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 Home Mortgage Interest Deduction

Audits of tax returns with large home mortgage interest deductions indicate that many taxpayers and tax practitioners are not complying with the rules regarding debt limitations on the deductibility of home mortgage interest.

Home mortgage interest deduction is governed under IRC Section163 (CR&TC Section 17201). To fully deduct the home mortgage interest, the interest must be paid on acquisition or equity debt. The aggregate amount treated as acquisition debt for any period shall not exceed $1 million or $500,000 in the case of a married individual filing a separate return. The maximum aggregate amount of home equity debt for any period is $100,000, or $50,000 in the case of a married individual filing a separate return. Therefore, the aggregate amount of the principal balance of all the mortgage loans used in computing the deductible home mortgage interest may not exceed $1,100,000, or $550,000 in the case of a married individual filing a separate return. The acquisition debt or the home equity debt must be secured by the principal residence of the taxpayer, or one other residence of the taxpayer used as a residence and selected by the taxpayer for the taxable year. 

New debt that taxpayers incur to refinance their acquisition indebtedness also qualifies, but only up to the amount of the refinanced debt. The following example illustrates this issue:

Example:
 
Taxpayer acquires a qualified residence for $500,000 with a $100,000 down payment and a $400,000 mortgage. The $400,000 debt is acquisition indebtedness. After the taxpayer has paid the mortgage down to $300,000 and the home is worth $800,000, the taxpayer refinances with a new $500,000 mortgage. Only $300,000 of this new debt is acquisition indebtedness. However, an additional $100,000 may qualify as home equity indebtedness for a total of $400,000. How much debt can the taxpayer use to compute the deductible home mortgage interest? Only $400,000, not $500,000. 

If the remaining mortgage proceeds of $100,000 were not used for business or investment, then all the interest attributable to the $100,000 is personal interest. Personal interest is not deductible.

The Internal Revenue Service Publication 936 provides guidance and a worksheet, which may be used to figure the qualified loan limit and deductible home mortgage interest.

Taxpayers have to figure the average balance of each mortgage to determine their qualified loan limit. They can use the highest mortgage balance during the year, but they may benefit most by using average balances. Two methods discussed below are:

  1. The average of first and last balance.
  2. Average balance computed on a daily basis.

1. Average of first and last balance method can be used if the following apply:

  • Taxpayer did not borrow any new amounts on the mortgage during the year.
  • Taxpayer did not prepay more than one month's principal during the year.
  • Taxpayer had to make level payments at fixed equal intervals on at least a semi-annual basis.

To determine the average balance of the debt, add the principal balance as of the first day of the taxable year that the debt is secured by the qualified residence and the principal balance as of the last day of the taxable year that the debt is secured by the qualified residence and divide the sum by two. The following example illustrates the computation under the average of first and last balance method.

Modified Example: (Regulation Section 1.163-10T(h)(5)(ii))

C borrows $100,000 in 2000, securing the debt with a second mortgage on a principal residence. The terms of the loan require C to make equal monthly payments of principal and interest so as to amortize the entire loan balance over 20 years. The balance of the debt is $96,520 on 01/01/2001, and is $94,500 on 12/31/2001. The average balance of the debt during 2001 may be computed as follows:
                          
Average Balance: $96,520 + $94,500 = $95,510
                                    2                 

2. To determine average balance computed on a daily basis –

Add the outstanding balance of a debt on each day during the taxable year that the debt is secured by a qualified residence, and divide the sum by the number of days during the taxable year that the residence is a qualified residence.

The following example illustrates the average balance computed on a daily basis.

Modified Example: (Regulation Section 1.163-10T(h)(3)(ii))

Taxpayer A incurs debt of $100,000 on 09/01/2003, securing the debt with A's principal residence. The residence is A's principal residence during the entire taxable year. Taxpayer A pays current interest on the debt monthly but makes no principal payments. The debt is, therefore, outstanding for 122 days with a balance each day of $100,000. The residence is a qualified residence for 365 days. The average balance of the debt for 2003 is computed as follows:

Average Balance: 122 X $100,000 = $33,425
                                   365

If the debt is secured by a qualified residence for less than the entire period during the taxable year that the residence is a qualified residence, the average balance may be determined by multiplying the average balance determined under the "average of first and last balance method" by a fraction, the numerator of which is the number of days during the taxable year that the debt is secured by the qualified residence and the denominator of which is the number of days during the taxable year that the residence is a qualified residence. The following example illustrates this scenario:

Example:

Loan #1: In 2005, Taxpayer B incurred acquisition debt of $1,500,000 securing the loan with his principal residence. The beginning balance of the loan on 01/01/2007, was $1,441,260 and the ending balance on 12/31/2007, was $1,419,218. During 2007, Taxpayer B paid mortgage interest of $85,876 on this loan. The terms of the loan require B to make equal monthly payments of principal and interest so as to amortize the entire loan balance over 30 years.

Loan #2: Taxpayer B incurred a debt of $100,000 on 03/01/2007, securing the debt with B's principal residence. On 12/31/2007, the principal balance of the loan is $97,786. The residence is a qualified residence for 365 days in tax year 2007. During tax year 2007, the loan was held for a total of 306 days from 03/01/2007, through 12/31/2007. During 2007, Taxpayer B paid total interest of $4,951 on this loan. The terms of the loan require B to make equal monthly payments of principal and interest so as to amortize the entire loan balance over 20 years.    

For 2007, the deductible home mortgage interest is computed as follows:

Average Balance of Loan #1:  $1,441,260 + $1,419,218  = $1,430,239
                                                         2

Average Balance of Loan #2:  $100,000 + $97,786    X       306       = $82,908
                                                      2                        365

Aggregate Average Balance: $1,430,239 + $82,908 = $1,513,147


Total Interest Paid on Loans #1 & #2: $85,876 + $4,951 = $90,827


Deductible Home Mortgage Interest:
   $1,100,000  X $90,827 = $66,028
                                                               $1,513,147