Mortgage Interest Deduction

Mortgage Interest Deduction Bus 225K

Considerations • Definitions – Acquisition debt, home equity debt • Limitations and how applied • Ability to treat a debt as not secured by a qualified residence • Using data from Form 1098 • Planning

Some housing data • In 2006, the average Form 1098 amount was ___? • In 2006, ___% of individual returns reported a mtg interest deduction • In 2006, the median home sales price was ___? • As a tax expenditure, the annual “cost” of the home mtg deduction is ___?

JCT - Distribution by Income Class of Selected Individual Tax Expenditure Items, at 2008 Rates and 2008 Income Levels (pg 54) [Money amounts in millions of dollars, returns in thousands] JCT, Estimates Of Federal Tax Expenditures For Fiscal Years 2009-2013 (1/10)

Tracing vs. QRI §1.163-8T(m)(3) • “(3) Qualified residence interest. Qualified residence interest (within the meaning of section 163(h)(3)) is allowable as a deduction without regard to the manner in which such interest expense is allocated under the rules of this section. In addition, qualified residence interest is not taken into account in determining the income or loss from any activity for purposes of section 469 or in determining the amount of investment interest for purposes of section 163(d). The following example illustrates the rule in this paragraph (m)(3): • Example. Taxpayer E, an individual, incurs a $20,000 debt secured by a residence and immediately uses the proceeds to purchase an automobile exclusively for E's personal use. Under the rules in this section, the debt and interest expense on the debt are allocated to a personal expenditure. If, however, the interest on the debt is qualified residence interest within the meaning of section 163(h)(3), the interest is not treated as personal interest for purposes of section 163(h).”

§163(h) Basics – Personal Interest Expense • “Personal interest expense” is not deductible. • QRI is not non-deductible personal interest. • Personal interest: • §163(h)(2), interest other than trade or business, investment interest, passive activity, QRI, §221 • Interest on 1040 tax deficiency = personal interest

§163(h) Basics of QRI • QRI • “any interest which is paid or accrued during the taxable year on— • (i) AI with respect to any QR of the taxpayer, or • (ii) HEI with respect to any QR of the taxpayer. • For purposes of the preceding sentence, the determination of whether any property is a QR of the taxpayer shall be made as of the time the interest is accrued.”

Acquisition indebtedness • (i) “any indebtedness which— • (I) is incurred in acquiring, constructing, or substantially improving any QR of the taxpayer, and • (II) is secured by such residence. • Such term also includes any indebtedness secured by such residence resulting from the refinancing of indebtedness meeting the requirements of the preceding sentence (or this sentence); but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness. • (ii) $1,000,000 Limitation. The aggregate amount treated as AI for any period shall not exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return).”

Home equity indebtedness • (i) “The term “home equity indebtedness” means any indebtedness (other than AI) secured by a QR to the extent the aggregate amount of such indebtedness does not exceed— • (I) the fair market value of such qualified residence, reduced by • (II) the amount of acquisition indebtedness with respect to such residence. • (ii) Limitation. The aggregate amount treated as HEI for any period shall not exceed $100,000 ($50,000 in the case of a separate return by a married individual).”

Qualified residence • “(I) the principal residence (within the meaning of section 121) of the taxpayer, and • (II) 1 other residence of the taxpayer which is selected by the taxpayer for purposes of this subsection for the taxable year and which is used by the taxpayer as a residence (within the meaning of section 280A(d)(1)).”

Add’l rules • Special transition rules for pre-October 13, 1987 debt • Mortgage insurance premiums (§163(h)(3)(E)) • MFS • Cooperative housing corporations

Regulations §1.163-10T • Issued - T.D. 8168, 12/21/87 • TRA’86 version of 163(h)(3) rather than Revenue Act of 1987 version • But some of the concepts are similar • Also: • PLRs, Rev. Rul. 96-32, Notice 88-74 • Pub 936 (although not authority) • Form 1098 and instructions

Secured §1.163-10T(o) • (o) Secured debt. • (1) In general. • (2) Special rule for debt in certain States. • (3) Times at which debt is treated as secured. • (4) Partially secured debt. • (5) Election to treat debt as not secured by a qualified residence.

