Home remedies: helping your clients relieve mortgage interest deduction headaches

National Public Accountant, The, Feb, 1995 by Annette Hebble

The tax provisions governing the deductibility of mortgage interest have become increasingly complex. A number of traps exist for the unwary homeowner.

A recent IRS Revenue Procedure (94-27) clarifies when the payment of points in connection with the acquisition of a principal residence may be deducted for tax purposes. The ruling provides a new tax break when points are paid by the seller at closing.

On one hand, the tax rules encourage the maximization of mortgage debt in the connection with the purchase of a residence. On the other hand, the mortgage interest deduction does not always result in significant tax benefits due to the manner in which taxable income and the tax liability are determined. Each homeowner should evaluate different financing alternatives based on a combination of long-term investment goals, current financial position and marginal tax bracket, and not based on tax considerations alone.

A result of TRA '86 was that personal interest expenses were no longer deductible for tax purposes. Although mortgage interest is a personal expense, it does remain deductible for many homeowners, with certain limits. Additionally, this tax deduction does not necessarily generate significant tax savings.

Knowledge of the rules is essential for the homeowner in determining the appropriate type of financing and understanding the related tax benefits. However, no real tax benefit is derived unless the mortgage interest plus other itemized deductions exceed the standard deduction. Even then, actual tax savings may still be of limited value.

Qualified Residence Interest

Mortgage interest must meet the definition of qualified residence interest [Sec. 163(h)] in order to be deductible for tax purposes. Qualified residence interest is further divided into two categories: acquisition debt and home equity debt.

Acquisition Debt

Acquisition debt [Sec. 163(h)(3)(B)] is a loan secured by a primary or second residence and incurred in connection with a purchase, construction or home improvement. The deduction of interest paid during the construction phase is limited to 24 months. Further, the home must meet the definition of a qualifying [TABULAR DATA OMITTED] residence at the time the dwelling is ready for occupancy. The interest deduction is limited to interest paid on acquisition debt of up to $1,000,000. Interest paid in excess of the ceiling is treated as a personal interest expense and, hence, is nondeductible for tax purposes.

The term residence includes a vacation home, condominium, mobile home, boat or recreational vehicle. To meet the definition of a qualifying residence, the property must have basic living accommodations (i.e., sleeping space, toilet and cooking facilities). A home mortgage must be secured by the residence in order to be considered qualified residence interest and result in a deduction on the homeowner's tax return. For example, it is common that a prospective homeowner borrows some of the funds needed to finance a home from relatives or family members. Unless the lender actually takes a lien on the property in question, any interest paid by the taxpayer is considered personal in nature and not deductible for tax purposes.

Further limitations apply to individuals who own three or more homes. Such homeowners can deduct the interest paid on two of these homes during any one year. The principal residence is considered one of the two homes. Any one of the other homes may be chosen as a qualified residence and the selection may vary from year to year. The two homes combined cannot exceed the $1 million ceiling for acquisition debt.

Homeowners who are considering refinancing an existing acquisition debt should proceed with caution. Over the years the outstanding balance on a residence's acquisition debt is reduced by principal payments. The portion of a new mortgage that exceeds the old mortgage does not meet the definition of acquisition debt unless the loan proceeds are used for home improvements. Thus, the acquisition debt can be refinanced only to the extent that the principal amount of the refinancing does not exceed the principal amount of the acquisition debt immediately before the refinancing. The interest paid on any excess refinanced debt will be treated not as qualified residence interest but as personal interest.

The interest on any mortgage loan signed on or before October 13, 1987, remains fully deductible: This holds true regardless of the size of the mortgage or the actual use of the proceeds. However, in the event of the refinancing of one of these existing mortgages, the new rules apply and interest paid on debt in excess of $1 million is nondeductible personal interest.

Home Equity Loans

The term "qualified residence interest" also includes interest paid on home equity loans [Sec. 163(h)(3)(C)]. These loans utilize the personal residence as security, but the proceeds may be used for personal purposes. Interest on home equity loans is limited to an amount that does not exceed the fair market value of the property securing the debt or $100,000 of principal. However, the interest on home equity loans is deductible regardless of how the money is used (unless the loan proceeds are used to purchase a tax-exempt investment).