This article reviews the home loan interest deduction for reporting the tax consequences of financing first and second homes.
Two residences, two deductions
The federal government has a long-standing policy of encouraging residential tenants to become homeowners. The incentive provided by the government to individual tenants is in the form of a significant reduction in the income taxes they will be required to pay if they finance the purchase of a residence or a vacation home.
For a residential tenant considering his income taxes, the monthly payment on a purchase-assist home loan is not just a substitute for his monthly rent payment, it also reduces his combined state and federal taxes by an amount equal to 20% to 30% of the monthly loan payment.
Real estate agents handling the sale or purchase of single family residences must be able to intelligently discuss this tax reduction incentive with residential tenants if the tenants are to be persuaded to buy based on the full range of homeownership benefits.
Due to the special home loan interest deduction rule for income tax reporting, the interest accrued and paid on loans is deductible from income as an itemized expense if:
- the loans funded the purchase price or paid for the cost of improvements for the owner’s principal residence or second home; and
- the loans are secured by either the owner’s principal residence or second home. [Internal Revenue Code §163(h)]
Without the home loan interest deduction rule, interest paid on a loan which funded the purchase or improvement of a principal residence or second home is not deductible. If the loan did not fund the purchase or improvement of the principal residence or other personal expense, it funded the acquisition of an investment or business property.
Also, interest paid on equity loans secured by the property owner’s principal residence or second home is tax deductible under the home loan interest deduction rules, whether or not the loan’s net proceeds were used for personal or investment/business purposes.
The loan interest deductions for the first and second home reduces the property owner’s taxable income as an itemized deduction under both the standard income tax (SIT) and the alternative minimum tax (AMT) reporting rules. In contrast, the real estate property tax deduction on the first and second homes applies only to reduce the owner’s SIT, not his AMT.
Two categories of loans exist to control the deduction of interest paid on any loans secured by the principal residence or second home, which include:
- interest on the balances of purchase or improvement loans up to a combined principal amount of $1,000,000; and
- interest on all other loan amounts up to an additional $100,000 in principal, called home equity loans.
Interest paid on money loans and carryback credit sales originated to purchase or substantially improve an owner’s first or second home is fully deductible on combined loan balances of up to $1,000,000 for an individual and for couples filing a joint return if the loan is secured by either home. The loan balance is limited to $500,000 for married persons filing separately.
Thus, if the loan funds are used to acquire, construct, or further improve a principal residence or second home, and the loan funds, collectively exceed $1,000,000, only the interest paid on $1,000,000 of the purchase and improvement loan balances is deductible as purchase/improvement interest. However, interest paid on the excess loan amounts, up to an additional $100,000, qualifies for a deduction as interest paid on a home equity loan.
To qualify home improvement loans for interest deductions, the new improvements must be substantial. Improvements are substantial if they:
- add to the property’s market value;
- prolong the property’s useful life; or
- adapt the property to residential use.
Loan funds spent on repairing and maintaining property to keep it in good condition do not qualify as funding for substantial improvements. [IRC §163; Temporary Revenue Regulations §1.163-8T]
If an owner refinances a purchase/improvement loan, the portion of the refinancing used to fund the payoff qualifies as a purchase/improvement loan for future interest deductions. However, interest may only be written off as a purchase/improvement loan on the amount of refinancing funds used to pay off the principal balance on the existing purchase/improvement loan.
For example, consider an owner who borrows $200,000 to fund the purchase of his principal residence. The loan balance is paid down to $180,000 and the owner refinances the residence, paying off the original purchase/improvement loan. However, the new loan is for a greater amount than the payoff demanded on the old loan.
In this scenario, interest on only $180,000 of the refinancing is deductible as interest paid on a purchase or improvement loan, unless:
- the excess funds generated by the refinance are used to improve the residence; or
- the excess loan amount qualifies as a home equity loan under its separate ceiling of $100,000 in principal.
$100,000 home equity loans
Interest on loan amounts secured by the first or second home may not qualify for the purchase/improvement home loan interest deduction, due either to a different use of the loan proceeds or the $1,000,000 loan limitation. However, the interest on loan amounts which are secured by the first or second residence and do not qualify as purchase/improvement loans is deductible by individuals and those couples filing joint returns as interest paid on additional or other loan amounts up to $100,000 in principal, called home equity loans.
For married persons filing separately, the cap for the principal amount of equity loans on which interest can be deducted is limited to $50,000, half of the joint $100,000 ceiling. [IRC §163(h)(3)(C)(ii)]
Home equity loans are typically junior encumbrances, but also include proceeds from a refinance which do not qualify as purchase/improvement funds and purchase/improvement loan amounts which exceed the $1,000,000 ceiling.
The proceeds from home equity loans may be used for any purpose, including personal uses unrelated to the property.
