Here is a real-life tax situation I was recently asked about -
A retired taxpayer lives in South Carolina and his adult son lives and
works in California. The son wants to purchase a personal residence in
California worth $1.3 Million but needs the help of his father with both the
down-payment on the property and the monthly mortgage payments. The purchase
mortgage principal will be $1.1 Million. Title to the residence will be held in
the name of the son and the father jointly and both will be named on the purchase
mortgage – but only the son will actually live in the property. The property
will be the primary personal residence of the son – but not the father. The son
will pay 75% of the monthly mortgage payment and the father will pay 25%.
I was asked to answer two questions -
(1) Can the California property be considered a “qualified second
residence” of the father for purposes of deducting acquisition debt mortgage
interest on his Schedule A or is it treated as an “investment property” with
the applicable mortgage interest deducted by the father as investment interest,
subject to the investment income limitation?
(2) If the property is considered a qualified second residence of the
father how much of the interest paid by the father can he deduct on Schedule A.
Taxpayers
who itemize on Schedule A can deduct interest paid on “acquisition debt” - debt
used to buy, build, or substantially improve a main residence or a qualified
second home. A “substantial improvement” is one that adds value to the
home, prolongs the home’s useful life, or adapts the home to new uses.
In
order to qualify for the deduction -
*
The home must be the owner’s personal residence (primary or secondary).
*
The home must be used as the security for the loan.
* If
the homeowner defaults on the loan the home will be taken to “satisfy” the
debt.
*
The loan must be recorded with the appropriate agency under state law, usually
at the county level.
Qualified
residence interest can only be deducted if you have an ownership interest in
the home, you are legally obligated to pay the mortgage debt, and you actually
make payments on the debt.
When
two people buy a home together, and both owners are named on the mortgage, each
owner can deduct the amount of interest he or she actually pays. If you pay 25%
of the mortgage payment you can deduct 25% of the interest. If you pay 50% of the mortgage payment you
can deduct 50% of the interest. If you
own a home with a partner, but pay the entire mortgage payment each month you
can deduct 100% of the mortgage interest on your Schedule A.
For
mortgage loans on new home purchases incurred after December 15, 2017,
you can deduct the interest on up to $750,000 in principal ($375,000 if
Married Filing Separately). Qualified
debt cannot exceed the cost of the home and any substantial improvements.
The principal limitation applies to unmarried
co-owners of a qualified residence on a per-taxpayer basis and not a
per property basis. Each individual unmarried co-owner can deduct
mortgage interest on up to $750,000 (or $1 Million) of acquisition debt. So, an unmarried couple who jointly purchase
a property in 2022 with a mortgage of $1,500,000 can each deduct 50% of the
total interest paid on the property, assuming they each pay half of the monthly
mortgage payment, and even though the loan principal exceeds $750,000.
Also
deductible on Schedule A is “investment interest” - interest that is paid on
loan proceeds used to purchase taxable investments or securities. Real estate is an investment. The deduction is limited to the taxpayer’s
“net investment income” – taxable interest, “non-qualified” dividends, net
short-term capital gains, royalties, and annuities less deductible investment
expense (obviously not including investment interest). Qualified dividends and long-term capital
gains can be included in investment income if the taxpayer elects not to tax
this income at the special lower capital gain rates. Excess investment interest (investment
interest paid that is not deductible on the current return) can be carried
forward and deducted on future returns, subject to the net investment income
exclusion.
In our
scenario the father is not charging his son any fair market rent for his ownership
interest, so the father is considered to be using the home for personal
purposes and it can be treated as a qualified second home of the father
for purposes of claiming a mortgage interest deduction.
And
since the principal limitation if per taxpayer and not per property, and the
father is named on the mortgage, the father can deduct the full amount of
mortgage interest he pays. If the total
interest for the year is $10,000 and the father paid 25% of each monthly mortgage
payment paid from his funds, he can deduct $2,500 as mortgage interest on
his Schedule A.
I
have written a special report on “Deducting Mortgage Interest” that discusses
in detail all the rules and regulations for the Schedule A mortgage interest
deduction. It emphasizes the vital
importance of keeping separate track of “acquisition debt” and “home equity
debt” and provides a detailed example and worksheets for you to use. The cost is only $2.00.
It
is my firm belief that more often than not taxpayers who itemize are deducting
the wrong amount of mortgage interest – either too much or too little. Every single homeowner with a mortgage who
itemizes on their federal tax return needs to purchase and read this report.
To
order your copy of this report send a check or money order for $2.00 –
payable to Taxes and Accounting, Inc – and a SASE to –
DEDUCTING
MORTGAGE INTEREST
TAXES
AND ACCOUNTING INC
POST
OFFICE BOX A
HAWLEY
PA 18428
TTFN