15.2 Home Acquisition Loans

A qualifying “home acquisition loan” is a loan used to buy, build, or substantially improve your principal residence or second home, provided the debt is secured by that same residence. Interest paid on such home acquisition loans is fully deductible if the total debt does not exceed $1,000,000, or $500,000 if you are married filing separately. See 15.1 for the two-residence limit.

The $1,000,000 (or $500,000) limit applies to acquisition loans taken out after October 13, 1987. If you incurred substantial loans before October 14, 1987, and plan to purchase a new home, your deduction for the mortgage for the new home may be limited. The $1 million limit for acquisition debt after October 13, 1987, is reduced by the amount of outstanding pre–October 14, 1987, debt. Although interest on a pre–October 14, 1987, debt is generally fully deductible regardless of the size of the loan, refinancing a pre–October 14, 1987, debt for more than the existing balance subjects the excess to the $1 million ceiling (15.7).

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image Court Decision
Family Financing of Residence
The Tax Court allowed a taxpayer to deduct mortgage interest payments on a loan that his brother obtained when the taxpayer’s poor credit rating prevented him from obtaining a mortgage loan. The taxpayer’s brother bought the house but allowed the taxpayer and his wife to live there on the condition that they make the mortgage payments directly to the bank.
The IRS disallowed the taxpayer’s deduction for the mortgage interest on the grounds that he was not liable for the mortgage debt; his brother was. However, the Tax Court allowed the deduction, holding that the taxpayer was the equitable owner of the home and that he was legally obligated to his brother to pay off the mortgage.
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Loan limit for buying new home may be increased from $1million to $1.1million.

The maximum home acquisition debt limit is $1,000,000, or $500,000 if you are married filing separately. However, there can be “home equity debt” on the initial purchase of a home, thereby increasing the allowable debt limit. Up to $100,000 of debt ($50,000 if married filing separately) in excess of the $1,000,000 (or $500,000) acquisition debt limit may qualify as home equity debt (15.3), which allows interest to be deducted on debt up to $1.1 million ($550,000 if married filing separately).

Home equity debt is defined as debt other than acquisition debt that is secured by the residence (principal residence or second home) and which does not exceed the fair market value of the residence minus the acquisition debt. For example, assume that you buy a new principal residence for $1.5 million, using $300,000 cash and a $1,200,000 mortgage loan secured by the residence. The first $1,000,000 of the debt is home acquisition debt (assuming you do not file as married filing separately). Of the remaining $200,000 debt, $100,000 qualifies as home equity debt, as it is less than the $500,000 excess of the fair market value ($1.5 million) over the acquisition debt ($1million). Therefore, interest is deductible on debt of $1,100,000 ($1 million acquisition debt and $100,000 home equity debt).

The IRS and Tax Court hold that the $1.1 million debt limit applies to the total debt secured by the principal residence and second home regardless of the number of owners. Thus, unmarried co-owners must allocate the $1.1 million limit between them, as discussed below.

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image Caution
Unmarried Co-Owners Must Allocate the $1.1Million Debt Limit Between Them
The IRS and Tax Court require unmarried co-owners to split the $1million home acquisition debt limit, and the $100,000 home equity debt limit, between them; see the Example in 15.2.
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Use IRS worksheets if debt limit exceeded.

If your total debt exceeds the $1.1 million debt limit (or $550,000 if married filing separately), you must use IRS worksheets included in Publication 936 to figure the amount of your deductible interest. You need to divide the debt limit by the average mortgage balance to get the deductible percentage of interest paid. Publication 936 provides options for figuring your average balance.

Unmarried co-owners together are limited to $1.1 million debt limit.

The Tax Court agrees with the IRS that unmarried co-owners do not each get a $1.1million debt limit. The $1.1 million limit applies to the total debt secured by their first and/or second homes. This is the same limit that applies to a married couple filing jointly. If unmarried co-owners have mortgages on their first and second homes that total more than $1.1 million, they must allocate the limit between them and on their individual returns they may only deduct a proportionate part of the interest paid.

