January 5, 2011

Debt Exceeding $1 Million Can Be Home Equity Indebtedness

By Patricia Aas, Senior Manager, Tax & Business

Related Service Tax & Business

Debt Exceeding $1 Million Can Be Home Equity Indebtedness Tax & Business

For those of us with homes in the million-dollar plus range, the home mortgage interest deduction for married couples has increased to include “home equity indebtedness” in addition or together with acquisition indebtedness. The IRS has ruled that debt incurred by a taxpayer to acquire, construct or substantially improve a qualified residence can constitute home equity indebtedness to the extent it exceeds $1 million but is subject to the $100,000 and fair market value limitations. Prior to the ruling, homeowners were generally limited to a deduction relating to home acquisition indebtedness up to $1 million dollars. However, qualifying home equity debt up to $100,000 dollars had also been deductible. There has been some discrepancy among the courts and the Internal Revenue Service as to whether one could deduct interest on both the $1 million and the $100,000 dollars on an original purchase mortgage. The language in the law appeared to rule against the taxpayer and limit the total amount to $1 million, however contrary to the tax courts, the IRS decided in favor of the taxpayer in Revenue Ruling 2010-25.

Example:
A taxpayer buys a principal residence for $2.5 million, paying $500,000 in cash and borrowing the balance, with the residence as collateral. The residence’s fair market value is $2.75 million. Interest on $1 million is deductible as acquisition indebtedness. In addition, interest on $100,000 of the amount above $1 million is also deductible, as home equity indebtedness, under the Chief Counsel’s interpretation. Thus, the taxpayer may deduct interest on up to $1.1 million of the purchase price.

Conclusion:
IRS Chief Counsel advised that indebtedness incurred by taxpayer to acquire, construct or substantially improve a qualified residence can constitute home equity indebtedness to the extent it exceeds $1 million. This position taken by the IRS is inconsistent with the Tax Court decisions in Pau v. Commissioner and Catalano v. Commissioner. While, the IRS stated that it will not follow the Tax Court decisions, we suggest that you contact your Marcum Tax Professional to further discuss these cases and Revenue Ruling and how they may pertain to your home ownership.

Contact Patricia.Aas@marcumllp.com or Hunter.Morris@marcumllp.com from our New England offices for additional information.