Election Not to Treat Debt as Secured by a Qualified Residence

T he mortgage interest deduction has been part of U.S. tax policy since the 1913 Code. However, many taxpayers cannot deduct all mortgage interest paid. Proper planning can maximize the mortgage interest deduction and can be a useful strategy in overall tax planning.

Overview

Interest is the amount contracted for to pay for the use, forbearance or detention of money. Sec. 163(a) provides a general rule that all interest paid or accrued in the tax year on debt is deductible, but there are numerous exceptions. Usually, under Sec. 163(h), for a taxpayer other than a corporation, no deduction is allowed for personal interest paid or accrued during the tax year.

Sec. 163(d) limits a noncorporate taxpayers deduction for investment interest to net investment income for the tax year. 163(d)(2) permits an unlimited carryforward of any amounts so disallowed. Interest disallowed may be deducted in the succeeding tax year to the extent the taxpayer has investment income in that year.

Interest attributable to a trade or business or to property held for the production of income may be deducted by itemizers and nonitemizers alike, but is subject to the various ancillary restrictions, such as those governing passive activity losses (Sec. 469) and at-risk amounts (Sec. 465). Trade or business interest may also be subject to capitalization under Sec. 263A(f). Interest on certain student loans is partially deductible under Sec. 221.

Under Sec. 163(h)(2)(d), qualified residence interest (QRI) includes interest paid or accrued during the tax year on (1) acquisition debt on a taxpayers qualified residence or (2) home-equity debt on a taxpayers qualified residence.

QRI

There are two types of QRI, according to Sec. 163(h)(3)(A), on (1) acquisition debt and (2) home equity debt.

Acquisition debt: Sec. 163(h)(3)(B) defines acquisition debt as any debt incurred in acquiring, constructing or substantially improving a qualified residence and secured by it.  This term also includes debt secured by a qualified residence and incurred to refinance acquisition debt; however, such debt is limited to the amount of debt refinanced at the time of the loan.

An overall dollar limit under Sec. 163(h)(3)(B)(ii) caps the aggregate amount of acquisition debt at $1 million for any period ($500,000 for a married taxpayer filing separately); this  limit is not indexed for inflation. Aggregate amount probably means the total debt secured by one or more qualified residences, not just that secured by any one qualified residence.

Home-equity debt: Sec. 163(h)(3)(C) defines home-equity debt as any debt (other than acquisition debt) secured by a qualified residence, to the extent it does not exceed the residences fair market value reduced by any outstanding acquisition debt the residence secures. The aggregate home-equity debt for any period may not exceed $100,000 ($50,000 for a married taxpayer filing separately).

What is a Qualified Residence?

Sec. 163(h)(4)(A) defines qualified residence to mean either the taxpayers principal or a second residence. A second residence is a residence the taxpayer uses as such and for which the taxpayer elects such treatment. A taxpayer cannot have more than one principal or second residence at a time.

According to Temp. Regs. Sec. 1.163-10T(p)(3)(ii) and Sec. 163(h)(4)(B), a residence is generally a house, condominium, cooperative, mobile home, boat or house trailer that contains a sleeping space, toilet and cooking facilities. A residence does not include personal property (e.g., furniture) that is not a fixture under local law. If a residence is rented during the tax year, it is a residence only if the taxpayer uses it as such within the meaning of Sec. 280A(d) (i.e., he or she  uses it for personal purposes for the greater of (1) 14 days or (2) 10% of the number of days during the tax year for which it is rented at a fair rental).

The QRI dollar limits on deductions prescribed under Sec. 163(h)(3)(B)(ii) and (C)(i) bar taxpayers from deducting excess interest payments. QRI included in itemized deductions also may be limited in the case of high-income taxpayers. There are certain circumstances in which home-equity debt proceeds could be used to allow interest to be deductible under other Code provisions. Temp. Regs. Sec. 1.163-10T(o)(5) provides that a taxpayer may elect to treat home-equity debt as not secured by a residence.

Election

By making this election, the taxpayer frees the debt from the QRI dollar limit, making it available for another interest deduction, if applicable. Thus, if interest is deductible regardless of whether it is QRI, electing out of QRI treatment preserves the deduction for interest on other debts deductible only if it is QRI. For purposes of Temp. Regs. Sec. 1.163-10T(o)(5), a taxpayer may elect to treat any debt secured by a qualified residence as not secured by such residence.

The election is effective for the tax year for which made and for all subsequent tax years, unless revoked with IRS consent. While deducting the interest on the appropriate forms and/or lines is sufficient under the regulations to perfect the election, taxpayers are advised to make the election in a separate statement attached to the return.

Example: J has two outstanding debts secured by a qualified residence. For debt 1, the principal balance is $60,000; J used the proceeds to purchase machinery for his business. Debt 2s principal balance is $70,000; J used the proceeds to purchase a personal-use automobile. Both debts qualify as home-equity debt, but their aggregate amount ($130,000) exceeds the $100,000 cap. Thus, interest on only the first $100,000 of the two debts would be deductible QRI.

The interest on debt 1 is not subject to any of the limits on interest deductibility and is deductible regardless of whether it is QRI. The interest on debt 2, however, is personal and is deductible only if it is QRI. Under these circumstances, if J elects to treat debt 1 as not secured by a qualified residence, the interest remains fully deductible, and all of debt 2 will qualify as home-equity debt, fully deductible as QRI; see Exhibit 1. If J fails to make the election, $30,000 of his aggregate debt will fail to qualify as home-equity debt; the interest on such debt will not be deductible.

Conclusion

Taxpayers need to be aware of all possible tax implications for borrowing on homes and the deductibility of the related interest, so as to maximize the tax benefit.

From Pawan Agarwal, Patrick Kopplin, CPA, and Brad Whatley, CPA, PKF Texas, Houston, TX