Small Business Taxes & Management

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Mortgage Interest Deduction

 

Small Business Taxes & ManagementTM--Copyright 2010-2015, A/N Group, Inc.

 

Qualified Residence Interest

Technically know as qualified residence interest, mortgage interest deductions by individuals are limited under a sometimes complex set of rules. The discussion here is limited to qualified residence interest. Generally, any interest deductions are limited to a mortgage to purchase (or improve) a first and second home and up to $100,000 of home equity loans. The loan must be secured by the home.

You can deduct the interest on the following mortgages:

Example 1--Sue and Fred borrow $450,000 to purchase a principal residence for $600,000. Interest on the mortgage is deductible in full. A year later they borrow another $125,000, using the entire proceeds to add two rooms. Since the proceeds are used to build or improve a first or second home, interest on the $125,000 loan is deductible in full.

Example 2--The facts are the same as in example 1, but Sue and Fred decide to only use $15,000 of the additional debt to remodel a bath. The rest of the funds ($110,000) they use to pay off credit card debt. Interest on only the first $100,000 is deductible as home equity interest; interest on the additional $10,000 is not deductible.

Example 3--Martha and Mark borrow $550,000 to purchase a principal residence for $600,000. Interest on the mortgage is deductible in full. A year later, when the fair market value of the home has declined to $580,000 they take out a home equity loan for $100,000, using the money to purchase two new cars. Here the fair market value restriction applies. The limit on the home equity debt is the fair market value of the home ($580,000) reduced by the debt to purchase the home ($550,000) or $30,000. Thus, interest on $70,000 of the home equity loan ($100,000 less $30,000) is not deductible.

Example 4--Sarah and Dale have a $350,000 mortgage at 8% outstanding on a home they purchased two years ago. They refinance the loan to lower the interest rate and take down an additional $125,000 to pay off credit card debt. The fair market value of the home is $600,000. The interest on only the first $450,000 ($350,000 original acquisition debt plus $100,000 home equity debt) is fully deductible. Interest on the additional $25,000 of debt is not deductible.

Tax Tip--Even though interest on home equity debt in excess of $100,000 is not deductible, it still makes sense to borrow and use those funds to pay down high-interest credit card debt.

Tax Tip--If you roll the refinancing costs into the new loan that amount would go towards any amount that qualifies as a home equity loan.

 

Secured Debt

You can deduct your home mortgage interest and any home equity interest only if your mortgage is a secured debt. A secured debt is one in which you sign an instrument (e.g., mortgage) that:

A debt is not secured by your home if it is secured solely because of a lien on your general assets or if it is a security interest that attaches to the property without your consent (e.g., a mechanic's lien or judgment lien). A wraparound mortgage is not a secured debt unless it is recorded or otherwise perfected under state law. If the seller takes back a note for a portion of the purchase price, he or she may not record or perfect the loan. In that case interest on the note would not be deductible.

Tax Tip--It's not unusual for parents or other relatives to loan their children either part or all of the purchase price of a home. Often the child will sign a note for the amount of the loan, but the loan may not be recorded and/or secured by the home. If so, any interest on the loan is not deductible. And, unless interest is charged at no less than the Applicable Federal Rate, a portion of the foregone interest could be deemed to be a gift.

Tax Tip--You can make an election to treat the debt as not secured by your home. In that case any interest would not be deductible as mortgage interest. When would you make the election? One example is if the funds borrowed are used to finance your business or investments and the interest would be deductible as business interest or investment interest. That could allow you to take out a home equity line or borrow to acquire a vacation home. Caution. If you make the election, you can only revoke the choice with the consent of the IRS.

