                         T.C. Summary Opinion 2014-4



                        UNITED STATES TAX COURT



            YONG J. DONG AND LIJUN WENG, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 23204-12S.                    Filed January 9, 2014.



      Frank Agostino, for petitioners.

      Peggy J. Gartenbaum and Michael Sihksnel, for respondent.



                             SUMMARY OPINION


      ARMEN, Special Trial Judge: This case was heard pursuant to the

provisions of section 7463 of the Internal Revenue Code in effect when the
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petition was filed.1 Pursuant to section 7463(b), the decision to be entered is not

reviewable by any other court, and this opinion shall not be treated as precedent

for any other case.

      Respondent determined deficiencies in petitioners’ Federal income tax for

2007 and 2008 of $15,802 and $14,932, respectively.

      After concessions by the parties,2 the sole issue remaining for decision is

whether petitioners are entitled to home mortgage interest deductions for 2007 and

2008 in excess of the amounts respondent allowed. We hold that they are not.

                                     Background

      This case was submitted fully stipulated under Rule 122. We incorporate by

reference the parties’ stipulation of facts, second stipulation of facts, stipulation of

settled issues, and accompanying exhibits.




      1
        Unless otherwise indicated, all subsequent section references are to the
Internal Revenue Code in effect for the years in issue. All Rule references are to
the Tax Court Rules of Practice and Procedure.
      2
        For 2007 and 2008 petitioners concede that they are entitled only to the
deductions on their Schedules E, Supplemental Income and Loss, as determined in
respondent’s notice of deficiency. Respondent concedes all of the adjustments on
Schedules A, Itemized Deductions, other than the home mortgage interest
deduction. The parties agree that the computational adjustments to petitioners’
itemized deductions will be made on the basis of the outcome of the issue
regarding the home mortgage interest deduction.
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         Petitioners resided in the State of New York at the time that the petition was

filed.

         At all relevant times petitioners have owned the property at 50th Avenue,

Oakland Gardens, New York (Oakland Gardens property), and have used it as

their primary residence.

         In June 2005, around the time petitioners acquired the Oakland Gardens

property, they entered into a loan agreement with petitioner Yong J. Dong’s

parents, Xing Ming Dong and Hang Lian Yang, in respect of the Oakland Gardens

property. This was commemorated in the “Home Equtty [sic] Loan Agreement”

(loan agreement) and “Home Equiity [sic] Deed of Trust” (deed of trust). The loan

agreement allows for a loan amount up to $130,000 with an interest rate of 3.5%

plus a prime rate not to exceed a 12% annual rate. This was not a purchase money

mortgage; rather, it appears to have been a credit line mortgage.

         The loan agreement provides that petitioners’ interest in the Oakland

Gardens property is specific security for the payment of the debt.

         The loan agreement and the deed of trust were never recorded in any

jurisdiction. The parties agree that New York State law governs the loan

agreement and the deed of trust.
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      In 2007 petitioners made payments pursuant to the loan agreement totaling

$26,442. In 2008 petitioners made payments pursuant to the loan agreement

totaling $26,162.

      Petitioners timely filed their 2007 and 2008 Federal income tax returns. On

their 2007 tax return petitioners claimed a home mortgage interest deduction

totaling $70,784. On their 2008 tax return petitioners claimed a home mortgage

interest deduction totaling $71,431.

      In July 2012 respondent issued petitioners a timely notice of deficiency,

determining deficiencies of $15,802 for 2007 and $14,932 for 2008. The notice of

deficiency disallowed, inter alia, $26,442 of the $70,784 petitioners claimed on

their 2007 tax return and $26,162 of the $71,431 petitioners claimed on their 2008

tax return with respect to their home mortgage interest deductions. The portions

disallowed were attributable to payments petitioners made to Xing Ming Dong and

Hang Lian Yang in connection with the loan agreement in respect of the Oakland

Gardens property.

      Petitioners filed a timely petition for redetermination with the Court for

2007 and 2008.
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                                     Discussion3

      Deductions are allowed solely as a matter of legislative grace. Deputy v. du

Pont, 308 U.S. 488, 493 (1940); New Colonial Ice Co. v. Helvering, 292 U.S. 435,

440 (1934).

