserve the principal residence capital gain exclusion for the survivor. This will also be a topic of a future post.]
As always, a trusted tax advisor is key to getting this stuff right. If you have any questions, feel free to contact me.