IRS Breaks With Tax Court on Deduction Limits

The deduction of home mortgage interest is one of the most valuable and hotly debated benefits provided in the tax code to individuals. Since 1987, the code has restricted the interest deduction based on the amount of home mortgage debt the taxpayer has incurred, and the reasons for the debt. In a recent ruling, however, the Internal Revenue Service announced it would not follow a court ruling that limited the amount of deductible home mortgage interest — noteworthy because this time the IRS ruled in the taxpayer’s favor.

In general, a taxpayer may deduct a certain amount of interest paid on a loan secured by his or her main home, or a second home, whether the loan is a first or second mortgage, a home equity loan, or line of credit. To claim the deduction, the taxpayer must file a Form 1040 and itemize deductions, the loan must be a bona fide legal obligation of the taxpayer, and the debt must be a secured by a home in which the taxpayer has an ownership interest. For mortgages taken out after Oct. 13, 1987, the amount of interest that is deductible depends on the amount of the mortgage and how the taxpayer uses the loan proceeds. Under IRC §163(h)(3), individuals may deduct interest on “acquisition indebtedness” and “home equity indebtedness” if the indebtedness is secured by the taxpayer’s principal residence and/or one other residence used by the taxpayer. “Acquisition indebtedness” is any debt that the taxpayer uses to acquire, construct, or substantially improve a personal residence; however, acquisition indebtedness is capped at $1 million. Thus, interest paid on any debt in excess of $1 million is not deductible, even if the loan proceeds are used to acquire, construct, or substantially improve a personal or secondary residence. However, the code also allows a taxpayer to deduct interest paid on up to $100,000 of “home equity indebtedness” — defined as any interest paid on “indebtedness (other than acquisition indebtedness)” that is secured by the taxpayer’s residence, so long as there is sufficient equity in the property (i.e., the fair market value of the residence must exceed the amount of the acquisition debt on the property by at least the amount of the home equity indebtedness, measured as of the time of the borrowing).