Taxing Lessons From Court Decisions

Decisions — Points of Interest

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This week’s published cases included discussions about the deductibility of mortgage interest and points.

In T.C. Memo. 2014-135 (Hume/Dilani), the taxpayer owned two homes, with an average mortgage balance on both mortgages exceeding $3 million. He deducted home mortgage interest on the loans. The taxpayer also had a home equity line of credit that exceeded $400,000.

The taxpayer failed to show he had lived in one of the houses for the requisite amount of time, and the court decided the IRS was correct in limiting the amount of deductible interest.

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In T.C. Summary Opinion 2014-67 (Simpson), the taxpayers deducted points on their 2008 return related to a home purchased in 2004 and foreclosed on in 2008. (Points are interest that you pay in advance on a mortgage loan. Typically, the more points you pay, the lower the interest rate on the loan.)

The court believed the foreclosure had taken place inside the taxpayer’s bankruptcy, and so the bankruptcy estate bore the tax consequences.

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Acquisition indebtedness and home equity indebtedness.

Acquisition indebtedness is indebtedness incurred to acquire, construct, or substantially improve a residence.

Home equity indebtedness is indebtedness other than acquisition indebtedness.

Acquisition indebtedness cannot exceed $1 million and home equity indebtedness cannot exceed $100,000.

CCA 200940030 reinterprets the definition of acquisition indebtedness, and allows a taxpayer to deduct interest on the first $1.1 million of a mortgage instead of the usual $1 million limit.

You generally cannot deduct the full amount of points in the year paid. Because they are prepaid interest, you generally deduct them ratably over the term of the mortgage.

1. You can fully deduct points incurred when you obtain a home mortgage in the year you pay the points if you meet all the following tests. (You can also choose to deduct the points over the life of the loan.)
–Your loan is secured by your main home.
–Paying points is an established business practice in the area where the loan was made.
–The points paid were not more than the points generally charged in your area.
–You use the cash method of accounting. This means you report income in the year you receive it and deduct expenses in the year you pay them. Most individuals use this method.
–The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.
–The funds you provided at or before closing, plus any points the seller paid, were at least as much as the points charged. The funds you provided are not required to have been applied to the points. They can include a down payment, an escrow deposit, earnest money, and other funds you paid at or before closing for any purpose. You cannot have borrowed these funds from your lender or mortgage broker.
–You use your loan to buy or build your main home.
–The points were computed as a percentage of the principal amount of the mortgage.
–The amount is clearly shown on the settlement statement as points charged for the mortgage. The points may be shown as paid from either your funds or the seller’s.

2. You can fully deduct in the year paid points paid on a loan to improve your main home, if tests (1) through (6) are met.

3. Generally, points you pay to refinance a mortgage are not deductible in full in the year you pay them. However, if you use part of the refinanced mortgage proceeds to improve your main home and you meet the first 6 tests, you can fully deduct the part of the points related to the improvement in the year you paid them with your own funds. You can deduct the rest of the points over the life of the loan.