Question – secured by • On 2/1/09 Eric purchased a home as his principal residence. He borrowed $100,000 from Big Bank with this mortgage secured by his home. His parents also loaned him $50,000 evidence by a note they wrote based on a loan agreement found on a website. This loan is not secured by the home. • On 3/1/10, you are meeting with Eric to prepare his 2009 return. What do you do and what interest expense can Eric deduct in 2009?

Question – special election • Martha is a sole proprietor CPA. To purchase some new computer equipment for her business, she borrowed $30,000 from the bank and had to use her principal residence as collateral. This is the only debt she has on this home and owns no other home. How should Martha treat this debt?

PLR 200932030 • Taxpayer was granted relief under §301.9100-1 to amend returns for Years 1 and 2 so as to make an election under §1.162-10T(o)(5) to treat debt secured by T’s second residence as not secured by the residence. • IRS granted relief! • “According to Ts' representations and the information supplied, Ts acted reasonably and in good faith because they reasonably relied on a qualified tax professional, and the tax professional failed to make, or advise the taxpayer to make, the election. In addition, the interests of the government are not prejudiced in this case. Ts have represented that granting relief would not result in a lower tax liability in the aggregate for all taxable years affected by the election than Ts would have had if the election had been timely made. Furthermore, the tax year in which the regulatory election should have been made, and any tax years that would have been affected had it been timely made, are not closed by the period of limitations on assessment.”

“Involuntary” debt • -10T(o)(1) last sentence: • “A debt will not be considered to be secured by a qualified residence if it is secured solely by virtue of a lien upon the general assets of the taxpayer or by a security interest, such as a mechanic's lien or judgment lien, that attaches to the property without the consent of the debtor.” • In Re: Vale, 78 AFTR 2d 96-6836 (BK, IN) • Involuntary tax lien on debtors' residence cannot produce QRI.

Question – extra security • T borrows $950,000 from B to finance purchase of residential lot and construction of a residence on the lot. • Loan secured by lot, residence and a deposit T will maintain on deposit at B. • If T defaults, “B will have the right, at its option, to either foreclose on the deed of trust, or levy upon T's deposit, or both, as necessary to collect the amount due. B intends to record and otherwise perfect the financing documents in accordance with the applicable state law.” • Question – is this AI or is the additional security a problem? • PLR 9038023

Definition of QR -10T(p) • (p) Definition of qualified residence. • (1) In general. • (2) Principal residence. • (3) Second residence. • (4) Allocations between residence and other property. • (5) Residence under construction. • (6) Special rule for time-sharing arrangements.

Question - Multiple residences • Smiths own principal residence + vacation home – both with AI. • January 1, 2010, move to home owned by employer due to work relocation. • In 2010, visit both homes they own and neither is leased out. • What interest can they deduct in 2010?

Question – extra land • Bartons borrowed money to acquire 5 acres of land adjacent to their PR to incorporate into their PR. What is nature of the debt? • PLR 8940061

Question – office in home • Janet uses a room in her home as a valid home office and deducts expenses for it. The home represents 1/5 of the total square footage of the home. • Janet has a mortgage on the home where proceeds were used to acquire the home. The debt amount is $200,000. Her Form 1098 for last year indicates $12,000 of interest was paid. • Question – how much of the $12,000 interest is deductible as QRI?

Question – what is a QR? • The Smiths purchased an RV financed by dealer. Is the interest deductible? • What about a motor home (RV)? • What about a boat?

Question – residence destroyed • Jane’s PR is destroyed by hurricane. While she lives elsewhere and thinks about whether to rebuild or sell, she is still incurring mortgage interest. Is it QRI? • Rev. Rul. 96-32

Residence under construction -10T(p)(5) • “A taxpayer may treat a residence under construction as a qualified residence for a period of up to 24 months, but only if the residence becomes a qualified residence, without regard to this paragraph (p)(5)(i), as of the time that the residence is ready for occupancy.”

