A promissory note is not a cash equivalent


The Tax Court recently reiterated that a cash-method taxpayer cannot deduct residence interest added to the principal of a mortgage note but not actually paid.

The court emphasized that cash-method taxpayers can deduct interest paid during the tax year in cash or its equivalent.

No deduction is allowed for personal interest, except as specifically provided by law. Among the enumerated items of deductible personal interest is qualified residence interest.

In Phillip C. Smoker v. Commissioner (TC Memo 2013-56, Feb. 21, 2013), Phillip Smoker owned two residences, one in California and another in Michigan. Smoker purchased the Michigan property with a $450,000 adjustable rate note secured by a mortgage on the property.

The interest rate was reset monthly and the maximum amount of Smoker's monthly mortgage payment was limited. To the extent the monthly mortgage payment was insufficient to cover the interest accrued on the note, the excess was added to the principal of the note.

Like most individual taxpayers, Smoker used the cash receipts and disbursements method of accounting. On his 2006 and 2007 returns, he claimed deductions of $75,000 and $83,000 for home mortgage interest. These amounts included accrued but unpaid interest that had been added to the principal of the note.

The court agreed with the IRS that a cash-method taxpayer may not deduct accrued but unpaid interest. The court found that a cash-method taxpayer is allowed a deduction for interest paid in cash or its equivalent during the tax year. However, the delivery of a promissory note to satisfy an interest obligation – without an accompanying discharge of the note – is a mere promise to pay and not a payment in a cash equivalent, the court found.

The court rejected Smoker's argument that he had "paid" interest. Smoker claimed that adding accrued interest to the principal of a mortgage note is akin to taking out a second mortgage to pay the interest accrued and is indistinguishable in substance from borrowing from a third party to make the interest payments. The court disagreed. Smoker had not discharged – but had only postponed – his obligation to pay the interest.