Mortgage Interest & Tracing Rules By Phil Shaffer, EA, CFP Acquisition Debt Main or second home Acquire Construct Substantially Improve» Can be additional amounts Must be secured by the home Debt is limited to $1 Million ($500K, MFS)» In the case of unmarried co-owners the $1 Million debt limit applies to the property. unmarried co-owners collectively limited to interest deduction of $1.1 million. Refinancing of acquisition debt does not change the character unless it exceeds the principal just before refinancing. Acquisition debt can be home equity debt to extent it exceeds $1 Million. Home Equity Debt Debt that exceeds acquisition debt Limited to the lesser of» FMV of home less total acquisition debt» $100K, ($50K MFS) You remember me from last time. I go with Phil wherever he II tgoes, complements of Microsoft. Grandfathered Debt Mortgage incurred before 10/14/1987 All interest secured by the home is fully deductible - regardless of how the funds were used. Grandfathered debt reduces the $1 Million limit for debt incurred after 10/14/1987. Refinancing of acquisition debt does not change the character unless it exceeds the principal just before refinancing. And The repayment term is not longer than the original If not to be repaid over term, Term of first refinancing Not more than 30 days Equitable Owner A person who has the economic benefits and burden of ownership may deduct mortgage interest even though one has no legal title» Occupying and maintaining the home» Paying mortgage and taxes Trans TC Memo 1999-233 Uslu TC Memo 1997-551 Edosada 2012-17 Secured Debt Secured Debt Home mortgage interest must be secured debt to be deductible Makes borrowers ownership in a qualified home security for payment of debt In case of default, home satisfies debt Recorded or otherwise perfected under state or local law A debt is not secured by a home if it is secured solely because of A lien on general assets A security interest attaches the property without consent» Mechanics lien» Judgment lien 1
10 T Election Election to treat debt as unsecured Enables debt to be treated as other than mortgage interest» Begins in the year choice is made and continues for all later tax years.» Revocation requires consent of IRS. I told Phil to go easy on the clipart since MS Office doesn t have II tit any more. He must have found it someplace else. Oh well! 10 T Election Sample election statement under Temp. Regs. Sec. 1.163-10T(o)(5) to treat debt as not secured by a qualified residence Taxpayer name: J Soc. Sec. No.: 999-99-9999 Form 1040, tax year ending 12/31/XX The taxpayer elects to treat $60,000 of home-equity debt, the proceeds of which were used to purchase machinery for his business, as trade or business debt. The interest on this debt for tee tax year was $10,543 and is claimed on Line 16b of Schedule C. A factoid Separate Loans unnecessary for home interest deductions A single loan can be both acquisition debt and part home equity debt The points paid on a loan to purchase the main home including seller paid points Seller paid points are deducted from the purchase price to compute basis. Deductible in full if: Secured by main home Amount conforms to standard business practice for the area Cash method paid from own funds Not from loan proceeds not paid in place of other normally separately stated items appraisal, inspection fees taxes percentage of principal amount settlement statement clearly identifies points often referred to as :» loan origination fees» loan discount» loan discount points» taxpayer may choose to amortize points over the life of the loan even though they qualify to be fully deductible. Limit on deductible points Not deductible to the extent the underlying mortgage exceeds the qualified loan limit. These points can t be deducted currently Loans to purchase or improve a second residence Refinancing loans unless used for improving the main home Home equity loans or line of credit loans not used for improving the main home. Home improvement Loan Same as for points paid on a loan to purchase the main home Except the following conditions need not be satisfied percentage of principal amount settlement statement clearly identifies points paid on Refinance Must amortize points over life of new loan unless proceeds used for substantial improvement of main residence. If loan paid off early, unamortized points may be deducted in year loan paid in full except Same lender, remaining points over life of new loan. Short term financing as a first step in obtaining a permanent mortgage points on obtaining permanent mortgage deductible in year paid 2
