Deferred interest payments

A family friend is willing to loan money and receive a first mortgage on a home purchased by a recent college grad.

The homebuyer is not in a position to deduct the interest payments on his income taxes for the next several years. Can the interest be deferred and paid in a subsequent year(s) when the homebuyers income will increase and thus he will be able to itemize deductions and receive a tax benefit for the interest payments?

If so, can the homebuyer make principal payments while the interest is being deferred?

Reply to
Pico Rico
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I know of nothing in the law that prevents a qualified mortgage loan from being written with negative amortization (interest is earned but unpaid and increases the balance of the loan by the accrued amount) for a set number of years and the payments increasing in the remaining years of the loan to pay off the interest and principal.

Reply to
Alan

Whether or not it makes sense to itemize deductions is based on the amount of the standard deduction, not the amount of income.

I agree that negative amortization is not a problem, but what about the second part of the question -- can he still make payments during the interest accrual (negative amortization) period and simply claim that they are 100% principal? For example, suppose his first payment under a normal amortization schedule (equal monthly payments) would be $20 principal plus $800 interest, total $820. If he makes a $20 payment, it makes sense that would be principal, but what if he makes a $520 payment? Can that all be considered principal? If so, then he has a net $300 increase in principal ($800 interest added to principal less $500 payment).

When the loan is eventually paid off, will he be able to deduct the full $800 as mortgage interest? This seems like a "too good to be true" method for shifting deductions into future years. On the other hand, a reverse mortgage does allow for deferred deduction of interest, but no current payments are made, only a balloon payment when the property is disposed.

I had a bank mortgage once that provided for negative amortization, but with each payment I was only credited for the normal principal amount, the rest went to (partial) interest.

Also, not asked, but I wonder whether the lender in this case would have to report interest income as it accrued, or only at the end of the loan, when it is paid?

Reply to
Mark Bole

good questions.

I think the plan would be accrue interest and one big balloon payment at the end of the term. If the homebuyer wants to and is able to make prepayments he is free to do so, and hopefully be able to pick how much he wants to count as principal and how much interest (including zero), if mutually agreed to.

If lender is an cash basis individual, when would he have to report interest income when it is accrued, or only when paid?

Reply to
Pico Rico

My guess is that if OP's friend does what he plans, and the IRS catches him, the lump sum interest deduction will be denied.

I agree with Alan that there is nothing that I am aware of that specifically prohibits doing what is proposed. But in the opposite situation (prepaid interest), the deduction for interest paid for years when it is not earned is not allowed.

Additionally, the IRS has the right to reallocate income from one year to another when they think that a distortion of income would otherwise occur.

Reply to
Stuart A. Bronstein

[...]

Put another way, can you have concurrent negative amortization and positive amortization, if the only purpose is to give you a tax advantage?

Reply to
Mark Bole

One way to accomplish this if your friend is amenable, is to write the loan with an adjustable rate. E.g., let's say the actual rate should be

4.5%. The monthly payment should be based on 4.5%. Year one's rate could be 0%. year 2 = 1%. year 3 = 2%. year 4 = 3%. year 5 = 4.5%. year 6 and beyond = 4.5% plus a small fraction that would act as a catchup. The loan would have a sliding prepayment penalty built in for x number of years to protect the lender.
Reply to
Alan

There are special rules about loans at below-market interest rates, where the loan is treated as a gift, but the lender has to pay tax on the imputed interest anyway, or something like that. Read all about it in this baffling bit of the tax code:

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Reply to
John Levine

Yeah, I would guess that the lender would be taxed currently under either the "below market interest" or "original issue discount" (which covers more than just OID per se) rules. Also, if the lender and borrower are related, it becomes more likely that a "gift" would be found within this arrangement.

MTW

Reply to
MTW

While I still don't know about tax deductibility, I don't think the loan as structured in Alan's example is necessarily "below market". First, while he said to use a variable rate, it was structured so that the overall rate for the life of the loan, as well as the monthly payments, were based on a market rate.

A bank wants to extend a loan as long as possible, that's how they make money. But an individual might legitimately value an early payoff, and build in an incentive to make that happen. That is what Alan's method amounts to. I made a small personal loan once to a relative that included essentially the same thing: an early payment bonus, not penalty.

Also, in non-deflationary times, it's my understanding that one expects a lower rate of return on a short term loan vs. long term, so it makes sense to me that rate earned by the lender in the first few years might start lower and then rise over time.

Reply to
Mark Bole

Mark is on point to my method. The interest rate for the loan period will meet the AFR rules and the prepayment penalty early in the life of the loan also ensures that the loan meets the AFR rules and will keep the IRS off your back.

Reply to
Alan

The mortgage can be written any way the buyer and lender agree, Whether the IRS will accept the loan language as compliant with tax law is a separate question.

Back in the 70s I had a student loan that was written such that all principal was paid before any interest. The university received a PLR (or whatever they may have been called then) allowing the practice.

I seem to recall that the same was allowed recently (within last year or two), but I can't remember the specifics or in what context.

Ira Smilovitz

Reply to
ira smilovitz

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