More on debt and constructed home • Notice 88-74 • EX – Bob uses cash to buy land and build a home to be his PR. Total cost is $400,000. Completed on 3/1/10 and Bob moves in. On 5/1/10 borrows $200,000 to furnish his home and pay some personal debts. Debt secured by his new PR. • Because Bob borrowed the funds no later than 90 days after the date construction was completed, he can treat the $200K as AI (and it is secured by his PR).

Is a before or after rule – “Notwithstanding the tracing rules of section 1.163- 8T, in the case of the acquisition of a residence, debt may be treated as incurred to acquire the residence to the extent of expenditures to acquire the residence made within 90 days before or after the date that the debt is incurred.” Example from Pub 936 that illustrates rule of Notice 88-74 -- More on 90-day rule

Question - categorization • Refinance AI when balance is $210K and take out loan of $400K. What type of debt does borrower have?

Mtg Interest: $1 vs $1.1 million • CCA 200940030 • A single debt in excess of $1 million used to acquire, construct or substantially improve a residence can be treated as $1 million of AI and $100,000 of HEI • Believed that interpretation of AI as including the $1 million limitation was the correct one (rather than an interpretation that it did not include a dollar limit). • Referred to §108(h)(2) to support position – refers to AI definition but with $2 million rather than $1 million (suggesting that $1 million is part of AI definition) • Referred to §56(e) to support position – qualified housing interest refers to AI and HEI definitions. If dollar limits were not part of these definitions, than would be no debt limit for AMT • Acknowledge that position is inconsistent with Pau, T.C. Memo. 1997-43 and Catalano, T.C. Memo. 2000-82, but believe it is a better interpretation • Likely need to disclose on return since contrary to two Tax Court decisions.

Application of debt limits for co-owners • CCA 200911007 (3/09) • $1 million acquisition indebtedness limit is per residence, not per co-owner per IRS interpretation of §163(h) language • Facts – co-owners of residence with mortgage in excess of $1 million. T paid P% of all interest due on the Mortgage and Co-Owner paid Q% of interest due • T’s deduction = P% x $1,000,000/ amount of Mortgage • “Under §163(h)(3)(B)(i), acquisition indebtedness is defined, in relevant part, as indebtedness incurred in acquiring a qualified residence of the taxpayer - not as indebtedness incurred in acquiring taxpayer's portion of a qualified residence.” • IRS also referred to Reg. §1.163-10T(e) • Theoretically, would also have to adjust if either co-owner also had AI on a second residence. • More guidance needed • Why a CCA rather than updating the regs?

Question – exceed AI and HEI limits • Is this a good planning idea? • Trents have mortgage of $1,300,000 all used to purchase PR. No other debt. They arrange with lender to not pay any interest until they pay their debt down to $1.1 million.

Question – whose debt? • T owns condo. • Homeowner’s association borrows money for some repairs and improvements. • “The Association obtained a commitment from the Bank to loan $x to the Association to finance the construction project. The collateral for the loan consists of the regular and special homeowners' assessments, a deed of trust on the common elements, and the assignment of homeowners' dues. Taxpayer's home was not pledged as collateral on the loan.” Will impose a special assessment on owners to service the mortgage. • Can T deduct any of this interest as AI or HEI? • PLR 200029018

Question - Planning • Mr. and Mrs. Jones have a PR and 2 vacation homes (never rented), all with mortgages and the following interest expense in prior year: • PR $20,000 • Vacation home 1 $ 4,000 • Vacation home 2 $ 9,000 How much is deductible and what planning advice do you have for them?

Question – more planning • Mr. and Mrs. Nguyen own home in San Jose and just made last mortgage payment. FMV = $600,000. Want to move to Santa Cruz and keep the San Jose house as a rental. They obtained a loan using the SJ home as collateral and used the money to buy the Santa Cruz home for $400,000. • Current year rental information: • Rental income $20,000 • Mortgage interest $18,000 • Property tax $ 4,000 • Misc expenses $ 5,000 • Explain their tax consequences.

