Mortgage interest deductions are the subject of recent examinations conducted by the
Internal Revenue Service through the mail.
The examinations basically require taxpayers or their representatives to complete worksheets to determine how the deduction on Schedule A of Form 1040 was determined.
This requires extensive record keeping on the part of the taxpayer regarding the original financing (so-called acquisition indebtedness) and any home equity loans they may have taken, plus any refinancing that may have occurred during the period of home ownership.
In addition, many have borrowed against home equity for purposes other than acquisition of a second home or repairs or improvement to the primary residence (or one other).
Basic rules state that acquisition indebtedness is limited to $1 million regardless of the number of residences.
If the primary residence has a mortgage of $1.2 million and the second home has a mortgage of $500,000, then each must be proportionately reduced to arrive at the Schedule A amount.
Thus $1.2 million in proportion to $1.7 million in total, multiplied by the mortgage interest, is the amount of interest on that mortgage that may be deducted, regardless of the interest rates or other factors.
Home equity loans have additional problems because interest on only $100,000 is available for the Schedule A calculation, while no home equity loan is available for the alternative minimum tax unless the loan was used to add to, or improve, a principal residence or one other residence.
This requires the tracing of the home equity loan proceeds to the use of the funds.
The home equity loan, therefore, should be separate and not part of the acquisition indebtedness on the home.
A recent ruling stated that if an acquisition indebtedness of $1.4 million is placed on a principal residence for acquisition, then only the interest on $1 million is deductible for Schedule A.
A quick illustration of a refinancing will show the complexity of the transaction:
Current fair market puts the value of the principal residence at $500,000 and a new refinancing loaning is $400,000.
The problem lies in determining how much of the interest on the new $400,000 loan is deductible for Schedule A.
One key issue to consider is when the residence was acquired.
A key date is Oct. 13, 1987, as there were no deductibility limits before that date.
In this case, assume the residence was acquired July 1, 2000. We also need the amount of the original mortgage placed on this property, which we'll assume to be $150,000.
Assume, too, that principal payments from the date of acquisition to the date of refinancing total $50,000. The balance on the original debt, therefore, is $100,000. Also assume that no other borrowings have occurred.
Of the $400,000 new loan, the first $100,000 is assumed to be acquisition indebtedness, since it replaces the original loan and we are safe in deducting interest on it.
What about the rest? The second $100,000 may be considered the home equity line.
If so, then for the regular tax on Schedule A, the interest on that second $100,000 may be deducted, but not for the alternative minimum tax, unless the funds were used to add to, improve or acquire a principal residence or one other.
There now remains $200,000 on the new loan and the deduction for that interest is determined by the use of the funds.
The possible categories are trade or business interest, investment interest, personal interest and — if used to acquire a rental property — possibly the passive activity rule limitation.
While I have tried to simplify this portion of what should be an easier calculation, without appropriate records, responding to a mailed examination request will require knowledge of the rules and hopefully retention of all the records.
It would definitely be advisable to consult a qualified tax expert.
