T.C. Memo. 2014-226



                          UNITED STATES TAX COURT



      CHARLES COPELAND AND ARLENE COPELAND, Petitioners v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 5605-13.                           Filed October 30, 2014.



      Charles Copeland and Arlene Copeland, pro se.

      Sebastian Voth, for respondent.



                            MEMORANDUM OPINION


      LAUBER, Judge: The Internal Revenue Service (IRS or respondent)

determined a deficiency in petitioners’ Federal income tax for 2010. After

concessions,1 the sole remaining issue is whether petitioners are entitled to a


      1
          Petitioners conceded that unemployment compensation of $3,133 received
                                                                     (continued...)
                                        -2-

[*2] mortgage interest deduction under section 163(a) and (h)(2)(d)2 for interest

that was capitalized into the principal of their mortgage note but not actually paid

during 2010. We hold that they are not so entitled.

                                    Background

      This case was submitted fully stipulated under Rule 122. The stipulated

facts and the related exhibits are incorporated by this reference. Petitioners

resided in California when they petitioned this Court.

      Petitioners are cash basis taxpayers. In 1991 they purchased a residential

property in Yucaipa, California, for $334,000. They financed this purchase with a

$300,000 mortgage loan secured by the property. Petitioners have occupied this

property as their home since 1991. In 2007 petitioners refinanced the Yucaipa

property with a $600,000 loan from Gateway Funding Diversified Mortgage

Services (GFDMS). This loan was likewise secured by a mortgage on the

property. Bank of America subsequently acquired the GFDMS mortgage loan.



      1
       (...continued)
in 2010 was includible in taxable income. Respondent conceded that a health
savings account distribution of $2,400 received in 2010 was not includible in
taxable income.
      2
       All statutory references are to the Internal Revenue Code as in effect for the
taxable year in issue. All Rule references are to the Tax Court Rules of Practice
and Procedure. We round all monetary amounts to the nearest dollar.
                                        -3-

[*3] In 2010 petitioners applied for a loan modification with Bank of America.

This application was granted, and the terms of petitioners’ mortgage loan were

permanently modified. The modifications included a reduction of the interest rate,

a change in the payment terms, and an increase in the loan balance. Immediately

before the modifications, the outstanding loan balance was $579,275; after the

modifications, the new balance was $623,953. The difference (equal to $44,678)

resulted from adding the following amounts to the loan balance: past due interest

of $30,273, servicing expense of $180, and charges for taxes and insurance of

$14,225.

      Bank of America issued petitioners Form 1098, Mortgage Interest State-

ment, reporting that it had received from them during 2010 interest of $9,253 with

respect to the Yucaipa property. On their timely filed 2010 tax return, petitioners

claimed a deduction of $48,078 for home mortgage interest. The IRS issued peti-

tioners a notice of deficiency disallowing $38,825 of this deduction, namely, the

amount by which it exceeded the interest that Bank of America had reported on

Form 1098. Petitioners have conceded that $8,552 of this deduction was properly

disallowed. They contend, however, that they are entitled to the remainder of the

claimed deduction, or $30,273. This represents the past-due interest that petition-
                                        -4-

[*4] ers did not pay during 2010 which was capitalized into the principal of their

modified mortgage loan.

                                     Discussion

      Deductions are a matter of legislative grace, and the burden is on the tax-

payer to prove entitlement to the deductions claimed. INDOPCO, Inc. v. Commis-

sioner, 

, 84 (1992); New Colonial Ice Co. v. Helvering, 

,

440 (1934). This case was submitted fully stipulated under Rule 122. Since there

remain only legal issues, the burden of proof is irrelevant. See, e.g., Nis Family

Trust v. Commissioner, 

, 538 (2000).

      Section 163(a) generally allows a deduction for interest. However, section

163(h)(1) provides that “[i]n the case of a taxpayer other than a corporation, no

deduction shall be allowed * * * for personal interest paid or accrued during the

taxable year.” Nondeductible “personal interest” is defined to exclude several

categories of interest, including “any qualified residence interest.” Sec.

163(h)(2)(D), (3). The parties agree that during 2010 the Yucaipa property was a

“qualified residence” and that petitioners paid some “qualified residence interest.”

