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Because of the Tax Reform Act of 1986, home equity loans came into vogue. These loans allow a taxpayer to deduct interest on a loan secured by a principal residence, even though it has no relation to the acquisition or substantial improvement of the residence.

First time homeowners may deduct “Qualified residential interest” from their taxable income. “Qualified residential interest” comes from the following two sources:

-          Aggregate acquisition indebtedness not exceeding $1,000,000. This applies to primary and second residence combined. For married people filing separately, the limit is $500K. This means that borrowers cannot write interest for borrowings past $1,000,000 for acquisition of primary residence and 2nd homes combined.

-          Aggregate home equity indebtedness cannot exceed $100,000. This means that borrowers cannot write off interest on more than $100,000 of home equity indebtedness.

 Acquisition debt – debt that is incurred in acquiring, constructing, or substantially improving the primary residence or second residence and is secured by such property.

 Acquisition debt decreases as payments are made, and cannot be increased by refinancing.

             Pre-1987 grandfathered debt

+          Post 1987 acquisition (or construction )debt

+          Substantial improvement debt

            Acquisition Debt

 Home Equity Debt – Debt other than acquisition debt secured by the taxpayer’s principal or second residence and does not exceed the Fair Market Value (FMV) of the qualified residence by the amount of acquisition debt on the residence.

             Total secured debt

-          Acquisition debt

Home Equity Debt (not to exceed the lower of $100K or FMV)

 Example 1

Party 1 takes out a mortgage of $85K to purchase a principal residence. He pays the debt down to $60K. His acquisition indebtedness cannot with respect to this residence be increased above $60K, unless additional secured debt taken out is used for home improvement.


Example 2

Party 1 purchases a principal residence for all cash. A year later, he refinances it for $200K (all cashout). The acquisition debt immediately before refinancing is $0, therefore the full $200K is excess debt with only $100K eligible for home equity debt. P1 can now deduct only 50% of his interest expense. Maybe poor tax planning.

One notable exception occurs if the taxpayer is subject to the Alternative Minimum Tax (AMT). Those subject to the AMT don’t get as many write-offs as other taxpayers. Only interest on mortgage debt that was used to buy, build, or improve a home can be deducted by those subject to the AMT.

 If an individual acquires the interest of a spouse in a qualified residence incident to a divorce, and the indebtedness is secured by the residence, the acquisition debt will be increased by the new total amount of financing, not to exceed FMV.

 A residence is a house, condo, mobile home or house trailer that contains sleeping space and toilet and cooking facilities.

 A qualified residence is the taxpayer’s principal and secondary residence.

 For a 2nd home to be a 2nd home and not a rental –

-          it must not be rented  - or

-          it must be personally used the greater of 2 weeks out of the year or 10% of the number of days it is rented out. The residence is rented during any period that it is held out for rent.

 If the residence is used also for business, interest must be prorated. If 10% of the residence is used for trade or business, then 10% of the interest may be deductible as business interest expense.

 If the taxpayer rents out a portion of the principal or 2nd home, that portion may be treated as residential if:

 -          the tenant used the rented portion for residential purposes

-          the rented space is not self-contained containing separate sleeping and cooking facilities

-          the total number of tenants (directly or by sublease) does not exceed two. If two persons and their dependents share the same sleeping quarters, they are treated as one.

Time share arrangements are considered qualified residences as long as the taxpayer does not lease their use. Therefore, swapping personal-use time-share units should not jeopardize the qualified residence status.

If two newly-weds both owned individual primary residences and one owned a vacation home, they did own two deductible home. Now they have one non-deductible home.

Bad tax planning – purchasing vacation homes with loans secured on their primary residences. The result is that a loan normally considered acquisition debt on a second residence is now considered home equity debt of the primary residence. The deduction is severely limited. This may, however, be balanced out by the lower monthly mortgage payment as a result of the loan being on owner-occupied property as opposed to a second home.

You can convert nondeductible personal interest expense into deductible home mortgage interest expense by putting your home up as collateral for the personal debt, e.g., a car loan with the house as security. It would be the same thing as taking out a HELOC (Home Equity Line of Credit) to buy a car.

This interest is only deductible to the date that the loan was secured (recorded) against the property.


Points are deductible over the loan term for a refinance. These are considered to be similar to a prepayment of interest. Points are viewed as a substitute for a higher interest rate.

 Also other NRCCs (Non-Recurring Closing Costs) are not considered “points.”

Points are deducted entirely in the year of payment if –

      -          the loan is for a purchase

-          The cashout from the refi is for home improvement. The percentage of the total points that can be deducted in the year of loan closing is equal to the percentage of the total loan amount that is used for home improvements. The remainder of the points in a refinance must be deducted over the life of the loan.

-          The points charged are not excessive

The HUD1 must clearly designate the points as points, line item 801. It must be stated using labels such as loan origination fee, loan discount, discount point, service points fee, commission paid to mortgage broker, etc.

Make sure points are paid in cash. In order for points to be deductible, they must be paid from separate funds at the time of closing. They cannot be paid from borrowed funds. Points withheld by a lender from loan proceeds may not be deducted by a borrower in the year the points were withheld, because holding does not constitute payment within that tax year.

Points can be paid out of earnest money deposit. So long as the funds are not borrowed, points may be deducted if they do not exceed the down payment, escrow deposit, earnest money applied at closing and other funds actually paid over at closing. To sum it up, points do not have to be paid in cash at closing as long as the earnest money deposit exceeds the points.

Points charged during a refinance are deducted over the entire life of the loan. If part of the proceeds of a refinance are used to improve the personal residence, the taxpayer may deduct a portion of the points in the tax year paid.

If the residence is sold or a balloon payment comes due on the mortgage, the unamortized part of the financing expense can be charged off and deducted as interest expense.

If the borrower prepays the loan early, the points become fully deductible in the year of payment of the loan. Refinancing, however, will not trigger that option.

Other Non-Recurring Closing Costs incurred during a purchase should be included in the calculation of the property’s adjusted basis. Common purchase fees include escrow fees, title fees, broker fees, lender fees, recording costs, and any expenses related to the purchase other than those that physically affect the property, such as the repair costs. By adding closing costs to the property’s depreciable basis, the closing costs are depreciated over the specified useful life of the property. By neglecting to include the purchase closing costs in the adjusted basis, the first time home owner reduces the amount of depreciation deduction allowed.

For more information, refer to IRS Publication 936, “Home Mortgage Interest Deduction.”










































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