California Jet Set

A few months ago I received a “Check the Box” audit for a married couple living in one of California’s most famous wine regions. The IRS was questioning the large mortgage interest expense deduction on their Schedule A.

The members lived on a ten acre lot where their main home was situated. On this property there was also a farming activity as well as a residential real estate rental, which were both reported on the members’ income tax return.

The members had purchased the property with a $2.3 million interest-only mortgage. Of this amount, only the interest on the first $1.1 million would be deductible as a mortgage interest expense. Because of their high income levels, the members were also subject to the AMT. This meant that, among other things, the members would not benefit from the deduction of the real estate taxes on their large parcel of real estate.

The members had paid over $160,000 in mortgage interest and $25,000 in real estate taxes, but they were only able to deduct $63,000 of the mortgage interest expense due to the limitation. The remaining $122,000 was not being claimed anywhere else on the income tax return.

After speaking with the members at length, I learned that they leased out several acres of their land to grape growers who used it to cultivate grapes. They also explained that the lot had originally had only one home, and that they had constructed a new home on the property to live in, while the original home is rented out to a tenant. That was when I checked the tax return again and learned that the Schedule F and Schedule E had no mortgage interest or real estate expenses listed.

I advised the members that they should be allocating the interest expense and the real estate taxes among the farming activity, the residential real estate rental activity and the primary residence. I suggested that they use the real estate property tax bill to get an idea of the relative values of the land for the two residences, and I explained that any losses on both the farming and rental real estate activities would not be currently deductible, as these two activities would be considered passive losses. But the good news was that the gross income from these activities could be reduced to zero with the allocation of the mortgage interest and the real estate taxes, and any unused losses from these activities could be carried over to future years until the property was ultimately sold.

The members thanked me profusely for bringing my observations to their attention. Not only did their audit result in a “no change letter,” but they were thrilled that they would have the opportunity to file amended federal and California income tax returns for the open years, which would get them back a tremendous amount of money. This solution certainly paid for the great California wine that was used to toast the resolution!