Monday, August 6, 2007


Kelly Phillips Erb, the internet’s TAX GIRL, discussed the question of whether the mortgage interest deduction for homeowners should be eliminated in her Friday, July 27th posting “Should We Pay for the Mistakes of Others?” – and ends with the question what do you think?

First some background.

There was a time when all interest was deductible on Schedule A. This included interest and finance charges on credit cards, auto loans, student loans, pension loans, insurance loans, margin loans, personal loans, etc. The very first Form 1040, from 1913, allowed a deduction for “all interest paid within the year on personal indebtedness of taxpayer”.

The Tax Reform Act of 1986 phased out the deduction for “personal interest” and limited the deduction to interest on qualified “acquisition debt” and “home equity debt” – debt secured by your residence – and investment interest (to the extent of net investment income).

The Act also limited the amount of principal on which interest could be deducted. Qualified “acquisition debt” - debt acquired after October 13, 1987, to buy, build, or substantially improve your main residence or a qualified second home – is limited to $1 Million ($500,000 if Married Filing Separately). Qualified acquisition debt also cannot exceed the cost of the home plus the cost of any substantial improvements. A substantial improvement is one that adds value to the home, prolongs the home’s useful life, or adapts the home to new uses. Qualified “home equity debt” is limited to $100,000 ($50,000 if married filing separately).

When you refinance an existing acquisition debt the new mortgage is treated as acquisition debt only up to the balance of the old mortgage principal just prior to the refinancing – plus any additional debt used to “substantially improve” the residence. Any excess principal is considered home equity and must be applied to the $100,000 limitation.

If you have total home equity debt of $150,000 and the interest on this debt for the year is $9,000 you can only deduct $6,000 ($100,000 divided by $150,000 x $9,000). This is, of course, a very simple example, and it is rarely ever that simple in the “real world”.

With the ease of using a home equity loan or line of credit to pay personal expenses (i.e. purchase a car or major appliances, or pay off credit cards and other personal debt) and the constant refinancing and consolidation of acquisition and equity debt over the past few years it is truly a major accounting undertaking to keep track of acquisition and equity debt and to calculate the proper amount of deductible interest. As a result there has been widespread abuse of the interest limitation rules.

To complicate matters more – under the dreaded Alternative Minimum Tax (AMT) you can only deduct interest on a mortgage whose proceeds are used to buy, build, or substantially improve your main home or a second home. Interest on home equity debt is not deductible for AMT purposes.

Similarly, in the case of rental property reported on Schedule E you can only deduct interest on a mortgage to buy, build or improve the property being rented. If you own a two family house and you live in one unit and rent out the other, only acquisition debt can be deducted against rental income on Schedule E. If you have home equity debt used to purchase personal items or pay off personal credit cards you cannot deduct any of this interest on Schedule E, even though it is secured by the property.

You can, however, deduct interest and finance charges on borrowing, whether or not secured by the rental property, for goods and services used in the rental activity or repairs to the rental unit or the property in general, including credit card interest. If you purchase a washer and dryer that is available for use by your tenant, appliances for the rental unit, or repairs to the rental unit with home equity debt or on a credit card the interest can be deducted on Schedule E.

For interest to be deductible on your personal residence the loan must be secured by the residence, but the money does not have to be used on the residence. With a rental property, the loan does not have to be secured by the property, but it must be used on the rental property or in the rental activity.

The form 1098 issued by banks and mortgage companies reports the total amount of mortgage interest – it does not differentiate between acquisition and equity debt and does not report principal balances. Taxpayers and tax preparers alike, for the most part, simply deduct the total amounts reported on the 1098s.

Now, back to the question.

The question of deducting home mortgage interest falls within the bigger issue of should the Tax Code be used to encourage or discourage certain behavior. The Form 1040 has been historically used, often successfully, to encourage a multitude of positive activity – to invest, to save for retirement, to contribute to charity, to pursue continuing education, to save for medical expenses, for people on welfare to go back to work, and to buy a home. I do believe that the creation of the IRA deduction for all taxpayers (whether or not covered by an employer plan) helped to bring interest rates back to normal in the mid-70s. This is good.

It was clear that Congress, when rewriting the Tax Code in 1986, wanted to continue to encourage home ownership by allowing a tax deduction for home mortgage interest. Congress also wanted to do away with the deduction for personal interest, possibly to discourage individuals from piling up excessive credit card debt, although it did allow for a deduction on up to $100,000 in non-property related home equity debt.

The government should continue this practice – it is still good to encourage home ownership. The deduction for home mortgage interest should not be eliminated. If Congress wants to do something to address the abuse of the home equity deduction perhaps they should limit the deduction to acquisition debt – to buy, build or improve a property.

Beginning with the effective date of the change, mortgage providers could be required to report acquisition debt and equity debt separately on the Form 1098. Acquisition debt could be revised to include any additional cost of refinancing that is added to mortgage principal, so individuals who refinance acquisition debt without taking out additional money for personal purposes could do so and not have to pay the closing costs “out of pocket”.

Perhaps mortgage providers could be required to pass along information regarding acquisition debt principal to new mortgage underwriters when a refinance occurs, similar to the way the Taxpayer Advocate and I, and lately many Congressmen, want brokerage houses to pass along cost basis information when an investor changes to a new broker. If nothing else there would be a beginning date from which we tax preparers would need to start tracking acquisition debt.

If a homeowner used an equity loan to pay for capital improvements he could be able to claim the interest as an additional acquisition debt deduction, and would need to keep good records to document the deduction.

So what do you think?


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