Excess Home Mortgage Interest

In many areas of the U.S., real estate prices are escalating at an annual rate of 10–20%. Many personal residences now have a price tag in the millions of dollars. As a result, the mortgages on these residences could also be millions of dollars.

Sec. 163(h)(3)(B) imposes a $1 million limit on home acquisition indebtedness ($500,000 if married filing separately). The following example and Exhibit 1 show how to calculate the mortgage interest paid in excess of this limit.

Example 1: On Jan. 1, 2001, S, a single taxpayer, purchased a home for $3,200,000. She obtained a mortgage for $1,600,000 at 7%, secured by the residence. Also in 2000, S earned a salary of $60,000 and received dividend and interest income totaling $54,000. The following table shows the amortization of the loan for 2001:

The question becomes how a practitioner should treat the mortgage interest of $34,449 that S paid in excess of the limit. Sec. 163(h)(1) disallows a deduction for personal interest. Sec. 163(h)(2) defines personal interest as any interest paid other than:

1. Interest paid on a trade or business debt;

2. Investment interest;

3. Interest taken into account in computing income or loss from a passive activity;

4. Qualified residence interest;

5. Interest on an unpaid portion of estate tax (under Sec. 6163); and

6. Interest on qualified education loans.

If the residence meets certain criteria, S may be able to deduct the $34,449 as investment interest on Schedule A.

Sec. 163(d)(5)(A) defines property held for investment as:

1. Property that produces interest, dividends, annuities or royalties not derived in the ordinary course of a trade or business;

2. Property that produces gain or loss not derived in the ordinary course of a trade or business from the sale or exchange of property that either produces item 1 types of income or is held for investment (but which is not an interest in a passive activity);

3. An interest in a trade or business activity that is not a passive activity and in which the taxpayer did not materially participate.

Does a primary residence fit into the definition of investment property under Category 2? Category 2 could be interpreted to include property that produces a gain or loss from the sale or trade of the property (excluding trade or business property).

If S were to sell her residence for $4 million, net of closing costs, she would realize a $800,000 gain ($4 million less her cost basis of $3.2 million). As a single taxpayer who meets the time requirements for occupying the residence, S can exclude, under Sec. 121, $250,000 of the gain. She would thus have a taxable gain of $550,000, which she would have to recognize in the year of disposition.

Arguably, the definition of "investment property," under Sec. 163 (d)(5)(A), is not an all-inclusive list, as the language indicates that it "shall include" these three categories of property. This can be interpreted to mean that other types of investment property (not included in these three categories) can also meet the definition. Buying a principal residence is probably the largest investment most taxpayers will make in their lives. However, there are currently no specific cases or rulings that clarify this issue.

Practitioners might be able to explore other alternatives in deducting the $34,449 as investment interest.

 Example 2: The facts are the same as in Example 1, except that S also has a substantial investment portfolio of liquid (and other) assets. S takes $500,000 from her investment portfolio and pays down the mortgage on her residence to $1,100,000. She refinances the mortgage with a new mortgage on her residence for $1,100,000. Now S has a new payment structure and amortization period for the mortgage. S borrows $500,000 on margin, secured by her investment portfolio, to restore her investment portfolio to its initial amount. The interest paid on the mortgage on the residence is fully deductible, and the interest paid on the margin loan is also deductible, subject to the investment-interest rules.

 The scenario in Example 2 works if S's investment portfolio included at least $500,000 of liquid assets (or other assets) which, when sold, would not generate a significant amount of taxable gain.

It is unlikely that any part of the $34,449 disallowed residential interest could be capitalized as part of the cost of the residence, which could be used to reduce any taxable gain realized when the residence was sold. Sec. 263A(f)(2)(B) excludes qualified residence interest from the uniform capitalization rules. Also, under Regs. Sec. 1.266-1(b)(2), additions to basis under Sec. 266 for carrying charges do not apply to any items not otherwise deductible.

As the cost of residential real estate continues to escalate, many mortgages will exceed the deduction limits. How practitioners treat the excess interest will continue to be a challenge. Practitioners should advise clients in writing of their options. Before taking any position, practitioners should have a good-faith belief that, if challenged, the position has a realistic possibility of being sustained administratively or judicially.

From Elizabeth C. Conner, CPA, University of Colorado, Denver, and Michael V. Schaefer, CPA, Denver, CO (neither affiliated with Summit International Associates, Inc.)