Mortgage Interest Deduction

Mortgage Interest
Deduction
Bus 225K
1
Considerations
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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
2
Some housing data
1.
2.
3.
4.
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 ___?
3
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)
4
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).”
5
§163(h) Basics – Personal
Interest Expense
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“Personal interest expense” is not deductible.
QRI is not non-deductible personal interest.
Personal interest:

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§163(h)(2), interest other than trade or business,
investment interest, passive activity, QRI, §221
Interest on 1040 tax deficiency = personal interest
6
§163(h) Basics of QRI
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QRI
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“any interest which is paid or accrued during the
taxable year on—
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(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.”
7
Acquisition indebtedness
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(i) “any indebtedness which—
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(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).”
8
Home equity indebtedness
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(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—
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(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).”
9
Qualified residence
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“(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)).”
10
Add’l rules
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Special transition rules for pre-October
13, 1987 debt
Mortgage insurance premiums
(§163(h)(3)(E))
MFS
Cooperative housing corporations
11
Regulations §1.163-10T
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Issued - T.D. 8168, 12/21/87
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TRA’86 version of 163(h)(3) rather than
Revenue Act of 1987 version
But some of the concepts are similar
Also:
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PLRs, Rev. Rul. 96-32, Notice 88-74
Pub 936 (although not authority)
Form 1098 and instructions
12
Secured §1.163-10T(o)
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(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.
13
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?
14
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?
15
PLR 200932030
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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.”
16
“Involuntary” debt
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-10T(o)(1) last sentence:
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“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.
17
Question – extra security
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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
18
Definition of QR -10T(p)
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(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.
19
Question - Multiple residences
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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?
20
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
21
Question – office in home
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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?
22
Question – what is a QR?
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The Smiths purchased an RV financed
by dealer. Is the interest deductible?
What about a motor home (RV)?
What about a boat?
23
Question – residence
destroyed
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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
24
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.”
25
More on debt and constructed
home
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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).
26
More on 90-day rule
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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 8874 --
27
Question - categorization

Refinance AI when balance is $210K
and take out loan of $400K. What type
of debt does borrower have?
28
Mtg Interest: $1 vs $1.1
million
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CCA 200940030
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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).
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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.
29
Application of debt limits for
co-owners
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CCA 200911007 (3/09)
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$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 CoOwner 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.
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More guidance needed
Why a CCA rather than updating the regs?
30
Question – exceed AI and HEI
limits
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Is this a good planning idea?
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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.
31
Question – whose debt?
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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
32
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?
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33
Question – more planning
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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:
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Rental income
Mortgage interest
Property tax
Misc expenses
$20,000
$18,000
$ 4,000
$ 5,000
Explain their tax consequences.
34
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.

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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))
35
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)”
36
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?
37
QRI and AMT - 1
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§56(e) – “qualified housing interest”
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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)
38
QRI and AMT - 2
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““qualified dwelling” means any—
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(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.”
39
QRI and AMT - 3
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So, not deductible for AMT:
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Interest on home equity debt.
Interest on second home that is a boat, RV
or mobile home used on transient basis.
40
Compliance challenges
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Complexity of rules:
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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
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EX – if debt exceeds the limitations
1098s do not include:
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the property’s address
debt amount
how debt was used (acq or equity)
if is refinanced
41
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.
42
Non-compliance

TIGTA, Mortgage Interest Data Could
Be Used to Pursue More Nonfilers and
Underreporters (8/09)
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Some who receive Form 1098 are nonfilers
About 136,000 taxpayers likely owe $1.4
billion
43
Points
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Fee, usually 1% of the loan amount,
paid to lender to lower the interest rate;
charged up front – “prepaid interest”
Guidance:
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§461(g)
Rev. Rul. 87-22
Rev. Proc. 87-15
Rev. Proc. 94-27
44
More on points
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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.

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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.”
45
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.
46
GAO Recommendations (7/09)
to improve compliance
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Perhaps change §163(h) limit from debt amount to
interest expense amount
More info on Form 1098
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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
47
Policy Considerations
Home mortgage interest
48
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
49
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
50
More data

CBO, An Overview of Federal Support for
Housing (11/09), explains types of federal
spending and tax expenditures devoted to home
ownership and rental affordability. Highlights:
• In 2007, 30% of homeowners and 45% of renters devoted over 30% of their
income to housing.
• In 2004, 68% of households owned their home.
51
“Better Value for Housing
Subsidy”

Per Citizens League


http://www.citizensleague.org/bottomline/
pdf/Bottom-Line-Housing.pdf
“Research shows that the home interest
deduction has little or no bearing on
home ownership rates. Home ownership
rates in the U.S. are about the same as in
Canada, Australia and England, which do
not have the deduction.”
52
“Reforming the Mortgage
Interest Deduction”



By Tax Policy Center - Eric Toder,
Margery Austin Turner, Katherine Lim,
Liza Getsinger
May 2009
Summarize data from various studies on
effects of the mortgage interest
deduction including whether it promote
home ownership.
53
Some findings

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“one of the oldest and largest tax expenditures in the federal income
tax and is the largest single federal subsidy for owner-occupied
housing.”
Cost in 2012 - $131 billion

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Budget of HUD = $48 billion
“disproportionately benefits taxpayers in the top fifth of the income
distribution”
“Because most who benefit would own homes without the deduction, it
mostly provides an incentive to live in more expensive homes, not to
own instead of rent.”
US home ownership rates similar to other countries without a
deduction.
“More broadly based interest subsidies or credits for first-time home
purchases could increase homeownership more, at the same or lower
fiscal cost.”
http://www.taxpolicycenter.org/publications/url.cfm?ID=412099
54
How does QRI deduction hold up
under principles of good tax policy?
1.
2.
3.
4.
5.
Equity
Certainty
Convenience of
payment
Economy of
collection
Simplicity
6.
7.
8.
9.
10.
Neutrality & efficiency
Economic growth and
efficiency
Transparency, visibility
& accountability
Minimum tax gap
Appropriate
government revenues
55
Alternative Policy Approaches


Eliminate deduction and lower everyone’s tax
rate.
Reduce deduction and replace it with a credit
and perhaps also cap the credit amount.




Refundable?
Cap benefit of deduction to 28%
Repeal HEI
Repeal 2nd home deduction
56
Treatment of mtg interest
under consumption tax

Flat tax (H.R. 1040)


No deduction
Fair tax (national sales tax) (H.R. 25)



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23% tax on purchase of a NEW home
0% tax on purchase of USED home
Since interest income not taxable, rates could go
down
See policy paper from FairTax.org and H.R. 25
57
Wrap-up




While the home mortgage deduction rules seems
fairly short and clear in the statute, there are a lot of
special rules to consider.
Can get complicated if own more than PR and a
second home, multiple refinancings, exceed debt
limits, construct home, planning to maximize interest
deductions.
Be aware of special rules to aid planning such as
electing to treat debt as not secured by QR if tracing
gets better result.
After review all materials, take quiz on Desire2Learn.
58

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