 

Qualified Home

A home includes a house, condominium, cooperative, mobile home, house trailer, boat, or similar property that has sleeping, cooking, and toilet facilities. Only your main home and a second home qualify. Your main home is the home where you ordinarily live most of the time. If the second home is not rented, you can deduct the interest on acquisition debt, regardless of your use of the property. If the property is rented, you can only deduct the interest if you use this home more than 14 days or more than 10% of the number of days during the year that the home is rented at a fair rental, whichever is longer. If you have more than one second home, you must decide which home to treat as the qualified second home during the year. You may change the home you treat as a second home each year. Under certain circumstances you can switch during the year. If you're renting a home on a regular basis, the rules can get complex.

The only part of your home that is considered a qualified home is the part you use for residential living. If you use part of your home for other purposes, such as a home office, you must allocate the use of your home. You must divide both the cost and fair market value between the qualified and nonqualified part. Basically, interest attributable to the home office portion will be deducted on your business return (e.g., Schedule C).

Under certain circumstances you can treat a part of a qualified home you rent to another person as being used by you for residential living. A number of conditions apply.

You can treat a home under construction as a qualified home for a period of up to 24 months, but only if it becomes your qualified home at the time it is ready for occupancy. The 24-month period can start any time on or after the day construction begins.

You may continue to treat your home as a qualified home even after it is destroyed in a fire, storm, or other casualty. Thus, you can continue to deduct the interest on your home mortgage. You can continue treating a destroyed home as a qualified home if, within a reasonable period of time after the home is destroyed, you either rebuild the destroyed home and move into it or sell the land on which the home was located. This rule applies to both your main and a second home.

A time-sharing arrangement can be treated as a qualified home if it meets all the other requirements.

If you're married and filing a joint return it doesn't matter whether the home is owned jointly or by only one spouse.

 

Special Situations

You can deduct a late payment charge on your mortgage as interest if it was not for a specific service in connection with your mortgage loan. If you pay off your mortgage early and pay a prepayment penalty, you can deduct the amount as home mortgage interest provided the penalty is not for a specific service.

If you sell your home, you can deduct your home mortgage interest paid up to, but not including, the date of sale.

If you pay interest in advance for a period that goes beyond the end of the tax year, you must spread this interest over the tax years to which it applies. Prepaid interest is not deductible. If you prepaid interest in 2015 that accrued in full by January 15, 2016, this prepaid interest may be included in box 1 of Form 1098. However, you cannot deduct the prepaid amount for January 2016 in 2010. You will have to figure the interest that accrued for 2015 and subtract it from the amount in box 1. You will include the interest for January 2015 with other interest you pay for 2015.

If a divorce or separation agreement requires you or your spouse or former spouse to pay home mortgage interest on a home owned by both of you, the payment of interest may be alimony.

You can only deduct interest on a loan for which you are liable and for which you make the payments. Thus, if a relative makes one or more of your mortgage payments during the year on your mortgage, he or she cannot take a deduction nor can you take a deduction for the interest. That's true even if the relative guaranteed the loan. (There are some exceptions to this general rule.)

Tax Tip--Because of financial problems, you need help with your mortgage. Rather than having your parents make the payment directly to the bank, they should gift you the necessary cash and you write a check out of your personal account.

The interest on a reverse mortgage is generally not paid currently but accrues (added to the loan principal) and paid only when the loan is paid off, the home sold, etc. Since interest is not deductible until actually paid, no deduction can be taken currently. In addition, a reverse mortgage is treated the same as a home equity loan.

You generally can't deduct expenses incurred in producing tax-exempt income. Thus, if you take out a home equity loan and invest some (or all) of the proceeds in tax-exempt securities, the proportionate share of the interest on the loan is not deductible.

If you receive a refund of interest in the same year you paid it, you must reduce your interest expense by the amount refunded. If you receive a refund for an amount deducted in an earlier year, you generally must include the refund in income in the year you receive it. Include in income only the amount the reduced your tax in the earlier year. If you need to include the refund in income, report it on line 21 of Form 1040.

A mortgage secured by a qualified home may be treated as home acquisition debt, even if you do not actually use the proceeds to buy, build, or substantially improve the home. This applies in the following situations.

