In Copeland (TC Memo 2014-226), an October 2014 U.S. Tax Court case, the taxpayer fell behind on his residential mortgage loan and negotiated a loan restructuring with his mortgage lender. In connection with the restructuring, the lender increased the loan’s principal balance in an amount equal to the interest that had accrued on the loan. When filing his taxes for the year in which the restructuring occurred, the taxpayer claimed an income tax deduction equal to the amount of the capitalized interest.

After auditing the taxpayer’s return for the year in question, the IRS disallowed the interest deduction on the basis that it was inconsistent with the taxpayer’s use of the cash receipts and disbursements accounting method for income tax purposes. Under the cash method, which is used by most individual taxpayers, expenses may be deducted for tax purposes only if they are actually paid. If interest is capitalized and added to the loan balance, the taxpayer has not made any actual interest payments and may not deduct interest expenses under the cash accounting method. The Tax Court agreed with the IRS and upheld the denial of the taxpayer’s interest deduction.

The taxpayer in Copeland might have been able to obtain a deduction if the lender had agreed to make an additional loan to the taxpayer so that the taxpayer could use the loan proceeds to pay the accrued interest on his original loan. The case law on this strategy is mixed, and it is not clear whether an interest expense deduction would be allowed under this arrangement. To have any realistic expectation of getting an interest expense deduction under this arrangement, however, the taxpayer must ensure that the lender deposits the proceeds of the new loan into an account that is controlled solely by the taxpayer. If the taxpayer then writes a check on that account to pay the interest on the original loan, there is some case law to suggest that he would get a deduction. Most lenders, however, will resist depositing additional funds into the hands of a distressed debtor without receiving adequate controls over the debtor’s use of those funds.