Schubel v. Comm'r of Internal Revenue

• Decision Date: 28 September 1981
• Docket Number: Docket No. 2314-80.
• Citation: 77 T.C. 701
• Parties: ROGER A. SCHUBEL and SHIRLEY D. SCHUBEL, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

77 T.C. 701

ROGER A. SCHUBEL and SHIRLEY D. SCHUBEL, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 2314-80.

United States Tax Court

Filed September 28, 1981.

Held, points and other “prepaid finance charges” withheld by the lender may not be deducted by petitioners in the year of borrowing under sec. 461(g)(2), I.R.C. 1954, since they were not “paid” within the taxable year. John E. Cicero II, for the petitioners.

J. Michael Melvin, for the respondent.

OPINION

EKMAN , Judge:

Respondent determined a deficiency of $602 in petitioners' Federal income tax for the year 1977. Due to a concession by petitioners, the sole issue remaining for our decision is whether amounts withheld as “prepaid finance charges” from a mortgage loan are deductible in the year petitioners received the balance of the mortgage loan proceeds.

This case was submitted fully stipulated pursuant to Rule 122, Tax Court Rules of Practice and Procedure. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference.

Petitioners Roger A. Schubel and Shirley D. Schubel, husband and wife, resided in Temple Terrace, Fla., at the time they filed their petition herein. Their Federal tax return for 1977 was filed with the Internal Revenue Service Center at Chamblee, Ga.

Petitioners, cash basis taxpayers, borrowed $20,000 from one Trilby Overstreet to purchase their personal residence. Petitioners also, in purchasing their personal residence, obtained a “first mortgage loan” from Florida Federal. After Mr. Overstreet's death, his widow requested that petitioners repay the $20,000 loan. In order to comply with that request, petitioners, on September 12, 1977, refinanced their residence by obtaining a “first mortgage home loan” from Pan American Bank of Tampa.

The Pan American Bank loan, in the amount of $55,000, was secured by a mortgage on petitioners' residence, and in connection therewith, petitioners incurred “prepaid finance charges” in the following amounts:

+---------------------------------------+
                ¦Origination fee     ¦1 percent¦$550.00 ¦
                +--------------------+---------+--------¦
                ¦Loan discount fee   ¦2 percent¦1,100.00¦
                +--------------------+---------+--------¦
                ¦Interest on new loan¦         ¦243.39  ¦
                +--------------------+---------+--------¦
                ¦Total               ¦         ¦1,893.39¦
                +---------------------------------------+
                

This amount was subtracted from the face of the loan and withheld by the bank. The 2-percent discount fee is an established practice in the Tampa area and is the amount generally charged in that area.

The balance of the proceeds of the loan, $53,106.61, was used by petitioners to pay the following debts:

+-----------------------------------------+
                ¦Note (Trilby Overstreet)      ¦$20,000.00¦
                +------------------------------+----------¦
                ¦Florida Federal (1st mortgage)¦29,599.60 ¦
                +------------------------------+----------¦
                ¦J. C. Penney's                ¦555.39    ¦
                +------------------------------+----------¦
                ¦J. C. Penney's                ¦497.34    ¦
                +------------------------------+----------¦
                ¦Maas Bros                     ¦604.00    ¦
                +------------------------------+----------¦
                ¦Sears                         ¦936.74    ¦
                +-----------------------------------------+
                

The $29,599.60 paid to Florida Federal satisfied the outstanding balance due on its first mortgage.

Petitioners contend that the prepaid finance charges incurred in connection with the refinancing of their personal residence qualify as points paid under section 461(g)(2) entitling them, as cash basis taxpayers, to a deduction for the full amount of those charges in 1977. Respondent disagrees.

Section 163(a) generally allows a deduction for all interest paid or accrued within the taxable year on indebtedness. Section 163 must be read in conjunction with section 461. Baird v. Commissioner, 68 T.C. 115, 130 (1977). Section 461(g)(1) provides:

(1) IN GENERAL .—-If the taxable income of the taxpayer is computed under the cash receipts and disbursements method of accounting, interest paid by the taxpayer which, under regulations prescribed by the Secretary, is properly allocable to any period—-

(A) with respect to which the interest represents a charge for the use or forbearance of money, and

(B) which is after the close of the taxable year in which paid,

shall be charged to capital account and shall be treated as paid in the period to which so allocable.

Thus, a cash basis taxpayer may deduct prepaid interest no earlier than in the taxable year in which (and to the extent that) the interest represents a charge for the use or forbearance of borrowed money during that period. See Joint Committee Explanation of Tax Reform Act of 1976 (Dec. 29, 1976), 1976-3 C.B. (Vol. 2) 1, 112; H. Rept. 94-658 (1975), 1976-3 C.B. (Vol. 2) 695, 791; S. Rept. 94-938 (1976), 1976-3 C.B. (Vol. 3) 49, 141.

