Mortgage interest: the ground shifts

Nation's Business, Oct, 1988 by Gerald W. Padwe

Mortgage Interest: The Ground Shifts Just when you thought you were starting to understand the dramatic changes that the 1986 tax law imposed on the deductibility of home-loan interest, Congress came along late last year and changed the rules again. Although the changes actually simplified some aspects of the tax rules involving home mortgages and home-equity loans, they also put some new limitations in place.

Recently, the Internal Revenue Service issued a notice offering guidance on a few aspects of the 1987 changes. The notice is presumably a preview of positions that the IRS will take when it issues regulations in this area.

In general, the 1987 changes restricted the deduction for a principal or second residence to interest on no more than $1 million of "acquisition indebtedness." plus an additional $100,000 of home-equity loans.

"Acquisition indebtedness" is debt incurred for the purchase, construction or substantial improvement of a principal or second residence, as long as it is secured by the residence. Home-equity debt is any other loan secured by the principal or second residence.

Suppose that a mortgage loan was taken out several years ago, and that it would qualify as acquisition indebtedness except that it exceeds $1 million. No problem. Debt incurred before Oct. 13, 1987, the effective date of the new provisions, is "grandfathered" and will automatically be treated as acquisition indebtedness even though it exceeds $1 million. Until the principal balance of that loan falls below $1 million, though, no other acquisition indebtedness can be incurred.

What if you were to borrow $750,000 to finance the purchase of a new home, but the loan was not secured by the home? Interest on the loan would not qualify for full deductibility but would be instead, "personal." If you subsequently arranged to have the loan secured by your new home, you would have then met both tests (purpose of the loan and having it secured by the residence), the loan would become "acquisition indebtedness," and interest paid from the date you changed security arrangements would be deductible.

If you start construction of a home or begin a substantial improvement project without taking out a loan, but later have to borrow money to see the project through, the IRS will allow debt incurred to "relate back" to construction or improvement work undertaken up to 24 months earlier. In fact, you may take out a loan as late as 90 days after completion of the residence or improvements, for expenditures going back 24 months prior to completion of the project.

PHOTO : Gerald W. Padwe is national director-tax practice for Touche Ross & Co. Readers should see

PHOTO : tax and legal advisers on specific cases.