FORM 1098 (Mortgage interest reporting)

(A) No. You should download the form 1098 from the website and fill it out and keep it for your records though.

(B) Only mortgage companies do that.

The mortgage interest is only deductible if it is secured by the house itself, meaning that if the borrower defaults then you can seize the house. I think this means that there should be a formal loan note on file with the title company, but I could be wrong.

Does that mean if someone has a second mortgage on his house through a commercial bank, but the value of the house has gone down so the second basically has no security to back it up, that interest payments on the second are not deductible?

Answering the last part first: The form is a 3 part scannable form. That is why you can't use a downloaded form.

I am assuming the condo is his residence and not business property.

Before answering the first part, you need to make sure that you are dealing with qualified mortgage interest payments. The interest payment would only be deductible by your son if the debt is secured by the home. This means that there is an actual contract (e.g., a deed of trust) that makes his ownership interest security for the loan and if he defaults the home could satisfy his debt and the paper is recorded with the county where the home is located per state law. If not, it is a nondeductible personal loan.

Finally, I don't know what you mean by the word "fund" in your first sentence. That being said, if the "fund" is in the business of lending money, then a 1098 is required to be filed with the IRS and a copy sent to your son. If the "fund" is not in the lending business but in the course of whatever business or trade it is in, it lent the money to buy the home, then the 1098 has to be filed. If on the other hand, the loan had nothing to do with the business or trade of the fund, then a 1098 does not have to be filed.

A small caution: if this "fund" is a related party to your son, then any loan must meet the minimum applicable federal rate in existence at the time of the loan. Otherwise, the loan "may" be subject to the below market rules if there are no exceptions.

The loan is still secured by the house: the second lender has the ability to force foreclosure, even if he isn't likely to actually receive any money as a result.

Seth

This is a most interesting observation, one that it seems the authorities never anticipated when they wrote either the code or the applicable supporting authority.

I've had more than a few clients who filed for bankruptcy this year. Many of them were able to strip off their second, and sometimes third and fourth, mortgages in bankruptcy because the homes FMV had fallen to the point where there was insufficient equity to cover the first and all succeeding mortgages. In those cases, the secondary mortgages were discharged in bankruptcy under the principal that the debt became unsecured when the house value fell low enough that there was insufficient equity in the house to cover all the mortgages.

I'm wondering how the IRS, and the state authorities, intend to interpret this. On a more direct note, I'm also wondering how we, as tax professionals, are supposed to treat this in the year of the bankruptcy discharge. If the bankruptcy court says that the second mortgage was discharged (let's say in November) because it was unsecured then do we treat the interest paid on that mortgage (through November) as unsecured and subsequently treat it as nondeductible?

I'm at a loss - I have been able to find NOTHING definitive on this. If any one out there has a take on this, I'd appreciate a citation.

Thanks, Gene E. Utterback, EA, RFC, ABA

OK, I should clarify, the load IS secured by the house. The loan is the first mortgage. The lien is on record.

As acquisition debt: No. As equity debt: Yes.

Acquisition debt: No, because the loan did not become unsecured until the court acted to declare such. At the time the interest was paid, it was a secured loan. I'm assuming a chapter 7 bankruptcy, where there would be no payments on a discharged loan. The acquisition debt rules don't care about how much equity may exist.

Equity debt: As the equity fell below the lesser of $100k or the amount borrowed as equity debt, one would adjust the amount of equity interest deductible without regard to the court's action anyway (to zero if no equity remained), so the bankruptcy makes no difference to the deduction.

The above represents my opinion of the IRC. I don't have a citation (other than IRC 163(h) itself).

Don't forget that for those with acquisition loans over $1M to recompute the open back years according to the new method per the CCM issued September 2009.

No. The lender can still seize the house and get whatever it is worth. It's a risk the lender takes. The payments are still deductible by the borrower just because the house is collateral, even though it may not be sufficient in the future.

Why not? If the house was purchased for 800k, primary loan 400k, secondary loan 100k, downpayment 300k; borrower defaults, home sold for 600k, and 4k of principal in first loan paid off, 1k of principal in second loan paid off; in this case will the primary loaner get the full 600k, or do they have to share it with the second loaner like

Why would the holder of the first get the whole $600k when only $396k was owed? The lender won't get more than was owed to it.

After the first gets paid off there is $204k left. So the first $99k goes to the holder of the second (that's how much is owed at that point) and the homeowner will get the rest.

I can tell you what my son and I did.I am not a tax professional.

A few years before the housing bubble burst, I helped my son buy a house by carrying his first trust deed (mortgage). We looked up minimum interest rates that had to be charged so that no part of the loan be considered a gift. Since then, I have reduced the interest rate once or twice according to what the rate blessed by the IRS became. My son and I both won. He got a low interest loan, and I got a high rate compared to what I could get from a bank account. As things stand now, he bought his home early enough so that he could sell out now at a profit if he so wished.

I made no filing with the IRS. I provide my son with a cumulative receipt for the year each month using an Excel spreadsheet spelling out how much interest and principle has been paid. I always declared the interest income.

At one time, the IRS questioned whether the interest paid was deductible. He showed them copies of the checks paid to me and the statements he received from me. I heard nothing on the subject from the IRS.

All in all, I believe if you deal with the IRS in good faith, it is a reasonable agency. I suppose there are some horror stories. I have always tried to do the right thing with my income tax. There have been some confusing and irritating issues at times, but they always seem to be resolved in a reasonable fashion. I do have the luxury of sufficient income so as not to be very tempted to cheat. At this time of my life, cheating would be more trouble than it is worth anyway. My fear is that tax law and policy is becoming so complicated, that it becomes ever more difficult not to violating something even in good faith.