  1. You buy your home within 90 days before or after the date you take out the mortgage. The home acquisition debt is limited to the home's cost, plus the cost of any substantial improvements within the limit described in (2) or (3), below.

  2. You build or improve your home and take out the mortgage before the work is completed. The home acquisition debt is limited to the amount of the expenses incurred within 24 months before the date of the mortgage.

  3. You build or improve your home and take out the mortgage within 90 days after the work is completed. The home acquisition debt is limited to the amount of the expenses incurred within the period beginning 24 months before the work is completed and ending on the date of the mortgage.

Example--You sell your old home for $400,000. The remaining mortgage is nominal and you take the cash proceeds and purchase a new home for $200,000 on April 1. On May 15 you take out a mortgage and use the funds to purchase vacant land. The $200,000 loan qualifies (assuming it meets all the requirements of qualified home acquisition debt) as home acquisition debt because it was taken out within the 90-day window.

The date you take out a mortgage is the day the loan proceeds are disbursed.

A substantial improvement is one that:

Repainting, minor repairs such as replacing plumbing parts, etc. are not substantial improvements. However, if the painting or other minor work is part of an overall bigger project such as remodeling a kitchen, they will qualify as part of the substantial improvement.

If you incur debt to acquire the interest of a spouse or former spouse in a home because of a divorce or legal separation, you can treat that debt as home acquisition debt.

 

Points

Points can represent a number of different charges paid to obtain a home mortgage. They may also be called loan origination fees, loan discount, or discount points. In some cases the points may be paid by the seller.

The full amount of points paid may only be deducted in the year paid if you meet the following tests:

  1. Your loan is secured by your main home. (Your main home is the one you ordinarily live in most of the time.)

  2. Paying points is an established business practice in the area where the loan was made.

  3. The points paid were not more than the points generally charged in that area.

  4. You use the cash method of accounting. Virtually all individuals use this method.

  5. The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.

  6. The funds you provided at or before closing, plus any points the seller paid, were at least as much as the points charged. The funds you provided do not have to have been applied to the points. They can include a down payment, an escrow deposit, earnest money, and other funds you paid at or before closing for any purpose. You cannot have borrowed these funds from your lender or mortgage broker.

  7. You use your loan to buy or build your main home.

  8. The points were computed as a percentage of the principal amount of the mortgage.

  9. The amount is clearly shown on the settlement statement (such as the Settlement Statement, Form HUD-1) as points charged for the mortgage. The points may be shown as paid from either your funds or the seller's.

If you meet the tests you can either deduct the points in full in the year paid or over the life of the loan. The same tests apply for a home improvement loan on your main home. (Generally, a home improvement loan falls under the same rules as the acquisition of a principal residence would.)

If you meet all the tests but the number of points charged exceeds those generally charged in your area (test 3), you can deduct the points generally charged in the year paid and deduct the remaining balance over the life of the loan.

You may be able to deduct points paid by the seller, but if you do you must reduce your basis in the house by that amount. For example, the purchase price of the home is $200,000; the seller is paying your $5,000 in points. Your basis in the home is only $195,000.

If you don't meet the tests described above, you may still be able to deduct the points, but you must do so ratably over the life of the loan. The tests for amortizing the points over the life of the loan are:

  1. You must use the cash method of accounting.

  2. The loan is secured by a home (not necessarily your main home).

  3. The term of the loan is not more than 30 years.

  4. If your loan period is more than 10 years, the terms of your loan are the same as other loans offered in your area for the same or longer period.

  5. Either the loan amount is $250,000 or less, or the number of point is not more than 4, if your loan period is 15 years or less, or 6, if your loan period is more than 15 years.

Points on your second home are deductible only over the life of the loan.

Points you pay to refinance a mortgage are not deductible in full in the year you pay them. That's the case even if the new mortgage is secured by your main home. Points related to proceeds from the refinancing used to improve your main home can be deducted in full in the year paid.

