Archive for October 5th, 2011

Following up on our previous post, those squares at the IRS have once again killed the collective buzz of an otherwise law-abiding medicinal marijuana facility and its clients:

When is a valid business expense deduction not a valid business expense deduction?  When you are running one of the country’s largest, most successful medical marijuana dispensaries, that’s when.  You see, back in 1982, Code Sec. 280E was added to the Internal Revenue Code.  We all remember the “war on drugs”, right?  Well, Congress decided that one way to crack down on drug traffickers was to disallow them any deductions incurred in the process of drug trafficking.  Specifically, Code Sec. 280E provides:

 No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business  . . . consists of trafficking in controlled substances . . . which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

 Now, I don’t know how compliant your average, run of the mill drug trafficker is with his or her tax filing obligations, but this would be quite a bitter pill to swallow (pun intended).

Fast forward to 2011.  Many states have now passed legislation that makes the use of medical marijuana legal.  At the forefront of this movement was the State of California, home of the Harborside Health Center.  Recently, the IRS used Sec. 280E to deny Harborside a deduction for many general business deductions.  As you can imagine, this generated quite a tax obligation, one that may put the company (and likely many other dispensaries like them) out of business. 

Stay tuned for further developments, as this is likely to be an evolving issue as more and more states look at medical marijuana legislation.  The full article can be found here.

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Pop quiz, hotshot. Can a taxpayer deduct mortgage interest on a home that’s never actually built?

Well, if you’d bothered to read my title, you’d already know the answer. And that answer, according to the Tax Court’s decision today in Rose v. Commissioner, T.C. Summary Opinion, 2011-117, is a resounding “yes.”


  • In 2006, Mr. Rose (Rose) purchased land and a home on beachfront property in Florida for $1,575,000. Rose didn’t want the house; he wanted to build his own. Thus, as part of the contract, the existing house was torn down prior to Rose’s purchase.
  • To purchase the property, Rose took out a $1,260,000 mortgage.
  • Florida required a lengthy permit application process before Rose could build on beachfront property. Before an application could even be submitted, Rose was required to perform survey work and provide core samples to the State.
  • To further the application process, Rose put together a team of architects, engineers, and designers who prepared and submitted the construction and site plans.
  • In early 2008, a full two years after Rose purchased the land, his permit to build was approved. Unfortunately, by that time the local real estate and lending markets had crashed, and Rose couldn’t obtain the necessary financing.
  • As a result, the house was never built, and Rose sold the raw land in 2009, taking a $850,000 bath.

On his 2006 and 2007 tax returns, Rose deducted the interest on the 2006 mortgage to purchase the raw land as “qualified residence interest.” The IRS disallowed the deductions, posing the logical argument that a home cannot qualify as a qualified residence — and thus mortgage interest can never be deducted — if it’s never built.  

 The Tax Court disagreed, siding with Rose and allowing the mortgage deductions.

 Relevant Law

Qualified residence interest is any interest that is paid or accrued during the taxable year on acquisition debt or home equity debt. Acquisition debt is any debt secured by the qualified residence of the taxpayer and incurred in acquiring, constructing, or substantially improving the qualified residence.

Section 163(h)(4)(A)(i) defines a qualified residence as the principal residence of the taxpayer and “one other residence of the taxpayer which is selected by the taxpayer.”

 Pursuant to section 1.163-10T(p)(5), a taxpayer may treat a residence that is “under construction” as his or her second residence for up to 24 months “commencing on or after the date that construction is begun”.

Tax Court Decision

To determine if Rose’s 2006 and 2007 mortgage interest was deductible, the Tax Court had to determine whether “construction” had begun with regards to Rose’s planned Florida home. In reaching its decision, the Tax Court held that Rose’s construction activity began even before he owned the land.

For all practical purposes, petitioners were responsible for the demolition work, and it came about as a direct result of their purchasing the property. The fact that petitioners did not hold legal title to the property at the time that the work occurred does not negate its relevance to our inquiry… Therefore, we find that by causing an entire house to be demolished and by clearing the lot so that it would be suitable for a new residence, petitioners undertook significant steps in the process of constructing their vacation house, as early as January 2006.

The court also determined that Rose’s two-year effort as part of the permit application process constituted continued “construction” on the home.

The work petitioners were required to complete before filing the application was extensive and required the labor of multiple building and design professionals. Petitioners undertook significant work in preparing to obtain a construction permit, and that work was a necessary component of the overall process of construction. We hold that the property was “under construction” as a residence during 2006 and 2007.

Lastly, the Tax Court was left to decide whether Rose’s failure to ever build the house negated the mortgage interest deductions in 2006 and 2007. Reaching the logical conclusion, the court held that it didn’t, as in 2006 and 2007, Rose would not be aware that the home would eventually fail to be built.

Section 1.163-10T(p)(5)(i) and (ii) allows qualified residence interest to be deducted for the 24-month period following the commencement of construction. In the event the residence under construction has not been completed and is not ready for occupancy by the end of the 24-month period, the residence under construction ceases to qualify after that 24-month period ends. If petitioners intended to claim the deduction for interest during the construction period, they had to claim it on their returns for the years immediately following the commencement of construction in January 2006…[in those years], it would be impossible for petitioners or the Internal Revenue Service to have known that the proposed residence would never become ready for occupancy.

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