New Rules are Quite Complicated
When it comes time to file personal income taxes, a lot of people breathe a sigh of relief, secure in the knowledge that they will be able to get a fat deduction for the home mortgage interest that they pay. Many simply transfer the amount shown on their 1098 that their lender sends to them and then continue checking off the boxes.
Unfortunately, mortgage interest is not all created equal, and though in the past the IRS may have let these errors slide, a new audit initiative has been announced that is specifically looking for those who are deducting more than they are entitled to for their home equity debt interest.
The rules on mortgages, home equity and interest can be quite complicated. Home acquisition debt is defined as the original mortgage as well as any debt that is taken on afterwards in order to make improvements, but not repairs. Taxpayers are permitted to deduct interest on this up to $1 million of debt.
They are also allowed to deduct up to $100,000 on home equity debt, with equity debt falling under a separate and distinct definition of debt that was not incurred to improve the home or to acquire it. It is not uncommon for equity debt to exceed the $100,000 limit, and for taxpayers to inappropriately and incorrectly deduct the full amount.
Some taxpayers are unaware of the limit, and others simply don’t understand it or how to address it. If a homeowner takes out a line of credit on their home in the amount of $120,000, then their home equity loan exceeds the $100,000 established by the tax code by $20,000, or 83.33 percent. That means that when they receive a 1098 indicating the interest that they have paid, they need to multiply the amount by that 83.33 percent in order to determine how much they are able to deduct as home mortgage interest on Schedule A of their tax forms. Here's the IRS explanation of Home Mortgage Interest.
The only way that the remaining interest can be deducted is if the taxpayer can show that the money that was borrowed was used either for investment purposes or for business purposes. If the taxpayer is able to trace the $20,000 borrowed to either of these types of expenses then the interest paid on it can be deducted as investment interest or as a business expense.
If tracing to an investment, it is important to be able to show that the amount borrowed doesn’t exceed your investment income after expenses. Whether taking the balance of the interest as a business expense or an investment expense, it needs to be documented on the appropriate business schedule or on Schedule A.
There is an alternative way to address home equity debt that exceeds the IRS limit. If the money that you borrowed as a home equity line of credit was used for a deductible expense, by indicating that the debt is “not secured” by the house you can then deduct it on whatever schedule is appropriate. The problem with this technique is that it is an all or nothing proposition – the IRS has indicated that the debt has to either be secured by the home, and therefore available to be deducted partially as home mortgage interest, or unsecured and then none of the loan can be deducted in that way.
This means that if you took out the same $120,000 line of credit in order to purchase a rental property and you used the full amount for that purpose, you can elect “not secured” and then deduct the interest on the Schedule E rental income and expense schedule. But if you used only $20,000 of the $120,000 for the rental property and elect “not secured” in order to write of the interest on the $20,000 on Schedule E, you are not also able to take the remaining $100,000 and attribute it to home mortgage debt.
Getting the elections right is particularly important going forward, as the IRS has announced that starting after 2016, they are requiring that banks provide additional information on Form 1098 to include mortgage origination dates, additional principal, and addresses of securing property.
All of this information will be used in future tax audits, which can result in adjustments going backwards many years. In order to make sure that you are making the most of your home mortgage interest without putting yourself in audit jeopardy, call our office today.
If you have questions concerning your home mortgage interest deductions, contact Gordon McNamee at (909) 949-4898.