If it Sounds Too Good to be True … Get a Second Opinion!

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I’m confused!

Sometimes people get interesting ideas about tax strategies. Given the amount of information available on the web and other places it’s not surprising. But every so often I run across something that just leaves me shaking my head … again. Tonight was no exception!

As I was browsing recent IRS rulings, I came across one where a married couple were denied their deduction for mortgage interest on their home. That got me interested – under what circumstances would that deduction be denied? It’s a pretty straightforward deduction, wouldn’t you think?

Turns out, what the couple claimed to have done was borrow money from their own, closely-held corporation, in order to pay off the mortgages on their home. Then, they claimed that the amount they paid their corporation each month was interest only … ergo, they could deduct every penny of their monthly mortgage payment.

The only problem with their theory was the complete lack of documentation. For example, they couldn’t provide any canceled checks noting their payments. They couldn’t produce an authentic copy of the promissory note. They couldn’t even show that a transfer deed had been properly recorded, noting the mortgage on the property, which should now be held by their corporation. Upon questioning in court, the taxpayers couldn’t even agree between themselves on the details of the transaction. The court was perhaps generous in calling their testimony “contradictory and incredible.”

With the huge mortgage interest deduction completely disallowed, the taxpayers were required to recalculate their return and wound up owning a fair chunk of money in unpaid taxes.

Diane and I see all kinds of strategies. Some are sent to us for a laugh, and others come in from clients asking, essentially, “Is this too good to be true?” It’s a little frightening to me just how willing we are, sometimes, to believe in things that just don’t quite ring true.

In this particular case, I can see how it could work. Say you’ve got a C Corporation with plenty of retained earnings kicking around. You want to use the money, but you can only get at that money in a few ways. Taking it out as a dividend means you will get a tax hit – currently 15%. Loaning the money to yourself, on the other hand, isn’t considered reportable income. So, loan yourself the money to pay off your own mortgage, and enter into a new mortgage – presumably with extremely favorable terms – such as interest-only payments. Now you’ve created a great tax break for yourself personally. Instead of writing off part of the money paid out each month towards your mortgage, you can write off all of it! You can’t do that when you purchase an investment property. And depending on the size of the mortgage, who wouldn’t want to do that? You’re potentially talking about a huge deduction!

But assuming the whole strategy is above board and won’t bring the IRS knocking on your front door, wouldn’t you just assume that proper-to-the-point-of-overkill documentation was a mandatory part of the strategy? In this case I couldn’t even find a mention that the bank had noted the payout and discharged their mortgage! That leaves me wondering if there was any money moving around at all, or whether the entire thing was just subterfuge to write off the couple’s entire mortgage payment.

Anyhow, at the end of the day, I guess the message is the same: “if a strategy seems to good to be true … get a second opinion before you buy into it!”

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