EXAMPLE-
Sophy and Voss jointly owned two homes in California. They were jointly and severally liable on the three mortgages that secured the residences; there was a home equity line of credit in addition to refinanced acquisition mortgages for each home. The average balance of the three mortgages for 2006 was $2,703,568 and for 2007 the average balance was $2,669,136. In 2006 Sophy paid mortgage interest of $94,698 on the two homes and in 2007 he paid $99,901. Voss paid mortgage interest of $85,962 in 2006 and in 2007 he paid $76,635. On their individual returns, they each deducted the interest paid but the IRS reduced their deductions for both years. The IRS limited Sophy’s mortgage interest deductions to $38,530 for 2006 and $41,171 for 2007. Voss was allowed deductions of $34,975 for 2006 and $31,583 for 2007.
In figuring their allowable mortgage interest deductions for each year, the IRS divided the qualified loan limit of $1.1 million by the average balance of the combined mortgages, and multiplied the resulting “limitation ratio” by the total interest each of them paid. For example, for 2006, the limitation ratio was 40.68697% ($1.1 million divided by $2,703,568 average mortgage balance for 2006). Since Sophy paid mortgage interest of $94,698 in 2006, the IRS formula allowed him a 2006 deduction of $38,530 (40.68697% x $94,698).
Sophy and Voss appealed to the Tax Court, which consolidated their cases. They argued that as unmarried co-owners, they should each be allowed a separate $1.1 debt limitation, which would allow them together to deduct interest on up to $2.2 million of acquisition and home equity indebtedness on their two homes.
However, the Tax Court agreed with the IRS that they must allocate the $1.1 million debt limit between them. The statutory language (Code Section 163 (h) (3)) that defines qualifying home acquisition debt and home equity debt, including the $1 million (acquisition debt) and $100,000 (home equity debt) limitations, focuses on the debt “with respect to” the qualified residences (principal residence and second home). The limitations refer to the total amount of debt that can be taken into account in relation to the qualified residences, rather than the amount of debt that can be taken into account by an individual taxpayer.

Was your debt incurred in buying, constructing, or improving a qualifying first or second residence ?

In some case, you may treat a loan as home acquisition debt even though you do not actually use the loan proceeds to buy, build, or substantially improve the home. For example, if you buy a home for cash and within 90 days you take out a mortgage secured by the home, the mortgage is treated as home acquisition debt to the extent it does not exceed the home’s cost; it does not matter how you use the mortgage loan proceeds.

When you build a home or make improvements, expenses incurred before the loan may qualify as home acquisition debt; see 15.4 for construction loans and 15.5 for improvement loans.

Interest on a mortgage to buy or build a home other than your principal residence or qualifying second home (15.1) is treated as nondeductible personal interest. If a nonqualifying home is rented out, the part of the mortgage interest that is allocable to the rental activity is treated as passive activity interest subject to the limitations discussed in Chapter 10; the interest allocable to your personal use is nondeductible personal interest.

Cooperatives.

In the case of housing cooperatives, debt secured by stock as a tenant-stockholder is treated as secured by a residence. The cooperative should provide you with the proper amount of your deductible interest. If the stock cannot be used to secure the debt because of restrictions under local law or the cooperative agreement, the debt is still considered to be secured by the stock if the loan was used to buy the stock. For further details on allocation rules, see IRS Publication 936.

Line-of-credit mortgages.

If you had a line-of-credit mortgage on your home on October 13, 1987, and you borrowed additional amounts on this line of credit after that date, the additional borrowed amounts are treated as a mortgage taken out after October 13, 1987. If the newly borrowed amounts are used to buy, build, or improve your first or second home, they are treated as home acquisition debt subject to the $1 million or $500,000 limit. If used for any other purpose, the amounts are subject to the home equity debt rules (15.3).

Mortgage interest paid after house destroyed.

If your principal residence or second home (15.1) is destroyed and the land is sold within a reasonable period of time following the destruction, the IRS treats the property as a residence for purposes of deducting interest payments on the mortgage during the period between the destruction of the residence and the sale of the land. In one case, the IRS allowed the interest deduction where a sale of land took place 26 months after the destruction of a home by a tornado.

If the destroyed residence is reconstructed and reoccupied within a reasonable period of time following the destruction, the property will continue to be treated as a residence during that period, and the interest payments on the mortgage on the property will be deductible. The IRS allowed an interest deduction where reconstruction began 18 months after, and was completed 34 months after, destruction of the home.

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