Many taxpayers make the mistake of refinancing their primary or second residence, or real property held for investment, and then find out that some or all of the interest is not deductible. Contrary to what friends, relatives, and others may tell you, mortgage interest is not always deductible. Certain conditions must be met in order to claim the deduction.
First, for “qualified residence interest,” taxpayers are allowed to deduct the interest paid on up to $1,000,000 of acquisition indebtedness ($500,000 for married filing separate). Acquisition indebtedness is debt secured by the property to purchase, or make substantial improvements on the property. The person deducting the interest, with certain exceptions, must be “personally liable for the debt”, and more importantly, must be the person actually making the mortgage payments.
Second, you can deduct the interest on up to $100,000 of home equity indebtedness. This is debt used for any purpose other than acquiring or improving you primary or second residence. Home equity interest is only deductible for regular tax, not alternative minimum tax.
The above rules seem simple, but there can be many traps and pitfalls for the unwary, and missed opportunities for the uninformed. For instance, a taxpayer made all the payments on over $1.1 million of acquisition and home equity debt on her primary residence that she owned jointly with her spouse. She filed a separate return and said she should be entitled to claim the interest on the entire $1.1 million since she was the one making the payments. The United States Tax Court disagreed, stating that the $500,000, $50,000 limits on married filing separate applied even though she made all the payments.[1]
The term, “personally liable for the debt” is not just limited to legal owners of the property, it also applies to equitable owners. In a 1997 court case, taxpayers were allowed mortgage interest deductions on property that the husband’s brother and the brother’s wife owned. Even though the taxpayers were not on title and not legally liable for the mortgage, they were the sole occupants of the property, paid all repairs, maintenance, improvements, property taxes, and insurance on the property. The brother and his wife testified that they only held the property because the “credit stricken” taxpayers could not obtain credit themselves. The kicker was an unrecorded quitclaim deed executed by the brother and his wife that transferred title to the taxpayers.[2] There is a caveat, however; equitable ownership is defined under state law. The IRS and the courts generally acquiesce to state law, which means what works in one state might not work in another.
One of the biggest mistakes made by owners of rental or investment real estate is borrowing money against those properties for personal purposes. The interest on that debt becomes non-deductible personal interest in those circumstances. On the other hand, home equity borrowing on a home for trade or business, or investment purposes can give rise to business or investment interest deductions. Such borrowing requires careful record-keeping to trace the source, and use of the borrowed funds.
[1] Faina Bronstein v. Commissioner, 138 TC 382 (link is to pdf of tax court summary)
[2] Saffet Uslu, et ux. v. Commissioner, TC Memo 1997-551 (link is to pdf of tax court memo)