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Oct 1991

Mortgage interest. (Federal Taxation)

by Santoro, John

    Abstract- Deductions of mortgage interest, through the Tax Reform Act of 1986, can be a useful strategy in tax planning. Full deductibility of mortgage interests is subject to limitations based on the mortgage issuance date, the amount mortgaged, and the use of the resulting finances. Limitations on acquisition indebtedness may be imposed based on the acquisition, construction, or improvement of a residence. An election of a reversion of debt security should be made if full deductions are possible on debt interest regardless of residence mortgage interest qualifications. Refinancing of mortgages at a value not greater than an existing mortgage's balance allows for continued availability of full deductions. Examples of secured debt and mortgage refinancing are included.

With the passage of TRA 86, tax practitioners and their clients have faced substantial tax law changes. In particular, the phase-out of the personal interest deduction has moved the mortgage interest deduction into the limelight as an important tax planning strategy.

Mortgage interest is interest incurred on a loan secured by a qualified residence. Loans secred by a principal residence, including first and second mortgages home equity loans, and refinanced mortgages are includable in the definition of mortgage interest. The IRS has set limitations on the deductibility of mortgage interest; these limitations depend on the date the mortgage was issued, the amount of the mortgage, and the use of the proceeds.

A qualified residence is defined as a house, cooperative apartment, condominium, house trailer, or a boat, provided it includes the basic living accommodations, including sleeping space, toilet and cooking facilities. A qualified residence includes a taxpayer's principal residence or second home. The taxpayer's second residence may be unoccupied, partially occupied, or rented to another party. If the second residence is rented, it will be subject to the personal use requirements relating to vacation homes. It will qualify as a personal residence if used by the taxpayer more than the greater of 14 days, or 10% of the number of days during the year that it was rented at fair value. If the taxpayer did not rent the residence at any time during the year, it will be considered a qualified residence. Regulations statement that the term "rental" is defined as holding a residence for rental or resale.

Mortgage interest is subject to certain limitations to be fully deductible. Acquisition indebtedness incurred prior to October 14, 1987, is not subject to the limitations imposed on indebtedness incurred subsequently. A $1 million limitation is imposed on the principal amount of acquisition indebtedness incurred after October 14, 1987.

Acquisition Indebtedness

Sec. 514(c) defines the term acquisition indebtedness as the unpaid amount of: 1. Indebtedness incurred by the organization in acquiring, substantially improving or constructing such property; 2. Indebtedness incurred before the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement; and 3. Indebtedness incurred after the acquisition or improvement of such property, if such indebtedness would not have been incurred but for such acquisition or improvement and incurring such indebtedness was reasonably foreseeable at the time of acquisition or improvement.

Debt can qualify as being incurred to acquire, construct, or substantially improve a residence under the tracing rules of Reg. 1.163- 8T. The determination of whether debt is incurred in acquiring, constructing, or substantially improving a residence will be made independently of the determination of whether the debt is secured by the residence and without regard to whether the residence is a qualified residence at the time the expenditures are made or the debt is incurred. Therefore, a debt that is not initially secured in acquiring a qualified residence may become acquisition indebtedness at the time the debt is subsequently secured by the qualified residence. Additionally, debt incurred in acquiring property that is not a qualified residence at the time the debt is incurred may become acquisition debt at the time the property subsequently becomes a qualified residence if the debt is secured by the qualified residence. Debt is determined to be incurred in acquiring a residence on the date the loan proceeds are disbursed for the benefit of the taxpayers.

Secured Debt

Secured debt is defined as an instrument that: * Makes ownership in a qualified home security for payment of the debt; * In case of default, the home can satisfy the debt; and * Is recorded or otherwise protected under applicable state or local law.

Any taxpayer can elect on their tax return to treat a debt secured by a qualified home as being unsecured by that home. This treatment begins in the tax year the election is made and is in effect for all later periods. It can be revoked only with consent of the IRS. The election should be made if the interest on the debt is fully deductible whether or not it is qualified home mortgage interest. This would allow more of a deduction for interest on other debts that are deductible only as home mortgage interest. Also, debt can be treated as incurred to purchase a residence if expenditures to acquire the residence are made within 90 days before or after the date the debt is incurred.

Example. Mr. Smith bought his principal residence on June 30, 1990, for $125,000. He purchased the home with proceeds from the sale of his old home. On July 31, 1990, Mr. Smith was issued a mortgage for $110,000 and used the money to invest in the stock market. The loan as issued should be considered a mortgage on his new home because he purchased the home within 90 days of the issuance of the loan. If the residence purchased was under construction or undergoing substantial improvement, debt incurred prior to the residence being completed can be treated as being incurred to construct or improve the residence to the extent the expenditures were made no more than 24 months prior to the date the debt was incurred.

Refinanced Mortgages

If an existing mortgage is refinanced for no more than the balance of the existing mortgage, the interest payments continue to be fully deductible. If an existing mortgage is refinanced after October 13, 1987, for more than the existing mortgage, that part that exceeds the existing mortgage balance is a home equity mortgage. A mixed-use mortgage will result if it qualifies as both home acquisition and home equity debt. Home equity debt is a mortgage issued after October 13, 1987, that is secured by a qualified home. Home equity debt cannot be more than the fair market value of that home minus the amount of home acquisition debt, including any grandfathered debt.

Example. Taxpayer has a first mortgage for $300,000, that was taken out in 1981. In January 1990, when the home had a fair market value of $500,000, the taxpayer owed $275,000 on a first mortgage. Taxpayer took out a home equity loan for $115,000, used $80,000 of the home equity loan proceeds for home improvements, and $35,000 for other purposes. All the interest incurred can be deducted on both mortgages; the first mortgage qualifies because it is grandfathered having been made before October 13, 1987. The home equity loan will qualify under the limits of home acquisition and home equity debt discussed previously.

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