Non-recourse Debt and Tax Shelter

[Jason Dillard]

I have a new CPA that is struggling to allow me to use the tax shelter from owning properties that have "Unqualified" debt.   Maybe a partner signed for the bank debt or I took a property subject to that disqualified me.   She says if I am not obligated to repay debt, I loose the deductions.   Someone please explain? 

[Linda Weygant]

Your CPA is correct, @Jason Dillard.  This is an IRS ruling that has been through the tax courts many times and is one of those things that nobody talks about when they try to sell you on how amazing "subject to" is.  

Here is what the IRS has to say about it: (Publication 936)

Secured Debt You can deduct your home mortgage interest only if your mortgage is a secured debt. A secured debt is one in which you sign an instrument (such as a mortgage, deed of trust, or land contract) that: Makes your ownership in a qualified home security for payment of the debt, Provides, in case of default, that your home could satisfy the debt, and Is recorded or is otherwise perfected under any state or local law that applies. In other words, your mortgage is a secured debt if you put your home up as collateral to protect the interests of the lender. If you cannot pay the debt, your home can then serve as payment to the lender to satisfy (pay) the debt. In this publication, mortgage will refer to secured debt. Debt not secured by home. A debt is not secured by your home if it is secured solely because of a lien on your general assets or if it is a security interest that attaches to the property without your consent (such as a mechanic's lien or judgment lien). A debt is not secured by your home if it once was, but is no longer secured by your home. 

Wraparound mortgage. This is not a secured debt unless it is recorded or otherwise perfected under state law.

Example. Beth owns a home subject to a mortgage of $40,000. She sells the home for $100,000 to John, who takes it subject to the $40,000 mortgage. Beth continues to make the payments on the $40,000 note. John pays $10,000 down and gives Beth a $90,000 note secured by a wraparound mortgage on the home. Beth does not record or otherwise perfect the $90,000 mortgage under the state law that applies. Therefore, the mortgage is not a secured debt and John cannot deduct any of the interest he pays on it as home mortgage interest.

Long story short:

In order to be deductible, you must be liable for the debt as well as actually pay the debt.