Property value ceiling
Interest paid on any portion of a loan balance which exceeds the fair market value of a residence is not deductible. In practice, the fair market value rule applies almost exclusively to home equity loans, including refinancing proceeds of a greater amount than the balance paid off on the purchase/improvement loan that was refinanced. [IRC §163(h)(3)(C)(i)]
The fair market value of each residence is presumed to be the original amount of the purchase price plus any improvement costs. Thus, any future drop in property value below the balance remaining on purchase-assist loans does not affect the interest deduction. [Temp. Rev. Regs. §1.163-10T]
Editor’s note — Consistent with its policy under codes such as §1031, the Internal Revenue Service (IRS) does not perform any appraisal activities. Thus, the IRS has substituted the easily computable original cost of purchase and improvements for the fair market value limitation established by Congress. However, an owner who takes out a home equity loan which, when added to the other loan balances on the residences, exceeds his purchase and improvement costs of the property, can rebut the IRS fair market value presumption of cost with a current fair market value appraisal provided by the lender.
Thus, on a refinance or origination of a home equity loan, it is advisable for an owner to request and receive a copy of the lender’s appraisal to later corroborate the property’s increased market value at the time the financing was originated.
Qualifying the principal residence and second home
To qualify for a home loan interest deduction, loans must be secured by the principal residence or second home.
A principal residence is defined as an individual’s home where the homeowner’s immediate family resides a majority of the year, which is close to the homeowner’s place of employment and banks which handle the homeowner’s accounts, and the address of which is used for tax returns. [IRC §163(h)(4)(A)(i)(I)]
A second home is any residence selected by the owner from year to year, including mobile homes, recreational vehicles and boats.
If the second home is rented out for portions of the year, the interest qualifies for the home loan interest deduction if the owner occupies the property for more than 14 days or 10% of the number of days the residence is rented, which ever number is greater. [IRC §280A(d)(1)]
If the owner does not rent out his second home at any time during the year, the property qualifies for the home loan interest deduction whether or not the owner occupies it. [IRC §163(h)(4)(A)(iii)]
The rental income on the second home is investment/portfolio income if the home qualifies for the interest deduction due to the owner’s days in occupancy exceeded the 14-day/10% rule.
If the second home has been rented, but the owner’s family occupied the property for more than 14 days or 10% of the days rented thus qualifying the home for the loan interest deduction, the owner is not allowed to treat the property as an investment. Since the property is not an investment, the owner cannot depreciate the home. [IRC §§163(h)(4)(A)(i)(II); 280A(d)(1)]
A second home, when purchased for personal use and held for a profit on resale, also qualifies as investment (like-kind) property for exemption from profit taxes under IRC §1031. [IRC §1221; IRS Private Letter Ruling 8103117]
Taking the deductions
Interest deductions on home loans are only allowed for interest which has accrued and been paid, called qualified interest. [IRC §163(h)(3)(A)]
Interest on first and second home loans is deducted from an owner’s adjusted gross income (AGI) as an itemized deduction. Further, limitations exists on the total amount of all deductions the homeowner can claim. Conversely, business, rental or investment interest are adjustments that reduce the AGI. Thus, the two types of home loan interest deductions directly reduce the amount of the owner’s taxable income (if the interest deductible is not limited by ceilings on the homeowner’s itemized deductions).
The inability to reduce the owner’s AGI by use of the home loan interest makes a substantial difference for high income earners. The higher an owner’s AGI, the lesser the amounts allowed for rental loss deductions, itemized deduction phaseout (starting at an AGI of $150,500 for 2006), and any tax credits available to the owner. [IRC §163(a), (h)(2)(A)]
Consider a homeowner who wants to generate funds to use as a down payment to purchase business, rental or investment real estate. His only substantial asset is the $300,000 equity in his home.
If the owner further finances with a home equity loan or refinances the existing loan to net $200,000 in loan proceeds, he will be paying interest which is only partially deductible. The non-purchase/improvement loan amount exceeds the $100,000 home equity loan cap. The interest the owner pays on the portion of home equity loan balance in excess of the $100,000 loan cap is not deductible under the home loan interest deduction rules.
The home as additional security
Consider a homeowner who encumbers the equity in his home to secure a note he executes as the down payment on the purchase of investment property.
The homeowner wants to avoid the home loan interest deduction limitations and be able to write off all the interest paid on the note against future income from the rental or portfolio property he purchased with the loan funds. Accordingly, the homeowner negotiates with the lender or carryback seller for the note to be secured by two separate trust deeds; one as a lien on the home and the other as a lien on the property purchased.
The lender or carryback seller is satisfied with the financial risk regarding the loss of principal. The lender or carryback seller receives a trust deed on the home, which he views as his primary source of recovery if the owner defaults on the note.
In addition to the owner’s home, the note is secured by the property purchased, to justify writing off the entire interest accrued and paid on the loan against income from the property purchased. The home is merely used as additional security under a separate trust deed.
The PMI deduction
Private mortgage insurance (PMI) premiums are treated as additional home loan interest and are fully tax deductible for owners whose AGI is below $100,000. For owners with an AGI exceeding $110,000, a phase-out eliminates the PMI premiums deduction entirely. Under the PMI phase-out, the amount of premiums treated as interest is reduced by 10% for every $1,000 the AGI exceeds $100,000. At an AGI of $110,000, no amount of PMI premiums remains to deduct. [IRC §163(h)(3)(E)]