Understanding Tax Deductions on a Residence

Journal of Financial Planning: November 2016


Julie A. Welch, CPA, PFP, CFP®, is the director of tax services and a shareholder with Meara Welch Browne P.C. in Leawood, Kansas.

Cara Smith, CPA, CFP®, is a senior tax manager with Meara Welch Browne P.C. in Leawood, Kansas.

The home mortgage interest deduction is a favorite among millions of taxpayers. You can deduct the interest on your home mortgage if the loan qualifies as either acquisition indebtedness or home equity indebtedness. Acquisition indebtedness is a loan that is used to acquire, build, or improve your primary or second home. Home equity indebtedness is any loan on your primary or second home other than acquisition indebtedness. Both types of loans must be secured by your primary or second home for the interest to be deductible.

Acquisition Loans

Clients can deduct the interest on their primary home and their pleasure home. A home is anything that has sleeping accommodations, a toilet, and cooking facilities. Thus, vacation homes, condos, mobile homes, and some boats qualify as homes. Some special rules apply, however. First, the total amount of the loans used to buy or improve the two homes cannot exceed $1 million ($1.1 million if you have no home equity loans, and one-half of those amounts for married individuals filing separate returns). This limitation does not apply to amounts borrowed before October 14, 1987.

Second, if you rent out the second home for more than 14 days, you must personally use the second home for 14 days or 10 percent of the rental days, whichever is more, to deduct the interest as personal mortgage interest.

Third, home mortgage interest only includes the interest on the loans on your primary home and one other home, even if the total amount of the loans on more than two homes is less than $1.1 million. If you own more than two homes, determine which homes you want to qualify as your primary and secondary homes. Each year you may choose a different residence as your second home.

Home Equity Loans

If you are paying interest on nondeductible personal loans and have equity in your home, it might make sense to consolidate your personal loans into a home equity loan. The interest you pay on a mortgage secured by your home is deductible if the loan is a home equity loan, which can be used for any purpose. You can deduct the interest on home equity loans even if you use the money for personal purposes. However, help clients watch for alternative minimum tax (AMT) differences. Interest paid on home equity loan proceeds not used to improve the residence are considered a tax preference item and are not deductible for AMT purposes. Here are two examples:

Example 1. You are in the 28 percent tax rate bracket. You have a $20,000 car loan, a $6,000 vacation loan, and $5,000 of credit card debt. At a 5 percent rate, you pay $1,550 ($31,000 x 5 percent) of nondeductible personal interest. If you take out a 5 percent home equity loan and pay off your $31,000 of personal debt, you will still pay $1,550 of interest expense. However, because the interest is deductible, you reduce your federal taxes by $434 ($1,550 x 28 percent). Note: If the AMT applies, your federal tax savings may be less.

The interest on home equity loans of up to $100,000 is potentially deductible. However, if the difference between the fair market value of the home and the acquisition loan balance is less than $100,000, only the interest on the lower amount can be deducted.

Example 2. You purchased your home for $220,000 three years ago by paying $22,000 cash and borrowing $198,000. Your home is now worth $250,000 and the balance on your acquisition loan is $194,000. You can deduct interest on a home equity loan balance of up to $56,000 ($250,000 [fair market value of your home] – $194,000 [acquisition loan balance]). Even if you can borrow more than $56,000, you can only deduct interest on a home equity loan balance of up to $56,000 (the lesser of $100,000 or $56,000).

The Case of Unmarried Co-Owners

Since the issuance of the Internal Revenue Service’s (IRS) Chief Counsel Advice 200940030 in 2009, taxpayers have been able to deduct interest on home equity indebtedness up to $1.1 million even if they only have one primary loan and not a secondary home equity loan. Even with large mortgage balances in excess of $1.1 million, the first $1 million is treated as acquisition indebtedness and the next $100,000 is treated as home equity indebtedness.

The mortgage interest deduction is allowed under the Internal Revenue Code section 163, which is specific regarding mortgage interest limits for married taxpayers that file separate tax returns insomuch that interest is limited to amounts paid on $550,000 of indebtedness per spouse. Unmarried co-owners of a house are not addressed in the Internal Revenue Code.

