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IRS Changes Mind on Home-Mortgage Interest Limitations

Overview
Individual taxpayers who itemize deductions can claim a deduction for interest paid on a home mortgage. The law allows a taxpayer to deduct mortgage interest on up to $1 million of “acquisition indebtedness” (i.e., debts used to purchase, construct or substantially improve a qualified residence and that are secured by such residence). The limitation specifically provides that acquisition indebtedness is limited to $1 million in any tax year. In addition, a taxpayer may deduct interest on up to $100,000 of home equity indebtedness. Home equity indebtedness is defined as a mortgage loan other than acquisition indebtedness. Various limitations are set on these deductions, along with a requirement that the debt not exceed the fair market value of the residence at the time it is incurred.

What if the mortgage loan to acquire my main residence was $1.3 million?
The key question raised is whether a $1.1 million combined acquisition/home equity limitation is applicable to a single loan utilized to purchase the residence, or must the home equity loan NOT be for the acquisition of the residence? In reviewing the definition for home equity indebtedness, it is not clear whether mortgage debt used to acquire a residence that exceeds the $1 million limitation could be considered. Various taxing authorities (i.e., the IRS and the Tax Court) have tried to answer this question, and have come up with different answers.

The Tax Court limited the deduction to interest on $1 million of acquisition indebtedness. The taxpayer in this case had a single $1,300,000 loan and tried to treat $1 million as acquisition indebtedness and $100,000 as home equity indebtedness. However, in the eyes of the Tax Court, the taxpayer failed to prove that any portion of the debt was anything other than acquisition indebtedness, and therefore did not have a loan subject to the home equity indebtedness limitation.

The IRS has actually given a yes and no. First, the IRS allowed a single indebtedness to qualify as part acquisition debt and part home equity debt. Then in a later interpretation, the IRS took the position that interest on any portion of a home acquisition loan (or loans) over $1 million cannot also be a home equity mortgage loan. Consequently, the taxpayer could not utilize the total $1.1 million limitation on the acquisition mortgage loan.

Now, in a recent IRS interpretation from its own legal division, the $1 million is considered part of the definition of “acquisition indebtedness” and not just a limitation. Therefore, for a single loan, interest on the first $1 million and interest on an additional $100,000 of qualifying debt is deductible.

Example – Single Loan (Over $1,100,000 Limitation)
Jeff buys a home for $3 million, making a $700,000 down payment and borrowing the remaining $2.3 million. Under the advice of the new IRS Legal Memorandum 200940030, you can deduct interest on up to $1.1 million of the loan. Let’s say total interest expense for the year was $143,000 and there was $200,000 paid on principal during the year. The total itemized deduction for mortgage interest an individual would be allowed is $71,500 [143,000 x (1,100,000/([2,300,000+2,100000]/2)]. The $1.1 million in the formula is the total limitation. The average balance of the loan during the year is determined by taking the average of the beginning of the year balance ($2.3 million) and end of year balance ($2.1 million). This result is compared to $65,000 under the old IRS interpretation [143,000 x (1,000,000/([2,300,000+2,100000]/2)]. 

Conclusion
This article shows just one example of how confusing and troublesome the itemized deduction for home mortgage interest can be for the taxpayer.  If you have limited the deduction of your home mortgage acquisition loan to $1 million, you may be able to file a refund for any prior open tax year. This new IRS memorandum provides taxpayers with a source of documentation to use if you are under examination or as support for one’s position on a larger mortgage interest deduction. Of course, the memorandum states it is not to be used for “precedent,” but it would seem very hard for the IRS to ignore its own legal advice.

Please note that the IRS believes this deduction is often miscalculated when a taxpayer has a loan exceeding $1 million. The IRS has been busy sending out notices questioning certain taxpayers' home interest deduction and asking for taxpayers to send a copy of their limitation calculation. If you receive such a notice, feel free to discuss it with your Blackman Kallick representative.

For more information, please contact Kenneth Buczkowski at 312-980-2951 or your Blackman Kallick representative.
 

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.