Many Foreign Service families own homes state-side, which they rent while they are abroad. The Internal Revenue Code (IRC) allows for deductions on several home-related expenses, but each deduction has its own unique legal requirements. In general, there is no "double-dipping" or claiming a deduction twice for the same expense. The case of Hume v. IRS perfectly illustrates an important difference: deductible business expenses under IRC Sec. 162 (reported on Schedule C) versus deductible home mortgage interest payments under IRC Sec. 163(h) (reported on Schedule A).
In Hume v. IRS, a married couple bought a home in San Clemente, CA (Calle Pacifica) where they lived with their children as a family. They purchased a second home (Cazador Lane) that they intended to use as a rental property. Unfortunately, things did not go according to plan and Mr. Hume and Ms. Dilani divorced. The Cazador Lane home was never actually rented out or advertised as a rental/sale property. The couple then refinanced both homes for a total of over $3 million in new mortgages. Mr. Hume initially claimed the mortgage interest expenses on both homes as a Schedule C deduction for business expenses (IRC Sec. 162). The IRS disagreed that he met the ongoing business requirements of Section 162 and assessed a deficiency. The IRS's position was that, at best, Mr. Hume could deduct the mortgage interest he was paying on $1.1 million of his home loans on Calle Place alone (the only place he'd lived) because he never actually commenced operating the home as a rental property--a business. The Tax Court agreed with the IRS:
" . . .it is the third factor, whether petitioners’ business had actually commenced, that is ultimately determinative here. While not conclusive, it is important to note that Mr. Hume derived no income from and did not rent out Cazador in either of the two years at issue. Mr. Hume testified that petitioners never were able to get Cazador into a “condition to be able to” rent it. Additionally, Mr. Hume was living at Cazador during 2008 and 2009. Accordingly, his course of conduct was not consistent with that of a person who believed he was renting or able to rent out the property during 2008 or 2009.
"We conclude that during 2008 and 2009 petitioners had not yet restarted the prior owner’s rental business that petitioners had abandoned in December 2005 and therefore petitioners are not entitled to a section 162 deduction for 2008 or 2009. Consequently, the mortgage interest petitioners paid on the indebtedness secured by Cazador and Calle Pacifica is not a section 162 ordinary business expense, but rather is deductible, if at all, as qualified residence interest pursuant to section 163(a) that is subject to the limitations of section 163(h)."
The lesson here is that if you hope to deduct expenses, particularly mortgage interest, on a business property, you must actually be operating your business. Alternatively, if you hope to deduct your home mortgage interest, you must actually be living in the residence--your home.
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