In 2015 we saw the Sophy and Voss cases (Sophy v. Commissioner, 138 T.C. 204 (2012) and Voss v. Commissioner, CA-9, 2015-2 USTC ¶50,427). They dealt with the deductibility of home mortgage interest for unmarried taxpayers who had large mortgage balances.

The taxpayers, Charles Sophy and Bruce Voss, owned a home together in Beverly Hills, Calif., with approximately a $2 million first mortgage and a $300,000 home equity line. Sophy and Voss also owned a second home in Rancho Mirage, Calif., with a $500,000 mortgage. All three mortgages totaled $2,703,568. On individually filed returns, Voss and Sophy collectively deducted mortgage interest paid on the three debts based on separate $1.1 million indebtedness limits ($2.2 million in total). The IRS took the position that the interest deduction on both returns combined could not exceed interest on $1.1 million of indebtedness. In August 2015, the Ninth Court of Appeals (Voss v. Commissioner, 796 F.3d) reversed the Tax Court decision in the Voss case and allowed Sophy and Voss to each deduct interest on mortgages up to $1.1 million, thus allowing the $1.1 million indebtedness limit to apply on a per-unmarried-taxpayer, not per-residence, basis.

Gain Exclusion on Sale of Primary Residence

Consider the case of a gain on the sale of your primary residence. IRS code section 121 allows an exclusion from tax up to $500,000 of gain on the sale of a primary residence. You do not pay any tax on the gain if:

  • You or your spouse file a joint return, own and live in your home for at least two of the five years before you sell your home;
  • Your gain is less than $250,000 ($500,000 if you are married filing a joint return);
  • You have not excluded gain on the sale of another house during the two years before you sell your current house.

The exclusion applies each time you sell a home, but generally no more than once every two years. If you depreciated your home for either business or rental use after May 6, 1997, the exclusion does not apply to the depreciation portion of the gain. If you have not owned and lived in your home for the necessary two-year period, you may still be able to exclude your gain. If you sell your home due to health, a change in your employment, or unforeseen circumstances (death or divorce), your available exclusion is based on the portion of the two years you meet the requirements.

Unmarried co-owners of a primary residence can each exclude up to $250,000 of gain on the sale of their primary residence, solidified by the 2010 Tax Court opinion on Sung Huey Mei Hsu v. Commissioner. This Tax Court opinion allows the $250,000 gain exclusion to be made on a per-unmarried-taxpayer basis.

The taxpayer, Sung Huey Mei Hsu sold a home she used as a primary residence and owned jointly with a non-spouse. On her 2005 individual income tax return, she claimed an exclusion from income of $250,000 under section 121. The IRS issued a notice of adjustment, among other items, disallowing $125,000 of the section 121 gain exclusion. But the Tax Court allowed a full statutory exclusion of $250,000 on her gain on the sale of her house that was co-owned with a non-spouse citing nothing in the section 121 rules imposed the limitation asserted by the IRS. Further, regulations under section 121 specifically state that unmarried joint owners owning 50 percent of a house are each entitled to a full $250,000 gain exclusion upon the sale, as long as all other qualifications are met.

Tax Planning Considerations

Some tax planning considerations to keep in mind when advising clients are:

Couples considering marriage and home ownership, especially in high-cost housing areas, should be aware of the mortgage interest deduction limitations as a married couple and as co-inhabitants of the residence. Unmarried co-owners can, in the aggregate, deduct twice the amount of mortgage interest than their married counterparts (allowing interest on mortgage balances of up to $2.2 million to be deducted, while married couples can only deduct interest on mortgage balances up to $1.1 million).

Amended returns can be filed for unmarried co-owners whose mortgages exceeded $1.1 million to deduct interest on each return up to the $1.1 million mortgage limits.

Up to $100,000 of a home equity loan can be treated as acquisition indebtedness, but if proceeds are used to finance a business, it may be better to forego the home equity debt treatment and use the general tracing rules to deduct the interest as a business expense rather than an itemized deduction. 

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