Sharia Law and the Mortgage Interest Deduction (Part II)

Today’s blog post was written with the assistance of Daniel S. Eckenrode.  Daniel received his JD and LLM in Taxation from Villanova University School of Law. He is avidly learning about US- Middle Eastern international taxation. Daniel’s interest in this field stems from his studies and interaction with the Arabic culture at St. John’s University in New York. He hopes to specialize in this area and eventually to become one of its leading experts.

Possible Solutions- Sharia Compliant Alternatives to the Traditional Mortgage

Part I of this blog post detailed the background and overall dilemma faced by Muslim Americans in utilizing the US tax law mortgage interest deduction. Paying or receiving interest is generally prohibited under Sharia law’s concept of riba.

As a result of the prohibition, there have been various Sharia-compliant financial alternatives to traditional mortgage loans. Recently, two mechanisms have been popularized by financial institutions; the murabaha and the ijara. Of the two, the murabaha (more fully described below) may be the more preferred considering that it is a short term transaction and the financial institution bears little risk. (See Contemporary Islamic Finance: From Socioeconomic Idealism to Pure Legalism, pages 599-600).

Under the murabaha method of finance, the individual notifies the financial institution which home he wishes to purchase. The financial institution buys the house and then sells it to back to the individual at an agreed upon marked- up price which is fully paid through installments. The marked- up price resembles the principal price of the home and the “interest”.

As noted earlier, this method is the more preferred because the financial institution typically bears little risk. Oftentimes, the financial institution requires the home-buyer to make an irrevocable promise to buy the house. Additionally, as a fail-safe, the financial institution is allowed to charge a cancellation fee in the event the home-buyer breaks the promise. Sometimes at the closing, the individual will acquire full title to the property and make his initial down payment. This down payment toward the purchase price represents his initial investment in the property. The individual’s monthly payment is divided into two portions — “acquisition” and “profit”. As he makes monthly payments, the acquisition balance is reduced, thereby increasing the individual’s investment in the home.

On a similar note, under the ijara, the financial institution buys the property. However, instead of selling the home to the individual, it instead leases it back to the individual with an option to purchase at the end of the term. The individual’s monthly payments include rent and further payments on-account, thereby increasing his beneficial rights in the property. The individual can acquire full title to the property when the sum of his payments on-account equals the original purchase price. Thus, the individual pays the rent for the home typically up to the amount paid by the financial institution when it purchased the property. This type of transaction is typically longer than the murabaha with the financial institution owning the home during the lease term. Additionally, the institution pays the real estate taxes on the property, but the rent payments typically include the taxes that are due.

US Tax Perspective

Under these two mechanisms, the Islamic alternative mortgage payments have the potential to be considered for US tax purposes essentially the same as an ordinary mortgage payment – that is, a payment of principal and (the equivalent of) interest. The Internal Revenue Service (IRS) has not announced a position regarding the deductibility of interest using such financing mechanisms, but at least one financial institution (see FAQ 16) that offers faith-based home financing apparently believes the IRS may treat its Islamic mortgage alternative the same as an ordinary mortgage.

In order to utilize the mortgage interest deduction, generally, interest is paid on a mortgage loan secured by the taxpayer’s residence. With murabaha or ijara financing, the individual may not receive title to the home for many years. This lack of title opens the door for the IRS to deny the mortgage interest deduction on grounds that the purported home buyers do not actually own the residence (they are “renting” it or buying it in “installments”). Generally, taxpayers may only deduct interest on a loan if they are liable under the loan. The IRS can argue that with Islamic financing the buyers are not liable on a mortgage loan (e.g., instead the taxpayer has merely made an irrevocable promise to buy a house, or has an option to purchase it after years of making rental payments).

When using either of these two mechanisms, the financing institution may send the individual homebuyer an annual Form 1098-INT showing the “profit” paid to the financial institution for the particular year. The individual may then deduct this “profit” from his taxable income, as an itemized deduction taking the position that the “profit” is the equivalent of interest. Whether the IRS will challenge this position is unknown and the ultimate outcome unclear.

“Substance Over Form?”

If the IRS were to take the position that the interest deduction is not available because the mechanisms do not involve the payment of “interest” in the traditional sense, hope is not fully lost. One saving grace for the taxpayer is the so-called “substance over form” doctrine. This doctrine was established by the Supreme Court case, Gregory v. Helvering. Essentially, one can disregard the form of the financial instrument  or transaction and look at the economic substance. Even though it has been stated by the US Tax Court that only the government enjoys the ability to use this doctrine, there is a case to be made that it could be available for the taxpayer. For example, in Comm’r v. Danielson, the court allowed the taxpayer to use the doctrine in his favor.

Here, if the courts were to allow the taxpayer to use the substance over form doctrine, then the mortgage interest deduction might be available. The economic form of the Islamic mortgage alternatives is created purely for religious reasons- not tax avoidance. Both types of mortgages arguably result in the same economic consequence. Therefore, it can possibly be argued that despite the difference in form, the Islamic mortgage alternatives have the same economic substance of an ordinary mortgage and should be treated as such. These alternatives to traditional financing of a home purchase could allow the Muslim individual to follow his religious obligations and enjoy the US tax deductions – the best of both worlds.

Get Professional Tax Help In Choosing Your Sharia Compliant Mortgage Alternative

Due to the uncertainty, tax advice should ideally be sought before the Sharia compliant mortgage alterative is chosen. The tax professional would need to carefully examine the details of the proposed transaction and could then advise the individual about the risks of claiming an interest deduction. Some forms of Islamic financing may have certain features that are more favorable to upholding a position that taking the interest deduction is justified.

Indeed, it is an interesting time in the tax world regarding the intersection of Islamic financial transactions and US tax law. With the Muslim population growing in the US, the IRS will have to confront this issue head on as these alternatives will most likely be more frequently utilized. It will certainly be exciting to see the IRS’ official position and the possible attention in the US courts.


All the US tax information you need, every week — Just follow me on Twitter @VLJeker

Leave a Reply

Your email address will not be published. Required fields are marked *

Name *