Mortgage Interest Deduction Increased
New IRS interpretation on mortgages over $1,000,000
By Kaye A. Thomas
Posted October 6, 2009
Mortgage used to buy home can qualify as home equity debt.
Taxpayers who took out a mortgage for more than $1,000,000 in purchasing their homes may benefit from a new IRS interpretation of the law.
Contrary to the approach taken by the Tax Court in two memorandum decisions, the IRS says the amount above $1,000,000 can be treated as home equity debt, potentially increasing by as much as $100,000 the amount of mortgage debt for which interest payments are allowed as a deduction. Taxpayers may wish to amend prior year returns to take advantage of this new interpretation.
Background
Taxpayers who itemize can claim a deduction for interest paid on a home mortgage. The law allows them to deduct interest on up to $1,000,000 on "acquisition indebtedness" — in other words, debt used to purchase (or build) the home. In addition, they may deduct interest on up to $100,000 of home equity debt. These deductions are subject to various limitations, including a requirement that the debt not exceed the fair market value of the property at the time it is incurred.
The issue
Here's the issue: suppose you buy a home for $1,500,000, making a $200,000 down payment and borrowing the remaining $1,300,000. Are you allowed to deduct interest on $1,100,000, treating $100,000 of this loan as home equity debt? Or are you limited to interest on $1,000,000, because the entire loan was acquisition indebtedness?
Tax Court
The issue has come up a couple of times in the Tax Court. In both cases, the court said the limit would be $1,000,000. The definition of home equity debt excludes acquisition indebtedness, so the court concluded that the additional $100,000 wasn't available in this situation. These were "memorandum" decisions, however, meaning they were considered by a single judge rather than the full court. Discussion of the issue in these opinions was too brief to indicate detailed consideration.
IRS interpretation
Questions of legal interpretation are sometimes referred to the IRS Office of Chief Counsel, which responds in the form of a memorandum. These documents are intended as guidance for field agents rather than for public consumption, but the Freedom of Information Act requires the IRS to make these memos available. They don't represent binding legal precedent, but as a practical matter field agents and other IRS personnel will generally follow these interpretations.
In its memorandum, the IRS noted that the definition of home equity debt (the added $100,000) excludes acquisition indebtedness, but pointed to other language in the law indicating that for this purpose, any amount above $1,000,000 doesn't count as acquisition indebtedness. As a result, in the example described earlier, your mortgage consists of $1,000,000 of acquisition indebtedness and $300,000 that isn't acquisition indebtedness, even though it was part of the same loan used to buy the home. And because the additional $300,000 is "other than acquisition indebtedness," it can be treated as home equity debt, subject to the $100,000 limit and other applicable requirements. The IRS noted that the Tax Court had taken a different approach but concluded that the more favorable result was a better interpretation of the law.
Amending returns
It's likely that many taxpayers have been claiming the larger deduction, unaware that the Tax Court had a contrary view. Others, however, may have used the smaller limit in figuring their mortgage interest deduction, and based on the new interpretation by the IRS, these taxpayers are entitled to refunds. Depending on the tax bracket and the interest rate on your mortgage, someone in this situation might recover as much as $3,000 or more for each year.
To obtain a refund you would have to file an amended return. Generally you can do this until the third anniversary of the due date of your return. If you filed on extension in accordance with the rules, you can amend until the third anniversary of the date you actually filed. This means you still have time, but very little time, to amend a 2005 return that was filed very close to the extended deadline of October 15 in 2006.