They disagree as to whether the amount deductible as “qualified residence inter-

est” includes the $30,273 that was capitalized into the principal of the Bank of

America loan.
                                         -5-

[*5] Petitioners are cash basis taxpayers. It is well settled that “[a] cash-basis

taxpayer ‘pays’ interest only when he pays cash or its equivalent to his lender.”

Wilkerson v. Commissioner, 

, 982 (9th Cir. 1981), rev’g 

(1978); Davison v. Commissioner, 

, 41 (1996), aff’d, 

(2d

Cir. 1998); Smoker v. Commissioner, T.C. Memo. 2013-56. The delivery of a

promissory note to satisfy an interest obligation, without an accompanying dis-

charge of the note, is a mere promise to pay, not a payment in cash or its equiva-

lent. Don E. Williams Co. v. Commissioner, 

, 577-578 (1977);

; Davison, 

; see United States v. Clardy,

, 1151 (9th Cir. 1980) (“It is undisputed that if a new note is given

to satisfy an interest obligation by a debtor on a cash basis, the interest has not

been ‘paid.’”). The rationale for this rule is that “the note may never be paid, and

if it is not paid, ‘the taxpayer has parted with nothing more than his promise to

pay.’” Don E. Williams 

(quoting Hart v. Commissioner, 

, 852 (1st Cir. 1932), aff’g in part, rev’g in part 

(1930)).

      The same rule applies to a discounted loan. Where a lender withholds a sum

as interest from the face amount of a loan, the borrower is not regarded as having

“paid” that interest. See Davison, 

; Menz v. Commissioner, 

, 1186 (1983). Whether interest is subtracted from the loan proceeds or
                                         -6-

[*6] added to the loan principal, the economic reality is the same. In each case,

the borrower is able to postpone paying the interest until some time in the future,

over the life of the loan or as part of a balloon payment at maturity. See Heyman

v. Commissioner, 

, 485-487 (1978), aff’d, 

(6th Cir.

1980); Rubnitz v. Commissioner, 

, 627-628 (1977); Smoker, T.C.

Memo. 2013-56.

      Through the loan modification agreement, the $30,273 in past-due interest

on petitioners’ mortgage loan was added to the principal. No money changed

hands; petitioners simply promised to pay the past-due interest, along with the rest

of the principal, at a later date. Because petitioners did not pay this interest during

2010 in cash or its equivalent, they cannot claim a deduction for it for 2010. They

will be entitled to a deduction if and when they actually discharge this portion of

their loan obligation in a future year. See Smoker, at *11-*12.

      Against this backdrop of settled caselaw, petitioners ask us to recharacterize

their loan modification transaction. Instead of having modified the terms of their

existing loan, petitioners say they should be treated as if they had obtained a new

loan from a different lender and used the proceeds of that loan to pay both the

principal of the Bank of America loan and the past-due interest. Cf. 

(stating that if a separate loan from a third party is used to pay
                                        -7-

[*7] interest, “a deduction may be appropriate because the obligation between the

borrower and the original lender has not merely been postponed, it has been

extinguished”).

      Contrary to petitioners’ “substance over form” argument, the transaction

they hypothesize is not economically equivalent to the transaction in which they

engaged. For one thing, petitioners have supplied no reason to believe that they

could have obtained a $623,952 loan from a different lender, given the economic

environment prevailing in 2010. In any event, it is well established that taxpayers

must accept the tax consequences of the transaction in which they actually

engaged, even if alternative arrangements might have provided more desirable tax

results. See Don E. Williams 

; Noble v. Commissioner,

, 767 (1982); Smoker, at *12.3

      In sum, a taxpayer is not “entitled to mortgage interest deductions for

amounts capitalized into the principal of a mortgage note but not actually paid.”


      3
       Alternatively, petitioners say they should be treated as if they had obtained
a new loan from Bank of America and used the new loan proceeds to discharge the
old loan and the past-due interest. But petitioners would not be treated as having
“paid” the interest in this event either. Rather, they would be regarded as having
postponed payment of that interest by giving Bank of America a note, as they did
through the loan modification arrangement in which they actually engaged. Wil-

; Battelstein v. Commissioner, 

, 1184 & n.3
(5th Cir. 1980); Davison, 

-51.
                                      -8-

[*8] Smoker, at *2. We accordingly conclude that petitioners cannot deduct for

2010 the $30,273 of past-due interest that was not paid for 2010 but postponed by

being added to the loan balance.

      To reflect the foregoing,


                                            Decision will be entered under

                                     Rule 155.