Interest Deductions on Noncorporate Taxpayers
A.
To be deductible, interest paid or accrued by individual taxpayers must
fulfill the four basic requirements of deductible interest:
1. It must be "interest";
2. It must be paid or accrued during the taxable year;
3. The debt must be a valid debt; and
4. The debt must be the taxpayer's own obligation
B. Interest expense is segregated in seven types:
1. Trade or business interest;
2. Qualified residence interest;
3. Investment interest;
4. Passive activity interest;
5. Interest paid on certain unpaid estate taxes;
6. Interest on educational loans; and,
7. Personal interest (generally non-deductible).
C.
Under the Interest Allocation Rules, interest on a debt is allocated by
tracing disbursements of the debt proceeds to specific expenditures.
1. Interest expense is generally allocated by looking at what the proceeds of the underlying debt were used for.
2. The purpose for which the funds are borrowed and the type of property used to secure the debt is irrelevant.
Home Mortgage Interest
A.
Generally, home mortgage interest is any interest paid on a loan
secured by a taxpayer?s home (main home or second home); the loan may
be a mortgage to buy a home, a second mortgage, a line of credit, or a
home equity loan.
B. Home mortgage interest is deductible only if the taxpayer meets all the following conditions.
1. Taxpayer must be legally liable for the loan.
2.
Both the taxpayer and the lender must intend that the loan be repaid;
there must be a true debtor-creditor relationship between the taxpayer
and the lender.
3. The mortgage must be secured debt on a qualified home.
C.
Interest paid by the taxpayer on a real estate mortgage upon of which
he is the legal or equitable owner, even though the taxpayer is not
directly liable upon the note secured by such mortgage, may be deducted
as interest on the indebtedness.
D.
In most cases, all home mortgage interest is deductible; however
whether it is all deductible depends on the date the taxpayer took out
the mortgage, the amount of the mortgage, and the use of its proceeds
[Section 163(h)(3)].
E. There are three types of home mortgage interest.
1. Grandfathered debt; Mortgages taken out on or before October 13, 1987.
2. Acquisition debt; Mortgages take out after October 13, 1987, to buy, build, or improve the taxpayer?s home.
a.
The total amount of interest deductible as acquisition debt at any time
on the main home and second home cannot be more that $1 million
($500,000 if married filing separately). The $1 million is the amount
of debt borrowed and not the amount interest paid.
b.
This limit is reduced (but not below zero) by the amount of any
grandfathered debt; debt over this limit may qualify as home equity
debt (also discussed later).
3.
Home Equity Debt: Mortgages taken out after October 13, 1987, other
than to buy, build, or improve the taxpayers home (called home equity
debt).
a.
The limit on the amount of debt that can be treated as equity debt on
the main home and second home is limited to the smaller of $100,000
($50,000 if married filing separately), or the total of each home?s
fair market value (FMV) reduced (but not below zero) by the amount of
its home acquisition debt and grandfathered debt.
Note
? If taxpayer incurs debt to acquire the interest of a spouse or former
spouse in a home, because of a divorce or legal separation, taxpayer
can treat that debt as home acquisition debt.
Example:
Taxpayer owns one home that he bought in 1998. Its FMV now is $110,000,
and the current balance on your original mortgage (acquisition debt) is
$95,000. Bank M offers taxpayer a home mortgage loan of 125% of the FMV
of the home less any outstanding mortgages or other liens. To
consolidate some other debts, taxpayer takes out a $42,500 home
mortgage loan [(125% X $110,000) - $95,000] with Bank M. The equity
debt is limited to $15,000; this is the smaller of $100,000, the
maximum limit or, $15,000, the amount that the FMV of $110,000 exceeds
the amount of home acquisition debit of $95,000.
b.
Interest on amounts over the home equity debt limit generally is
treated as personal interest and is not deductible; but if the proceeds
of the loan were used for investment, business, or other deductible
purposes, the interest may be deductible.
F.
As a practical matter, the FMV cap should not come into play if a
prudent unrelated party makes the loan; however, some lenders may offer
home equity loans exceeding 100% of the value of the residence.
1. For these loans, interest allocable to the debt in excess of the home's FMV cannot be deducted as mortgage interest; instead,
2. The tracing rules will determine whether such interest is deductible.
G.
If all mortgages fit into one or more of the above three types at all
times during the year, deduct all of the interest on those mortgages.
1. If any one mortgage fits into more than one type, add the debt that fits in each type to any other debt in the same type.
2.
If one or more mortgages do not fit into any of these types, use the
tracing rules to figure the amount of interest that is deductible.
H. A qualified residence is a taxpayer's principal home and one other residence.
1. The homes can include a house, co-op apartment, condo, house trailer, motor home, timeshare property, houseboat; or
2. Similar property that has sleeping, cooking and toilet facilities [Reg. 1.163-10T(A)].
I.
Taxpayers with more than two homes can choose the property they want
for a second home on a year-by-year basis, but they can't have more
than one second home at any given point in time.
J. Non-conventional home refers to homes that are used on a transient basis such as a motor home and boat.
1.
The interest, if otherwise qualifying for the home mortgage interest,
is only deductible on Schedule A and is not deductible against AMT
(Alternative Minimum Tax).
2.
The instructions for Form 6251 refer to a qualified dwelling for
purposes of the AMT to be any house, apartment, condominium, or mobile
home not used on a transient basis.
K. Special rules apply if part of your qualified home is rented, which is beyond this discussion.
L.
The cost of building or substantially improving a qualified residence
includes the costs to acquire real property and building materials,
fees for architects and design plans, and required building permits; an
improvement is substantial if it:
1. Adds to the value of the home;
2. Prolongs the home's useful life; or
3. Adapts the home to new uses.
M.
If the amount of the mortgage is more than the cost of the home plus
the cost of any substantial improvements, only the debt that is not
more than the cost of the home plus improvements qualifies as home
acquisition debt; the additional debt may qualify as home equity debt.
N.
Effect of Refinancing: Refinancing creates situations where part of the
debt may exceed the sum of the acquisition debt and the home equity
debt.
1.
If this occurs, the interest on the debt is limited to the interest on
the sum of the acquisition debt and the home equity debt.
2.
Any excess interest would not be deductible as home mortgage interest;
however, the excess may be traced to other uses that may make the
interest deductible for other purposes.
O. Interest on debt secured by the home must first be allocated to the home to the extent permitted.
1.
The excess generally will not be deductible unless some portion of the
loan proceeds could be traced to another tax-deductible purpose
2.
If so, to the extent the proceeds can be traced to that other purpose,
the excess can be allocated in accordance with the general tracing rule.
P. As an alternative, taxpayers can elect to treat any secured debt as unsecured [Temp. Reg. 1.163-10T(o)(5)].
1. By making the election, the interest on the loan can be allocated by use of the proceeds by using the general tracing rules.
2.
The election may be made at any time but is then binding for all future
years unless permission is granted, by the IRS, to revoke it.
3.
The regulations do not state whether the election can be made for a
portion of a debt without tainting the remaining debt; thus, it appears
an election to treat debt as not secured by a qualified residence
prevents a taxpayer from claiming a qualified residence interest
deduction for any interest related to that debt.
Q.
Interest Limitation; unless subject to the overall limit on itemized
deductions, taxpayer?s can deduct all the interest paid during the year
on mortgages secured by main home or second home in either of the
following two conditions.
1. All the mortgages are grandfathered debt.
2.
The total of the mortgage balances for the entire year is within the
limits discussed earlier under acquisition debt and home equity debt.