Bill

The statute requires that the obligation be secured by the residence at the time the interest to be deducted is accrued. How can it be secured if the lender will get nothing by selling the security?

In bankruptcy law, to the extent that a debt secured by a mortgage exceeds the value of the property, it is considered not secured. Why would it be different in tax law?

He can foreclose if the borrower defaults. But the holder of the second won't get anything of value out of it. How is that security? Granted, the lender can take the house and keep paying the first, and hope it goes up enough in value to be paid back eventually. But that's highly speculative. Is it really security?

Your example is not a good one, because there is enough equity to pay off both the first and the second.

How about an example where the house has a $700k first, a $100k second and is how worth only $600k? Are you saying that the holder of the second has anything of value? That it has security ensuring that it will get paid? I doubt it.

This has nothing to do with bankruptcy or a court declaring a loan unsecured. From a practical standpoint, when someone with a second has a loan on property secured by a first that is greater than the value of the property, the holder of the second will get nothing if the property is sold. How is that security?

Section 163 requires the loan be secured when the interest is paid. But when the interest was paid the home was already under water on the first, and the second was worthless.

The statute says the loan must be secured. How is that secured?

going to go. But from a legal standpoint it seems inconsistent with the requirements of the statute.

I do not believe that I have ever seriously disagreed with you. But I do here!

The holder of the second mortgage almost certainly has the right of an unsecured creditor to foreclose and get a judgement against mortgagor (home owner).

I was told by a wise man that trying to get a judgement against someone who is current in their contractual payments is a good way to irritate a judge.

In cases where the mortgagor has other assets, loan payments on a worthless loan are preservation of those assets.

Dick

Exactly. So exactly what has his mortgage gotten him? Nothing - at least at the current moment. That's why it seems to me that, to the extent the sale of the propert wouldn't pay off the loans, the loans are unsecured.

But I do agree that, as a practical matter the IRS will allow the deduction of interest on those loans. It would be just too much of a mess to require homeowners to have an appraisal every month when they make a payment, to estabish that the loans are fully secured.

The loan also has to be secured by the house, meaning that the house is collateral for the loan. To be secured means you have to sign a note, get it notarized by the title company, and let them keep a copy of their note in their records -- but it could mean different things in different states and different companies. If your loan is an unsecured loan, meaning you didn't perform the necessary proper bookkeeping steps, they could be unreasonable.

The first trust deed is registered with the county recorder. To tell the truth, I do not know how a trust deed differs from a mortgage. Maybe it is a California thing for which the loan must be recorded and the collateral recorded. It all went through the California escrow procedure.

If you know, please enlighten me as to what distinguishes a mortgage from a trust deed.

Bill

In essence a mortgage and trust deed are the same thing. The most distinguishing innovation in trust deeds (in CA) is that they provide a "power of sale" for the trustee (normally the title company). That allows foreclosures after giving notice, but without having to go to court.

SNIPPED

In your situation, the primary loan gets paid, the secondary loan gets paid and the homeowner in default gets what's left over - works well as long as they home sells for MORE than the outstanding loan balances. But I'm seeing this -

Home purchased for $565K Primary Loan $450K Second Mortgage $115K Down Payment from buyer ZIP, ZERO House went to auction, opening bid was $135K - NO BIDDERS! (welcome to Florida)

In this case, the bank actually told my client to STAY in the home and look after it until they can figure out what to do next. Seems they prefer to have someone in it than risk it being vandalized, even though no payments have been made in almost 2 years.

Gene E. Utterback, EA, RFC, ABA

I've snipped my OP and am adding some additional info about loans and the idea of security, as I understand it.

First, according to my attorney resources the idea that any property is security is a technical misnomer. In reality it is the EQUITY in most items that is what gets attached. The bank has no real interest in my house or my car any more than Visa wants my furniture. What they want is interest on the loan. What they secure, or attempt to secure, is access to the equity in any item they extend credit on. The concept being that they assume (or hope) that we'll pay on it long enough so that when we stop paying and they seize and sell it, they will get enough from the payments collected and the residual salvage value that they will be ahead in the long run.

Second, regarding a subordinate lien holder's right and ability to foreclose - a subordinate lien holder can only foreclose IF he is wiling to satisfy the liens ahead of his. Apparently this is a supposedly well know principal of debt law. In order for the holder of a second mortgage to force a foreclosure either there has to be enough equity in the property to pay off the first after the sale OR the secondary lien holder has to buy out the primary lien. Otherwise the exercise of the secondary lien holder would unilaterally compromise a contract in place when they made the secondary loan.

My apologies if my wording isn't quite right. I'm not an attorney, I'm trying to parrot the gist of several discussions I've had with various attorneys I've worked with this year, in several states, regarding loan modifications, bankruptcy, and the negotiation of various debt instruments. I'm sure I haven't said it right, but I'm hoping most of you with either get my drift or let me know so I can try to clarify what I'm saying.

Apparently this is WHY many of the larger banks started making both the 80% primary and the 20% gap loan - because when they only made the secondary loan, based on equity, and the FMV dropped, they lost the ability to foreclose without assuming responsibility for the primary loan.

But this brings us back to the original issue - If there is insufficient equity in a property to satisfy all the loans on that property, does that ALONE make the debt, or some portion of it, unsecured and therefore nondeductible?

I am not sure, but I have not stopped looking, Gene E. Utterback, EA, RFC, ABA