The Tax Court recently decided that taxpayers may not deduct interest payments from their federal taxes related to a mortgage or deed of trust on their principal residence that was never recorded in the county records. Defrancis v. C.I.R., T.C. Summ. Op. 2013-88 (2013). Thus, if you have a loan secured by a mortgage or deed of trust against your principal residence, and you wish to deduct the interest payments, be sure that the document is recorded in the appropriate county recording office.

The facts are relatively simple. A man and woman purchased a home in Massachusetts and later obtained a loan from the woman’s mother. They signed a mortgage providing that the loan was secured by the home. The mortgage was never recorded. The couple paid interest on the loan and deducted it as interest on their qualified residence under Section 163(h)(2)(D) of the Internal Revenue Code. The IRS challenged the deduction arguing that it was not “secured debt” as required by the Code (specifically, Section 163(h)(3)(B)) and as defined by regulations.

Sections 163(h)(2) and (3) of the Code provide that individuals may deduct qualified residence interest, which is interest paid or accrued on acquisition indebtedness with respect to a qualified residence. A principal residence of the taxpayer is a qualified residence. The definition of “acquisition indebtedness” includes the requirement that the indebtedness be secured by the residence. The tax regulations provide that secured debt must be on an instrument (1) that makes the interest in the residence security for the payment of the debt, (2) “[u]nder which, in the event of default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated,” and (3) that it is recorded or otherwise perfected in accordance with applicable State law. Treasury Regulation § 1.163-10T(o)(T).

The Tax Court held that the interest payments were not related to secured debt because the mortgage was not recorded. By not being recorded, under Massachusetts law it was invalid against third parties without actual notice such that the mortgage did not subject the residence to the satisfaction of the debt with the same priority as a recorded mortgage. Therefore, requirement 2 above was not met. Furthermore, and more obvious, requirement 3 (i.e., recording or otherwise perfecting under State law) had not been satisfied.

In the end, for qualified interest payments to be validly deducted from your federal income taxes, the mortgage must be recorded or perfected in accordance with State law. Washington requires a mortgage/deed of trust to be recorded. If you have any questions regarding your real estate, please contact Bill Humphries or another MPBA attorney.