      As a general rule, a taxpayer may claim a deduction for “all interest paid or

accrued within the taxable year on indebtedness.” Sec. 163(a). Indebtedness

means an unconditional and legally enforceable obligation for the payment of

money. Autenreith v. Commissioner, 115 F.2d 856, 858 (3d Cir. 1940), aff’g 41

B.T.A. 319 (1940); Linder v. Commissioner, 68 T.C. 792, 796 (1977).4

      Section 163(h) prohibits an individual taxpayer from claiming a deduction

for personal interest paid or accrued during the taxable year. One of the limited

exceptions to this general rule permits individuals to deduct qualified residence

interest. Sec. 163(h)(2)(D). Qualified residence interest is interest paid or accrued



      3
       The issue for decision in this case is legal and not factual in nature.
Accordingly, the burden of proof does not inform the decisional process.
      4
        Where the transaction giving rise to the claimed indebtedness is between
family members, the evidence presented to establish such a debt must be closely
scrutinized for economic substance. See Woodward v. United States, 208 F.2d
893 (8th Cir. 1953); Wales v. Commissioner, T.C. Memo. 1978-125, aff’d without
published opinion, 624 F.2d 195 (9th Cir. 1980). Respondent does not dispute the
bona fide nature of the indebtedness, but disputes only petitioners’ compliance
with sec. 163(h)(3) regarding the secured nature of the indebtedness.
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during the taxable year on acquisition indebtedness or home equity indebtedness

with respect to any qualified residence of the taxpayer. See sec. 163(h)(3)(A). A

qualified residence includes a taxpayer’s principal residence. Sec.

163(h)(4)(A)(i)(I).

        The parties do not dispute that the Oakland Gardens property was

petitioners’ principal residence. The dispute is whether petitioners’ payments to

Xing Ming Dong and Hang Lian Yang constituted qualified residence interest.

Petitioners contend that the amounts paid to Xing Ming Dong and Hang Lian

Yang in 2007 and 2008 were “qualified residence interest” under section

163(h)(3). Because neither the loan agreement nor the deed of trust was recorded,

respondent contends to the contrary.

        Qualified residence interest is any interest paid or accrued during the

taxable year on acquisition indebtedness or home equity indebtedness that is

secured by the qualified residence of the taxpayer. Section 163(h)(3) provides in

part:

        (B) Acquisition indebtedness.--

              (i) In general.--The term “acquisition indebtedness” means any
        indebtedness which--
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                  (I) is incurred in acquiring, constructing, or
            substantially improving any qualified residence of the taxpayer,
            and

                   (II) is secured by such residence.

                   *      *       *      *       *       *      *

      (C) Home equity indebtedness.--

             (i) In general.--The term “home equity indebtedness” means
      any indebtedness (other than acquisition indebtedness) secured by a
      qualified residence to the extent the aggregate amount of such
      indebtedness does not exceed--

                   (I) the fair market value of such qualified residence,
      reduced by

                   (II) the amount of acquisition indebtedness with respect
      to such residence.

      Because both acquisition indebtedness and home equity indebtedness

require the indebtedness to be secured by the property, we look to the security of

the loan between petitioners and Xing Ming Dong and Hang Lian Yang to

determine whether payments on it are qualified residence interest. Pursuant to sec.

1.163-10T(o)(1), Temporary Income Tax Regs., 52 Fed. Reg. 48417 (Dec. 22,

1987), secured debt means:

      a debt that is on the security of any instrument (such as a mortgage,
      deed of trust, or land contract)--
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            (i) That makes the interest of the debtor in the qualified
      residence specific security for the payment of the debt,

             (ii) Under 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

            (iii) That is recorded, where permitted, or is otherwise
      perfected in accordance with applicable State law.

The parties agree that the loan agreement provides that petitioners’ interest in the

Oakland Gardens property is specific security for the payment of the debt. See

sec. 1.163-10T(o)(1)(i), Temporary Income Tax Regs., supra. Therefore,

petitioners have satisfied the first element of a secured debt under the regulations.

See id.

