Interest on Home-Equity Indebtedness

Editor: Kevin D. Anderson, CPA, J.D.

Expenses & Deductions

The IRS recently released Rev. Rul. 2010-25 to address whether acquisition indebtedness 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 (subject to the applicable dollar and fair market value limitations imposed on home-equity indebtedness by Sec. 163(h)(3)(C)). As a result, the IRS ruled that a taxpayer can deduct as qualified residence interest up to $1.1 million of the debt securing the purchase of a taxpayer’s principal residence.

Background

While personal interest is nondeductible, qualified residence interest, which includes interest on acquisition indebtedness and home-equity indebtedness, is generally deductible. Acquisition indebtedness is indebtedness incurred to buy, build, or substantially improve an individual’s qualified residence that is secured by the residence (Sec. 163(h)(3)(B)(i)). Sec. 163(h)(3)(B)(i) provides that the total amount treated as acquisition indebtedness cannot exceed $1 million for any period ($500,000 for a married individual filing separately), and any indebtedness in excess of $1 million is not acquisition indebtedness.

Sec. 163(h)(3)(C)(i) provides that home-equity indebtedness for any period cannot exceed $100,000 ($50,000 for a married individual filing separately). Home-equity indebtedness is indebtedness other than acquisition indebtedness secured by the taxpayer’s principal or secondary residence, to the extent the aggregate amount of the debt does not exceed the excess of the fair market value of the residence over the amount of acquisition indebtedness. Unlike acquisition indebtedness, the proceeds of home-equity indebtedness generally may be used for any purpose without affecting deductibility of the interest.

Rev. Rul. 2010-25 discusses a factual scenario in which an unmarried individual purchases a principal residence for $1,500,000 in 2009 with a cash down payment of $300,000 and a bank loan of $1,200,000 secured by the residence. In 2009, the taxpayer pays interest that accrues on the indebtedness during that year, and there is no other debt outstanding that is secured by the principal residence. The ruling concludes that the taxpayer may deduct the interest paid on the first $1 million of the original loan balance because it is considered acquisition indebtedness under Sec. 163(h)(3)(B). Under the ruling, pursuant to Sec. 163(h)(3)(C), the taxpayer may also deduct the interest paid on $100,000 of the remaining debt of $200,000 because the first $100,000 loan amount in excess of home acquisition indebtedness is considered home-equity indebtedness. Any interest on the remaining indebtedness of $100,000 is considered nondeductible personal interest under Sec. 163(h)(1) because it cannot be traced to any source other than the personal residence, which has already reached its limits.

Tax Court Precedent

In the ruling, the IRS formally states that it will not follow earlier Tax Court decisions (Pau, T.C. Memo. 1997-43; Catalano, T.C. Memo. 2000-82). The Tax Court in Pau limited the taxpayers’ deduction for qualified residence interest to the interest paid on $1 million of the $1.33 million indebtedness incurred to purchase their residence. The court ruled that Sec. 163(h) restricts home mortgage interest deductions to interest paid on $1 million of acquisition indebtedness and $100,000 of home-equity indebtedness. Citing Sec. 163(h)(3)(B), the court stated that acquisition indebtedness is defined as secured indebtedness that is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer.

Based on the definition of home-equity indebtedness, which in turn is based on the definition of acquisition indebtedness, the court further ruled that home-equity indebtedness as defined in Sec. 163(h)(3)(C) is any indebtedness other than acquisition indebtedness secured by a qualified residence. Hence, no deduction in excess of the $1 million acquisition limit was allowed where the debt was incurred in acquiring, constructing, or substantially improving the residence. The Tax Court in Catalano followed its earlier decision in Pau in reaching the same conclusion. These two taxpayer-unfavorable decisions created some uncertainty and highlighted the need for more guidance.

Holding

The IRS provided much-needed clarification by issuing Rev. Rul. 2010-25. This ruling states that the IRS will not follow the decision reached in each of these cases. The IRS rationalized that the holding in Pau was based on the incorrect assertion that taxpayers must demonstrate that debt treated as home-equity indebtedness “was not incurred in acquiring, constructing, or substantially improving their residence.” As the IRS explained, the definition of home-equity indebtedness in Sec. 163(h)(3)(C) contains no such restrictions, and as a result the IRS will determine home-equity indebtedness consistent with the provisions of Rev. Rul. 2010-25, notwithstanding the decisions in Pau and Catalano. Indebtedness 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 (subject to the applicable dollar and fair market value limitations imposed on home-equity indebtedness).

The deductions for interest paid on home-acquisition indebtedness and home-equity indebtedness represent a significant tax break to individual taxpayers, and this recent ruling allows taxpayers to take better advantage of these provisions and deduct more interest on first mortgages (up to $1.1 million). Sales of million-dollar homes have reportedly started to rebound in some parts of the country after being hit hard by the recession, and this ruling may help stimulate sales in that sector of the housing market.

EditorNotes

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 kdanderson@bdo.com.