It’s another Section 7463 “just sayin’”, but the reasoning is interesting. What does “construction” mean, when the taxpayer wants to deduct mortgage interest for “qualified residence indebtedness”, and the qualified residence hasn’t yet been built? That’s the question in Thomas G. Rose, Sr., and Cheryl G. Rose, 2011 T.C. Sum. Op. 117, released 10/4/11.
Tom and Cher wanted to build their dream house on the Florida coast. They bought land, on which stood an existing house they didn’t want. They entered into a contract to buy the land, but before they took title and pursuant to their contract of sale, the existing owner let them demolish the house. They then borrowed land acquisition mortgage money, closed title, and started the permitting process.
The permitting process proceeded for two years at a turtle’s pace, because the turtles were holding up the deal. Florida Department of Environmental Protection (FDEP) wanted to make sure that light from Tom and Cher’s putative palazzo wouldn’t disturb the nesting habits of the local sea turtles. While FDEP was checking out the turtle races, the Florida real estate market went south, and Tom and Cher couldn’t get their construction financing.
They sold the beachfront for whopping loss (which IRS didn’t question), and had deducted the mortgage interest for the two years while FDEP was checking out the turtles’ nightlife, claiming the house was “under construction” and therefore Section 163 qualified.
IRS said “No, it’s turtles all the way down. You had no residence, it was a hole in the sand, you weren’t building and you didn’t even own the property when the old house was demolished. Paper pushing and turtle-watching isn’t construction.”
Judge Ruwe to the rescue. “The issues we must decide are: (1) Whether the residence was ‘under construction’ during the taxable years at issue, and, if so, (2) whether the fact that events occurred after the taxable years in issue that prevented the completion of construction of a qualified residence should disqualify the interest deduction for prior years.” 2011 T.C. Sum. Op. 117, at p. 11.
Judge Ruwe answers question number one: “In order to determine the proper meaning attributable to the term ‘under construction’ it is useful to consult the meanings ordinarily given to those words. See Asgrow Seed Co. v. Winterboer, 513 U.S. 179, 187 (1995). ‘Construction’ is defined as ‘the act or process of constructing’. Webster’s New World College Dictionary 313 (4th ed. 2009) (emphasis added); The American Heritage Dictionary 315 (2d College ed. 1985). Furthermore, the applicable definition of ‘under’ defines the word as ‘in the process of’. (In fact, one of the examples given following the definition is ‘under construction’.) Webster’s Third New International Dictionary 2487 (1986); see also The American Heritage Dictionary (2d College ed. 1985). The definitions commonly attributed to both ‘under’ and ‘construction’ acknowledge that the terms can be read as being broad enough to encompass the entire process of construction and not simply the physical assembly of building materials. Therefore, the question becomes whether petitioners’ activities during 2006 and 2007 amounted to the commencement of the process of construction rather than merely preparatory activities.” 2011 T.C. Sum. Op. 177, at p. 13.
Yes, Tom and Cher were constructing: “Although the house was leveled and the lot was cleared before petitioners received legal title to the property in March, 2006, the work would not have occurred had petitioners not bargained for it in the purchase and sale agreement. For all practical purposes, petitioners were responsible for the demolition work, and it came about as a direct result of their purchasing the property. The fact that petitioners did not hold legal title to the property at the time that the work occurred does not negate its relevance to our inquiry, especially given the real property laws of the State of Florida. At the time the actual demolition and cleanup work took place with respect to the property, petitioners were possessors of equitable title. As such, petitioners were the beneficial owners of the property when the demolition of the existing house took place. Therefore, we find that by causing an entire house to be demolished and by clearing the lot so that it would be suitable for a new residence, petitioners undertook significant steps in the process of constructing their vacation house, as early as January 2006.” 2011 T.C. Sum. Op. 117, at p. 14 [Footnote omitted.]
And as to the permitting process, Judge Ruwe said : “Petitioners undertook significant work in preparing to obtain a construction permit, and that work was a necessary component of the overall process of construction. We hold that the property was ‘under construction’ as a residence during 2006 and 2007.” 2011 T.C. Sum. Op. 177, at p. 15.
As for the later frustration of Tom and Cher’s plan to build their dream house, each tax year stands on its own. Regulation Section 1.163-10T(p)(5)(i) and (ii) permits deduction of interest for 24 months while a qualified residence is a-building. After month 24, no deduction until the residence is finished. The deduction must be taken in the appropriate tax year. No way could Tom and Cher have known in 2006 or 2007 that the credit market would crater in 2008.
Or more elegantly, as Judge Ruwe says: “If petitioners intended to claim the deduction for qualified residence interest during the construction period, they had to claim it on their returns for the years immediately following the commencement of construction in January 2006. It is a well-known principle that each taxable year stands alone and is evaluated separately. In evaluating each year on its own, it would be impossible for petitioners or the Internal Revenue Service to have known that the proposed residence would never become ready for occupancy. The appropriateness of the deductions petitioners claimed should be evaluated on the basis of the facts and circumstances as they existed in 2006 and 2007. Events beyond petitioners’ control occurred in subsequent years and prevented petitioners from completing a residence.” 2011 T.C. Sum Op. 117, at pp. 16-17. [Citations and footnote omitted.]
So Tom and Cher win, and even better, IRS can’t appeal.