Yesterday was the unofficial start of “busy season” in the accounting world, which is every bit as depressing as it sounds. For the next few months we’ll be confined to our cubicles and deprived of sunlight and sound nutrition for days at a time; surviving only by adopting a singular focus on doing whatever it takes to make it until April 17th arrives to return our freedom. If busy season sounds a lot like a prison sentence, it’s because it is, only without all the free weights and shower shivvings.
But if we’re gonna’ do it, we may as well do it right. To that end, throughout the next few months I’ll touch on some commonly encountered tax compliance issues that are often misunderstood or misapplied. Today’s lesson: determining the deductible amount of mortgage interest when a taxpayer has total mortgage debt that exceeds the statutory limitations.
First, a primer on the limitations:
Since 1986, I.R.C. § 163(h)(3) has allowed a deduction for qualified residence interest for up to $1,000,000 of acquisition indebtedness and $100,000 of home equity indebtedness. Prior to amendment, the Code generally permitted a deduction for qualified residence interest on debt that did not exceed the basis of the residence and the cost of improvements.
Questions have surrounded the continued relevancy of temporary regulations that were issued prior to the 1986 amendments. The IRS recently answered these questions — albeit 25 years late — in Chief Counsel Memo 201201017. The memo holds the following:
- A taxpayer may use any reasonable method, including the exact method and simplified method provided for in the temporary regulations, to determine the amount deductible as qualified residence interest when total debt exceeds the statutory limitations.
- Regardless of which method is used, a taxpayer may allocate any interest in excess of the limited amounts in accordance with the use of the proceeds under the interest tracing rules. Thus, if the excess proceeds are traced to use in a rental activity, the interest can be deducted on Schedule E; if they were used to purchase investments, the interest may be deductible on Sch. A as investment interest, and so on…
If those bullets make perfect sense to you, lovely. If not, read on, as a detailed explanation and illustration follows.
The Temporary Regulations
The outdated temporary regulations[i] provided two methods for determining a taxpayer’s qualified residence interest when debt exceeded the applicable limitation: the simplified method and the exact method. Citing the legislative history of I.R.C. § 163, the IRS held in CCM 201201017 that a taxpayer can also use any reasonable method to allocate debt in excess of the $1,100,000 limitation. An example of any reasonable method would be the method used in the worksheet found in Publication 936.
Under the simplified method, interest on all debts is multiplied by the following fraction to determine the maximum deductible amount : $1,100,000/ the sum of the average balances of all secured debts.[ii]
To illustrate, assume you owned a home secured by the following debts: First mortgage: $900,000; Home equity line: $300,000; Second mortgage: $150,000.
Assume the home equity line was used for personal expenses and the second mortgage was used entirely in your rental real estate business. If the total interest expense on all three mortgages for 2011 was $80,000, using the simplified method the maximum amount of interest deductible on Schedule A as qualified residence interest would be: $80,000 * $1,100,000/$1,350,000 = $65,185.
Under the temporary regulations, if you used the simplified method you were required to treat interest on all excess debt as nondeductible personal interest. Thus, you would not be permitted to deduct any of the remaining interest in excess of the $65,185 computed above, even though the proceeds of the second mortgage were used in a rental activity. In perhaps the most important piece of CCM 20120107, however, the IRS ruled that a taxpayer using the simplified method can, in fact, apply the interest tracing rules to any interest expense in excess of the limited amount.
Under the exact method, the amount of qualified residence interest is determined on a debt-by-debt basis by comparing the applicable debt limit for the debt to the average balance of each debt. The applicable debt limit is an amount that is equal to the $1,000,000 limit on qualified residence debt reduced by the average balance of each debt that was previously secured by the qualified residence.
If the average balance of the debt does not exceed the limitation for that debt, all the interest on that debt is qualified residence interest. If the average balance of the debt exceeds the limitation, the amount of qualified residence interest is determined by multiplying the interest with respect to the debt by a fraction, the numerator of which is the applicable debt limit for that debt and the denominator of which is the average balance of the debt.
Applying the same facts as above, the applicable debt limit for the $900,000 first mortgage would be $1,000,000, and the entire interest expense related to the debt would be deductible. The applicable debt limit for the $250,000 debt would be $100,000 ($1,000,000 – $900,000), and 10/25 of the interest expense would be deductible as qualified residence interest. The interest on an additional $100,000 of the $250,000 debt would be deductible as home equity interest. Lastly, the applicable debt limit for the second mortgage of $150,000 would be $0, as the entire $1,000,000 limitation has been used.
Under the exact method, a taxpayer is also permitted to treat interest on debt that exceeds the limitations according to the use of the debt proceeds under the interest tracing rule. Thus, though the interest on the remaining home equity line of $50,000 would not be deductible — as it was used for personal expenses — the interest on the $150,000 second mortgage would be deductible as trade or business interest under the interest tracing rules.
[i] Treas. Reg. § Section 1.163-10T
[ii] Prior to the amendment, this numerator was the adjusted purchase price of the residence.
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