Mortgage Interest Deduction: A Subtle Surprise

Ah, the American Dream: Apple pie, a chicken in every pot and….. home mortgage debt.  Or, has home mortgage debt become something to be a wee bit wary of?

The home mortgage interest deduction is one of the most treasured benefits available to American taxpayers. However, there are exceptions to the deductibility rule as outlined within the Internal Revenue Code.  Currently, all individuals are allowed an itemized deduction (if they itemize) on Schedule A for “qualified residence interest.”  Qualified residence interest is interest on “acquisition indebtedness” and “home equity indebtedness.” 

• Acquisition indebtedness is debt that is secured by a “qualified residence” – an individual’s primary residence plus one additional residence – and is used to acquire, construct or substantially improve the residence.  Interest is deductible on debt of up to $1 million in total ($500,000 if married filing separately). 
• “Home equity indebtedness” is debt secured by a qualified residence, up to a maximum of $100,000, but is limited to the amount by which the fair market value of the residence exceeds the acquisition debt on that residence. 

In order to deduct interest as qualified residence interest, the debt must be secured by a qualified residence.  Simple?  Perhaps, not.

Take for example, Katie, who currently lives in her personal residence.  She would like to turn this personal residence into a rental property, borrow against the rental property, and purchase a new personal residence.   The debt would be secured by the rental property.  Question:  Does this qualify as acquisition indebtedness, and can Katie deduct the interest on her tax return?

• The rules above tells us that acquisition indebtedness must be secured by a qualified residence in order for Katie to deduct interest on her Schedule A.  Unfortunately, even though Katie will have a qualified residence, the debt will not be secured by the qualified residence.  Therefore, Katie will not be able to deduct the interest as qualified residence interest on her Schedule A.

What about deducting the interest on Schedule E, since that property will be securing the debt?  Here we run into the interest tracing rules.  The Internal Revenue Code and Regulations define the method for allocating interest, in order to apply the appropriate deduction limitations for passive activity interest, investment interest, and personal interest.  The key factor here, and the only relevant factor, is the use of the proceeds.

• So, even though the loan proceeds are secured by the rental property, they are used to purchase a principal residence.  The interest tracing rules tell us that the debt proceeds and related interest expense must follow the use of the proceeds.  So in this case, the interest cannot be deducted on Katie’s Schedule E.

Not so simple, is it?  This can be a major tax trap, since the interest will not be deductible at all.  This is because the money is being used for personal purposes and the residence-interest exception is not available where the loan is not secured by the primary residence or second home.  It is secured by the rental property.

Mortgage interest and tracing rules can be quite complex.  If the proper accounting and tracing is not done, the intended tax benefits could be lost.  Following the rules and documenting the transactions are central in ensuring that the desired results are achieved.

Consult your Marcum tax professional for more information.