Home transfers in divorce can render mortgage interest non-deductible.

picket fence with lightningThere are three parties to every divorce: the husband, the wife, and Uncle Sam. Uncle Sam is very picky about interest deductions on home mortgages, and a misstep can cost your client a tax deduction. Here’s a common situation that can trip you up, and ways to get around it.

Your client agrees to transfer the family home to his ex in the divorce, but since she can’t qualify to refinance the home, his name will remain on the mortgage. To ensure that the mortgage payment is made, he proposes paying the lender directly and reducing the support he pays to his ex-spouse.

If he deeds the house to his ex, and then pays the mortgage, can he take the mortgage interest deduction? Unfortunately, no. He can’t deduct the mortgage interest, because the mortgage must be secured by a home in which he has an ownership interest. She can’t get the deduction either, since she didn’t make the payment. Interestingly, since the mortgage is in his name, the 1098 form showing the interest paid on the mortgage will be issued in his name, and that’s what the IRS goes by when the IRS computers match his tax return to the reporting forms they have received.

But if your client doesn’t want to chance incurring the wrath of the IRS by taking a mortgage deduction to which he isn’t entitled, here’s a better solution: in the support agreement, call the mortgage payment additional spousal support. He can deduct the payment as spousal support because the payment is treated as though it was made to his ex and she made the payment.

Since his ex will have to pay tax on the mortgage payment as alimony, does she get the interest deduction? Yes if her name is on the mortgage, since she will be legally responsible for the debt. But what if the mortgage is in his name alone? I still believe she can deduct the interest, and here’s why. Treasury Regulation Sec. 1.163-1 says that if you are the legal or equitable owner, you can deduct the interest even if you aren’t directly liable on the note, as long as it is secured by the home.

If the home is jointly owned, it gets a little trickier. The payer can deduct half the payment as alimony, if it’s called support in the agreement, and the joint owners will split the interest deduction, if it continues to qualify as each of their primary or secondary residence, which is a whole ‘nother discussion.

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