Expenses & Deductions
The Tax Reform Act of 1986 imposed significant restrictions on the deduction of interest by enacting Sec. 163(h). Sec. 163(h)(1) provides that taxpayers (other than corporations) are not entitled to deduct personal interest. Sec. 163(h)(2) provides that the term “personal interest” means any interest other than trade or business interest, investment interest, passive activity interest, or qualified residence interest.
There are two types of home mortgage debt that produce deductible qualified residence interest: acquisition debt and home equity debt (Sec. 163(h)(3)). Acquisition indebtedness is debt secured to purchase, build, or substantially improve a qualified residence. Sec. 163(h)(3)(B)(ii) limits home acquisition indebtedness to $1 million ($500,000 in the case of a separate return filed by a married individual).
Home equity indebtedness is debt, other than acquisition indebtedness, secured by a qualified residence to the extent it does not exceed the fair market value of the qualified residence less the acquisition debt on such residence. Sec. 163(h)(3)(C)(ii) limits home equity indebtedness to $100,000 ($50,000 in the case of a separate return filed by a married individual).
Qualified residence interest is any interest paid or accrued during a tax year on debt that is secured by a principal residence and a second residence of the taxpayer. This second residence must generally be capable of being used by the taxpayer as a place to live. Temp. Regs. Sec. 1.163-10T(p)(3)(ii) defines a residence to include a house, condominium, mobile home, boat, or house trailer that contains sleeping space, a toilet, and cooking facilities.
Temp. Regs. Sec. 1.163-10T(o)(1) clarifies the term “secured debt.” In general, debt is secured by a qualified residence when the property can be used to settle the debt should the borrower default on his repayment commitment. The security interest must be recorded, where permitted, or otherwise perfected under applicable state law.
Interest Allocation Issues
Interest allocation issues can generally arise when a taxpayer incurs mortgage indebtedness that exceeds the $1.1 million threshold. While temporary regulations were issued in 1987 (Temp. Regs. Secs. 1.163-9T and 1.163-10T) to provide guidance on the allocation of excess interest expense, more guidance was needed. As a result, shortly after the issuance of the temporary regulations, the IRS released Publication 936, Home Mortgage Interest Deduction, to provide taxpayers with further guidance. However, taxpayers were left with some uncertainty as to which methodology they were required to follow.
Recognizing the dilemma, the IRS recently released Chief Counsel Advice (CCA) 201201017 to provide taxpayers with more concise guidance for allocating excess mortgage interest expense. The CCA provides that taxpayers may use any reasonable method to determine the amount of interest that is deductible when the combined limitations on acquisition and home equity debt have been exceeded. For these purposes, any reasonable method includes both the “exact” and the “simplified” methods described in the temporary regulations, the method provided in Publication 936, or a reasonable approximation of any of those methods until final regulations specifically addressing this issue are released.
Methods for Allocating Interest Expense
Under Temp. Regs. Sec. 1.163-10T(e), the “exact method” determines qualified residence interest on a debt-by-debt basis. It accomplishes this by comparing the applicable debt limit for each debt to its average balance. The applicable debt limit for each debt is the lesser of the fair market value of the residence on the date the debt is secured and the adjusted purchase price of the qualified residence at the end of the tax year, 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 of the interest on that debt is qualified residence interest and therefore deductible.
If the average balance of the debt exceeds the limitation, the amount of qualified residence interest is determined by multiplying the interest paid or accrued with respect to the debt by the applicable debt limit divided by the average balance of the debt. Under Temp. Regs. Sec. 1.163-10T(e)(4), a taxpayer is permitted to treat interest that exceeds the limitation according to the use of the debt proceeds under the interest tracing rules in Temp. Regs. Sec. 1.163-8T, which provides a variety of examples that give taxpayers much-needed guidance in applying the rules.
Temp. Regs. Sec. 1.163-10T(d) provides for a “simplified method,” which combines all debt. Under this method, interest on all secured debt is multiplied by the adjusted purchase price of the qualified residence divided by the sum of the average balances of all secured debts (substituting the $1 million acquisition indebtedness limitation and the $100,000 home equity indebtedness limitations for the adjusted purchase price, due to the changes made by the Omnibus Budget Reconciliation Act of 1987, P.L. 100-203). According to Temp. Regs. Sec. 1.163-10T(d)(2), a taxpayer is required to treat interest on all excess debt as personal interest under this method, therefore making it nondeductible.
However, Publication 936, in the instructions to line 13 of the “Worksheet to Figure Your Qualified Loan Limit and Deductible Home Mortgage Interest for the Current Year,” states that taxpayers may treat part of the secured debt that is not qualified residence interest in accordance with the use of the proceeds of the debt under the interest tracing rules in Temp. Regs. Sec. 1.163-8T. It does not state that a taxpayer must use the exact method to allocate the excess interest under the interest tracing rules. In CCA 201201017, the IRS resolves the discrepancy between the regulations and Publication 936 by advising that a taxpayer using the simplified method to determine the amount of qualified interest can use the interest tracing rules to allocate the amount of interest in excess of qualified residence interest if any of the interest is allocable to a trade or business or other deductible activity.
Election to Treat Secured Debt as Unsecured Debt
As CCA 201201017 points out, the taxpayer also has the option to make an election under Temp. Regs. Sec. 1.163-10T(e) to treat a debt that is secured by a qualified residence as not secured by a qualified residence. This election, which applies to the entire indebtedness, is made by reporting the interest on the tax return as business interest or other deductible interest, rather than qualified residence interest. A likely advantage of making this election is to permit a debt allocable to trade or business expenses to be deductible without regard to the Sec. 163(h) limitation, thereby allowing the full use of deductions that might otherwise be limited. The election would also permit the interest on the debt to be deductible under Sec. 62, allowable in determining adjusted gross income (to the extent the debt is allocable to a trade, business, or rental expenditure) rather than as an itemized deduction.
Overall, CCA 201201017 is a very taxpayer-favorable ruling, as it concludes that any reasonable method to determine the amount deductible as qualified residence interest under the Sec. 163(h) limitations may be used until final regulations are issued. This includes the exact and the simplified methods in the regulations, the method provided for in Publication 936, or any reasonable approximation of these methods. Further, a taxpayer may allocate the amount of interest in excess of qualified residence interest in accordance with the use of the debt proceeds, as provided in Temp. Regs. Sec. 1.163-10T(e)(4) and the instructions to line 13 of the worksheet in Publication 936. An election can also be made to treat a debt as not secured by a qualified residence, allowing the entire debt (rather than only the amount that exceeds the Sec. 163(h) limitation) to be deductible “above the line” as an ordinary and necessary business expense.
Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.