Definition — An Interesting Deduction

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Did you deduct home mortgage interest on your tax return? According to the IRS statistics of income, home mortgage interest is one of the four largest itemized deductions claimed by taxpayers. Home mortgage interest is deductible within the limitations put in place by the Omnibus Budget Reconciliation Act of 1987 (internal revenue code section 163). The general rule is you can claim a deduction for interest paid on up to $1,000,000 of “acquisition” debt secured by a qualified residence. In addition, you can take an interest deduction on up to $100,000 of home equity debt.

What happens when your mortgage exceeds those amounts? The answer depends in part on what you do with the loan proceeds. For example, if you use the proceeds for business or investing, you may be able to deduct part of the interest expense under rules for those types of deductions.

That’s what the taxpayer in T.C. Memo. 2015-56 (Minchem International, Inc.) wanted to do. He refinanced an outstanding loan for $2,501,935 through home equity indebtedness and allocated portions of the interest paid to mortgage interest and the remainder to investment interest expenses. Unfortunately, the taxpayer provided no records that showed the funds were used for investing, so the tax court sided with the IRS and disallowed the deduction.

However, the case provides a good explanation of qualified residence interest rules and quotes Temporary Regulation 1.163-10T(c)(1) regarding methods of allocating home mortgage interest. According to that regulation, there are two methods: simplified and exact.

The court and the regulation say if you use the simplified method, interest paid in excess of the amount considered “qualified residence interest” is not deductible. Under the exact method, you can deduct the excess interest if you used the loan proceeds for activities that would provide a deduction such as business or investment.

IRS Publication 936, Home Mortgage Interest Deduction, includes a worksheet for calculating the excess deduction. The worksheet is based loosely on the simplified method and the related instructions allow for the deduction of excess interest expense used for otherwise deductible purposes. This appears to differ from the wording in the temporary regulations.

An IRS technical advisor raised the question of whether the excess interest could be potentially deductible even when the simplified method is used. The IRS issued Chief Counsel Advice 201201017 in response.

What do you think the IRS decided?

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THE IRS DECISION
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This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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The excess interest is potentially deductible whatever method is used.

Since the legislative history states that until regulations are issued a reasonable method of allocating debt in excess of the limitation may be used, taxpayers may use any reasonable method, including the exact method and the simplified method described in the regulations, the method provided in Publication 936 (similar to the simplified method in the regulations) or a reasonable approximation of those methods.

A taxpayer using the simplified method may allocate excess interest under the interest tracing rules of section 1.163-8T, as described in the instruction to line 13 of the worksheet in Publication 936, without making an election under section 1.163-10T(o)(5). The method provided for in Publication 936 is another reasonable method allowed by the legislative history.

Editorial note: Chief Counsel Advices are legal interpretations for the benefit of IRS employees. While they are released to the public, they cannot be relied upon as legal authority or cited as precedent.

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