Prior to the enactment of section 461(g) (sec. 208, Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat. 1520, 1541), considerable confusion surrounded the deductibility of prepaid interest and a case-by-case analysis, to determine whether the deduction of prepaid interest materially distorted or clearly reflected income, characterized opinions of this Court¹ and rulings² published by respondent. See Joint Committee Explanation, supra, 1976-3 C.B. (Vol. 2) at 112; S. Rept. 94-938, supra, 1976-3 C.B. (Vol. 3) at 141; and H. Rept. 94-658, supra, 1976-3 C.B. (Vol. 2) at 791. It was intended by Congress that section 461(g)(1) would compel the cash basis taxpayer to deduct interest prepayments in the same manner as the accrual basis taxpayer. See H. Rept. 94-658, supra, 1976-3 C.B. (Vol. 2) at 792; S. Rept. 94-938, supra, 1976-3 C.B. (Vol. 3) at 142; and Joint Committee Explanation, supra, 1976-3 C.B. (Vol. 2) at 112-113.

An exception to the general rule of section 461(g)(1) is set forth in section 461(g)(2) which provides that section 461(g)(1):

shall not apply to points paid in respect of any indebtedness incurred in connection with the purchase or improvement of, and secured by, the principal residence of the taxpayer to the extent that, under regulations prescribed by the Secretary, such payment of points is an established business practice in the area in which such indebtedness is incurred, and the amount of such payment does not exceed the amount generally charged in such area.

Therefore, if the requirements of section 461(g)(2) are satisfied, the taxpayer is not limited to a ratable deduction of the “points,” ³ as would be the case for other instances of prepaid interest. Petitioners claim their “prepaid finance charges” fall within this exception.

Respondent contends that in order to fall within section 461(g)(2), prepaid finance charges must be “paid” and that the receipt of discounted loan proceeds is not “payment.” Respondent further contends that, even if petitioners' receipt or use of the discounted loan proceeds can be construed as the “payment of points,” in the case at bar such proceeds were not used for, and the points were not paid in respect of, “any indebtedness incurred in connection with the purchase or improvement of * * * the principal residence of the taxpayer” since the loan was used to pay their existing indebtedness.

Petitioners contend that they “paid” the “prepaid finance charges” in 1977, the year that the balance of the proceeds became available to pay their debts. Petitioners concede that the amount of the loan proceeds used to pay debts owed J. C. Penney's, Maas Bros., and Sears was not an amount used “in connection with the purchase or improvement” of their residence.⁴ However, they contend that amounts used to pay Overstreet and Florida Federal were used for that purpose and accordingly a percentage of the points is “points paid in respect of any indebtedness incurred in connection with the purchase or improvement” of their residence.

We agree with respondent's first argument that since petitioners received, or had available, only the face amount of the loan less the “prepaid finance charges,” those “prepaid finance charges” were not “paid” during 1977. In Rubnitz v. Commissioner, 67 T.C. 621, 628 (1977), we said:

it has been consistently held that a cash basis borrower has not paid interest when the loan transaction is structured so that a loan fee is “withheld” by the lender from what is called the principal amount of the loan and only the supposed principal amount minus the loan fee is actually made available for the borrowing taxpayer's use. J. W. Solof, 1 B.T.A. 776, 783; A. O'Day, 20 B.T.A. 455, 458; John C. Cleaver, 6 T.C. 452, affirmed 158 F.2d 342 (7th Cir.), certiorari denied 330 U.S. 849; John Randolph Hopkins, 15 T.C. 160, 180-181; Sanford Campbell, T.C. Memo. 1970-126, 29 T.C.M. 539, 1970 P-H Memo. T.C. par. 70,126; Rev. Rul. 75-12, 1975-1 C.B. 62; Rev. Rul. 59-260, 1959-2 C.B. 137.

See also Heyman v. Commissioner, 70 T.C. 482, 485 (1978), affd. without published opinion 633 F.2d 215 (6th Cir. 1980); Wilkerson v. Commissioner, 70 T.C. 240 (1978), revd. 655 F.2d 980 (9th Cir. 1981); Roemer v. Commissioner, 69 T.C. 440, 463 (1977), affd. sub nom. Holgerson v. Commissioner, 638 F.2d 104 (9th Cir. 1981).⁵

Petitioners contend that those cases involving discounted loans are not applicable since they concerned taxable years prior to the enactment of section 461(g). However, as stated in H. Rept. 94-658, supra, 1976-3 C.B. (Vol. 2) at 793, and S. Rept. 94-938, supra, 1976-3 C.B. (Vol. 3) at 143, Congress “[did] not intend the new rule to change the treatment of a discount loan under present law by a cash method taxpayer.” See also Joint Committee Explanation, supra, 1976-3 C.B. (Vol. 2) at 113.⁶

It is petitioners' position that this statement in the Committee reports should be limited to section 461(g)(1) and that Congress did not intend the rules applicable to discounted loans to apply to prepaid finance charges which are points within the meaning of section 461(g)(2). Petitioners c...