Example--Mark and Martha refinance the $400,000 existing mortgage on their main home, by borrowing $500,000. They pay $10,000 in points. They use the additional $100,000 borrowed that exceeds the original mortgage for adding 2 rooms to the home. They must amortize the $8,000 in points ($400,000/$500,000) over the life of the refinancing. The remaining $2,000 in points (attributable to the home improvement part) can be deducted in the year paid.

If you amortize the points (spread them over the life of the loan) you can deduct any remaining balance in the year the mortgage ends, but only if any refinancing is with a different lender. If you refinance with the same lender, spread the remaining balance over the term of the new loan.

 

Alternative Minimum Tax

This is significant trap for many taxpayers. You may have to add back some of your interest for alternative minimum tax (AMT) purposes. Or, looking at it another way, some of your home mortgage interest may not be deductible. Basically, you can only deduct for AMT purposes the interest on debt used to buy, build, or substantially improvement your principal and second home. That means interest on a home equity loan generally must be added back.

Example--During 2015 Mark and Martha incurred $11,000 in interest on their original mortgage used to purchase their home. They refinanced in September and the new loan was $50,000 more than the old loan. They used $25,000 of that additional amount to add a new bedroom. They used the other $25,000 to purchase a car. The interest on the refinanced loan was $6,000, of which $1,200 was attributable to the additional $50,000 of debt. Since half of the additional debt qualifies because it was used to improve their home, only $600 must be added back for AMT purposes. In addition, in November, they took out a home equity loan to help out a relative. The interest on that loan, $300, must also be added back for AMT purposes.

For additional information, go to the instructions for Form 6251 and the accompanying worksheet.

 

Mortgage Debt Forgiveness

Generally, if part of your mortgage debt is forgiven, the amount forgiven is cancellation of indebtedness income (COD for short). For example, you outstanding mortgage on your principal residence (the rule applies to all debt) is $190,000. You sell the house for $170,000 and the bank accepts that amount in full payment of the mortgage. The $20,000 difference is cancellation of indebtedness income and fully taxable. (There are exceptions to the rule if you are insolvent (your debts exceed your assets) or the debt is discharged in bankruptcy.)

For tax years 2007 through 2014, you may have been able to claim special tax relief and exclude the debt forgiven from your income. The only debt that qualifies must be incurred in the acquisition or improvement of your principal residence and the total amount forgiven cannot exceed $2 million. Home equity debt or additional debt on your home as the result of a refinancing doesn't qualify. For example, Martha and Mark incurred a mortgage of $250,000 to buy their principal residence. They refinance five years later and signed a mortgage for $325,000, using the additional $75,000 to add a bedroom and renovate the kitchen. The entire debt qualifies for forgiveness. Fred and Sue had an identical situation, but they used the additional $75,000 to pay down credit card debt. Only the original $250,000 qualifies for forgiveness.

This provision has expired and been reinstated several times. We include a discussion here because there's a good chance it may be extended again or made permanent.

Other Issues

You can deduct mortgage interest on debt of up to $1,000,000 to purchase (or improve) a principal or second residence. In addition, you can deduct interest on up to $100,000 of home equity debt. In a Tax Court case (Pau, T.C. Memo. 1997-43) the taxpayers' total debt related to the purchase of their residence was $1.33 million. The Court concluded that the taxpayers failed to demonstrate that any of their debt was not incurred in acquiring, constructing, or substantially improving their residence and thus was not acquisition indebtedness, thus limiting their interest deduction to the debt on $1 million and disallowing the use of the $100,000 home equity allowance as qualifying for acquisition debt. Rev. Rul. 2010-25 (IRB 2010-44) holds that a taxpayer may deduct as interest on acquisition indebtedness interest on the first $1 million of debt to purchase a qualified residence and interest paid on home equity debt up to $100,000 also used to purchase a qualified residence.

As always, the rules can be more complicated. We've covered the most frequently encountered issues. And, since a mistake here can be costly, get good advice.

 

 


Copyright 2010-2015 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536


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--Last Update 06/16/15