      However, neither the loan agreement nor the deed of trust was recorded in

any jurisdiction. Failure to record the deed of trust may serve to subordinate it to

the interests of third parties without actual notice of it, who are protected by the

New York recording statute. See N.Y. Real Prop. Law secs. 281, 291 (McKinney

2006 & Supp. 2013); see also Transland Assets, Inc. v. Davis, 813 N.Y.S.2d 675

(App. Div. 2006). N.Y. Real Prop. Law sec. 281 provides:

             (1). (a) For the purposes of this section, a “credit line
      mortgage” shall mean any mortgage or deed of trust * * * which
      states that it secures indebtedness under a note, credit agreement or
      other financing agreement that reflects the fact that the parties
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      reasonably contemplate entering into a series of advances, payments
      and readvances, and that limits the aggregate amount at any time
      outstanding to a maximum amount specified in such mortgage or
      deed of trust. * * *

                    *      *      *       *       *       *      *

             (2). Any credit line mortgage may, and when so expressed
      therein, shall secure not only the original indebtedness but also the
      indebtedness created by future advances thereunder made within
      twenty five years from the date of the recording of such credit line
      mortgage, whether such advances are obligatory or are to be made at
      the option of the lender or otherwise, to the same extent and with the
      same priority of lien as if such future advances had been made at the
      time such credit line mortgage was recorded pursuant to section two
      hundred ninety-one of this chapter, although there may have been no
      advances made at the time of the execution and acknowledgement of
      such credit line mortgage, and although there may be no indebtedness
      outstanding at the time any advance is made. * * * [Emphasis added.]

      N.Y. Real Prop. Law sec. 290(3) defines a conveyance to include “every

written instrument, by which any estate or interest in real property is * * *

mortgaged * * *”.


N.Y. Real Prop. Law sec. 291 provides:

             A conveyance of real property, within the state, on being duly
      acknowledged by the person executing the same, or proved as
      required by this chapter, * * * may be recorded in the office of the
      clerk of the county where such real property is situated, and such
      county clerk shall, upon the request of any party, on tender of the
      lawful fees therefor, record the same in his said office. Every such
      conveyance not so recorded is void as against any person who
      subsequently purchases or acquires by exchange or contracts to
                                        - 10 -

      purchase or acquire by exchange, the same real property or any
      portion thereof, * * * in good faith and for a valuable consideration,
      from the same vendor or assignor, his distributees or devisees, and
      whose conveyance, contract or assignment is first duly recorded, and
      is void as against the lien upon the same real property or any portion
      thereof arising from payments made upon the execution of or
      pursuant to the terms of a contract with the same vendor, his
      distributees or devisees, if such contract is made in good faith and is
      first duly recorded. * * * [Emphasis added.]

      Therefore, under New York State law, an unrecorded mortgage is invalid

against third parties who do not have actual notice of it. See id. secs. 281, 291;

Washington Mut. Bank, FA v. Peak Health Club, Inc., 853 N.Y.S.2d 112 (App.

Div. 2008); see also T & V Constr., Inc. v. Calapai, 935 N.Y.S.2d 68 (App. Div.

2011). In the event of a default the unrecorded mortgage would not be sufficient

to subject the residence to the satisfaction of the debt with the same priority as a

recorded mortgage because the unrecorded mortgage is valid only against a third

person having actual notice of it. See Washington Mut. Bank, 853 N.Y.S.2d 112;

see also Transland Assets, Inc., 813 N.Y.S.2d 675. Therefore, petitioners have not

satisfied the second element of a secured debt under the regulations. See sec.

1.163-10T(o)(1)(ii), Temporary Income Tax Regs., supra.

      Finally, because the deed of trust and the loan agreement were not recorded,

we consider whether the deed of trust or the loan agreement was otherwise

perfected under New York State law. See sec. 1.163-10T(o)(1)(iii), Temporary
                                        - 11 -

Income Tax Regs., supra. Petitioners have not, however, alleged or shown that

they perfected the deed of trust or the loan agreement in any other way. Neither

have they established that there is another way to perfect the deed of trust or the

loan agreement under New York State law, nor are we aware of any such way.

Thus, petitioners have not satisfied the third element of a secured debt under the

regulations requiring that a mortgage or deed of trust be recorded or otherwise

perfected under applicable State law. See id.

      Because petitioners’ indebtedness to Xing Ming Dong and Hang Lian Yang

was not a secured debt or otherwise perfected pursuant to State law as defined

under the regulations, moneys paid to Xing Ming Dong and Hang Lian Yang did

not constitute qualified residence interest. Accordingly, we sustain respondent’s

determination on this issue.

                                     Conclusion

      In holding for respondent on the disputed issue, we have considered all of

the arguments advanced by petitioners, and, to the extent not expressly addressed,

we conclude that those arguments do not support a result contrary to that reached

herein.
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In order to give effect to the foregoing,


                                                Decision will be entered under

                                           Rule 155.