Borrow from same lender If borrower repays loan including interest expense using funds borrowed from sale lender, may not be able to deduct the interest expense yet. • Issue – really have not paid that interest if cash method taxpayer. • See Battlestein (5th Cir. 1980), Wilkerson (9th Cir. 1981), Burgess (8 TC 47 (1947))

Limits on HEI • Karen used $5,000 of the proceeds of a home equity loan to purchase tax-exempt bonds, may she deduct the interest expense associated with that purchase? • §1.163-10T(b) – “Qualified residence interest is subject to the limitation imposed by … section 265(a)(2) (interest relating to tax-exempt income)”

Question - HEI • Your client is thinking about getting a home equity line of credit of $80,000. Today, their home is worth $600,000 and has AI of $400,000. What words of caution and advice should you offer your client?

QRI and AMT - 1 • §56(e) – “qualified housing interest” • Only includes interest on debt used to acquire, construct, or substantially improve: • (A) principal residence (per §121) at the time the interest accrues, or • (B) qualified dwelling which is a qualified residence per §163(h)(4)

QRI and AMT - 2 • ““qualified dwelling” means any— • (A) house, • (B) apartment, • (C) condominium, or • (D) mobile home not used on a transient basis (within the meaning of section 7701(a)(19)(C)(v)), • including all structures or other property appurtenant thereto.”

QRI and AMT - 3 • So, not deductible for AMT: • Interest on home equity debt. • Interest on second home that is a boat, RV or mobile home used on transient basis.

Compliance challenges • Complexity of rules: • Applying the limitations • PR and more than one other home • Multiple refinancings • Sufficient documentation – such as if refinance and take out more than current AI and use some of extra for improvements and some for personal • AMT • Points • 1098 does not always have the amount for the return • EX – if debt exceeds the limitations • 1098s do not include: • the property’s address • debt amount • how debt was used (acq or equity) • if is refinanced

Question – Form 1098 • To determine the amount of mortgage interest deductible on Schedule A, should you just total the amounts reported in boxes 1 through 4 on the 1098 forms they received? Explain.

Non-compliance • TIGTA, Mortgage Interest Data Could Be Used to Pursue More Nonfilers and Underreporters (8/09) • Some who receive Form 1098 are non-filers • About 136,000 taxpayers likely owe $1.4 billion

Points • Fee, usually 1% of the loan amount, paid to lender to lower the interest rate; charged up front – “prepaid interest” • Guidance: • §461(g) • Rev. Rul. 87-22 • Rev. Proc. 87-15 • Rev. Proc. 94-27

More on points • 461(g) – generally, prepaid interest is not deductible when paid – but instead over the loan term. Exception at (g)(2) – if paid on “any indebtedness incurred in connection with the purchase or improvement of, and secured by, the principal residence of the taxpayer to the extent that, under regulations prescribed by the Secretary, such payment of points is an established business practice in the area in which such indebtedness is incurred, and the amount of such payment does not exceed the amount generally charged in such area.” • Points are interest so subject to AI and HEI limitations. • If debt > $1 million, not all points deductible • PLR 199905033 – taxpayers not required to deduct under (g)(2); ok to instead amortize if prefer. Per IRS – “legislative history to section 461(g) indicates a Congressional intent to permit, but not require, taxpayers currently to deduct points on their home acquisition debt.”

Add’l guidance on points • For the tax treatment, you need to know how the points were paid, whether it was a refinancing and if so whether it was the same lender, whether they met the requirements laid out in Rev. Proc. 87-15.

GAO Recommendations (7/09) to improve compliance • Perhaps change §163(h) limit from debt amount to interest expense amount • More info on Form 1098 • Property address • Debt balance • Whether refinanced • How proceeds used • Sch A – ck box if debt limit exceeded • Better, more comprehensive training materials for Revenue Agents • http://www.gao.gov/new.items/d09769.pdf

Policy Considerations Home mortgage interest

Effective tax rates on housing & other investments Final report of President Bush’s Tax Reform Advisory Panel (p 71) http://govinfo.library.unt.edu/taxreformpanel/final-report/index.html

Distribution of benefit Final report of President Bush’s Tax Reform Advisory Panel (p 72) http://govinfo.library.unt.edu/taxreformpanel/final-report/index.html

Mortgage Interest Deduction