Mortgage Interest Deductions

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, June 6, 1999

Copyright 1999 Robert L. Sommers, all rights reserved.

Question: I sold stock to pay for home improvements. If I now refinance my home, may I deduct the interest?

Answer: Yes. Those who acquire, construct or improve a residence with personal assets or short-term financing may convert that amount to a long-term mortgage under the following rules:

In general, interest on mortgage debt not exceeding $1,000,000 (including refinancing that results in getting cash out) and secured by a first or second residence is deductible if the proceeds are used to acquire, construct or substantially improve your home or second home ("acquisition debt").

If you paid for improvements and later borrowed against your home, you may reimburse yourself by applying that amount to the mortgage and deducting the interest. However, you must be able to trace your original expenditures to the home improvements.

You do not have to trace your loan proceeds under the following conditions: (1) you purchase a residence within 90 days before or after receiving the loan; or (2) you construct or substantially improve a residence within the 24-month period prior to receiving the loan. Receipt occurs when loan proceeds are disbursed, although you may use the loan application date if the proceeds are received a reasonable time thereafter (IRS considers 30 days reasonable).

Note: Acquisition debt is subject to phase-out rules for itemized deductions for both single and joint filers with adjusted gross income ("AGI") of $124,500 (1998 tax year) at the rate of 3% over this amount. For example: If your AGI was $150,000 and your itemized deductions totaled $20,000, then you’ll lose $765 of your itemized deduction ($150,000 - $124,500 = 25,500; $25,500 X .03 =$765. Therefore, your itemized deductions are reduced to $19,235 ($20,000 - $765 = $19,235). The reduction, however, cannot exceed 80% of allowable deductions.

Question: I want to buy rental property. Should I borrow against my home or the new rental property. According to passive activity loss ("PAL") rules, I am disqualified from using losses from the rental to offset my income.

Note: In general, PAL rules permit annual deductions to a maximum of $25,000 for the active management of rental real estate for taxpayers with AGIs of $100,000 or less. Above this, the deduction phases out at $1 for every $2 of AGI; thus a $10,000 deduction will be phased-out at an AGI of $120,000; a $25,000 deduction will be unavailable for those with AGI’s of $150,000 or more. Note: An unused PAL is carried forward.

Answer: Under home-equity loan rules, interest on mortgage debt, other than acquisition debt, under $100,000 (or the fair-market value of your home, whichever is less), secured by a first or second home, is an itemized deduction, regardless of how the money is spent. Consider home-equity borrowing, which will increase your itemized-interest deduction and may reduce your other income, generating a current deduction instead of a non-deductible PAL.

Example: Assume you acquire a $500,000 rental property, with a $400,000 mortgage at 9% interest. If $100,000 of the $400,000 debt is financed through a home-equity loan, all interest on the home-equity portion (approximately $9,000) will shift from a non-deductible PAL to an itemized deduction.

Note: Home-equity debt is subject to both the phase-out of itemized deductions and the alternative minimum tax, so calculate your taxes before borrowing against your home. Also, consider non-tax factors such as possible foreclosure if you cannot repay the home-equity debt.


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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**