Amortizing Monthly, not annually Home equity line of credit Over life of loan except If used for home improvements of main home, points fully deductible Business or investment property Over the life of the loan Second home Personal use Amortized over life of loan Rental and personal use Personal use not more than: Greater of 14 days 10% of days home rented amortized Mixed use Allocate and amortize Cooperative Housing Corporations Co-Ops Mortgage interest allocated to a tenant shareholder in a coop are generally treated the same as other homeowners if: Only one class of shares Shareholder has the right to occupy, but is not required to occupy, a unit solely because of stock ownership No shareholder can receive a distribution except on liquidation of the corporation During the year the corporation Receives at least 80% of gross income from tenant shareholders or Makes available at least 80% of the property s total square footage for tenant shareholder use or Pays or incurs at least 90% of expenditures for acquisition, construction, management, maintenance and care of the property for the benefit of tenant shareholders Interest deduction is allocated by number of shares owned vs total shares outstanding. Late Charges Late mortgage payment charges generally deductible If not for a specific service, e.g. collection fees Land Rent Periodic lease payments made for use of land on which a house is located can be deducted as mortgage interest if: Land lease term is more than 15 years including renewal periods and is freely assignable by the lessee. The leasee has the right to terminate the lease and purchase the land by paying a specified amount Leasors interest in the land is a security interest to protect the entitlement to rent payment Construction Loans Interest in construction loans to buy a lot is qualified residence interest if The home on the lot is under construction for up to 24 months will when ready for occupancy will be the main or second home If the construction period exceeds 24 months, interest for remaining months is personal Loan proceeds must be traceable to construction expenses and lot purchase. Before construction begins, interest is personal 90 Day Rule A loan acquired within 90 days after construction is complete May qualify to the extent of construction expenses» Made within the period starting 24 months before completion» And ending on the date of the loan 3
Timeshares Can be considered second homes If any portion is rented to a third party, the personal part of the deduction may be lost Boats, Mobile Homes and House Trailers Can be a qualified home if: Sleeping facilities Cooking facilities Toilet facilities Prepaid Mortgage Interest Mortgage interest paid in 2013 that is fully accrued by January 15, 2014, may be included in Form 1098 Box 1. This interest must be deducted in 2014, not 2013. Reverse Mortgages Used to convert home equity to cash The amount received by the homeowner is a loan Tax free Doesn t affect social security Mortgage interest is added to the loan balance over the term of the loan When the reverse mortgage comes due, the lender recovers the amount owed. The mortgage interest is not deducted until the loan is repaid. Mortgage Insurance Premiums In 2013, insurance premiums paid in connection with the acquisition debt on a main or second home are deductible. Not so for 2014 at this time. Phased out based on AGI starting at $100000, gone by $109000, $54500 MFS. AMT Regular Tax (Deductible) on Mortgage up to $1 Million to acquire or improve a main home or second home Including certain boats and motor homes Interest on home equity loans up to $100K AMT (Deductible) on Mortgage up to $1 Million to acquire or improve a main home or second home Including certain boats and motor homes Interest on home equity loans up to $100K But only if used to acquire or improve Interest added to AMT is a exclusion item Not eligible for the Minimum Tax Credit (8801) later 4
New Mortgage Rules for 2014 by Consumer Financial Protection Bureau (CFPB) Designed to take a basic approach to mortgage lending and lower the risk of default and foreclosures. Lenders asked to comply with two new requirements: Ability to Repay Rule Qualified Mortgages Ability to Repay Rule Determine borrower has income and assets to afford to mke payments over life of loan Look at debt-to-income ratio Add up monthly obligations to include: Student loans Credit card payment Car payment Housing costs Utilities Other recurring costs Divide bimonthly gross income Lenders need to verify: Income Assets Credit history Debt Underwriting must be based on maximum monthly charges borrower will face. New Mortgage Rules for 2014 by Consumer Financial Protection Bureau (CFPB) Qualified Mortgages Debt to income ration generally must be less than 43% Minimum credit score is expected to be about 620 Can not include: Terms longer than 30 years Interest only payments Low minimum payments which allow the balance to grow Up front fees and charges can not ad up to more than 3% of the mortgage balance to include: Title insurance Origination fees and points And points paid to lower mortgage interest rates Rules restrict steering, the practice of giving financial incentives to loan officers or brokers for pushing people into higher interest loans they can not afford Interest Tracing Interest Expense Types Business Interest (Sch C, F) Capitalized interest Student Loan Interest (1040 Above the line) Interest paid to purchase or carry tax exempt securities Investment Interest (Form 4952) Mortgage Interest (Sch A, 8829) Passive Activity Interest (Sch E) Nondeductible Personal Interest Interest Allocation Rules Determine the category in which to place interest paid on loan interest paid on loan proceeds until Debt repaid Debt reallocated 30 Day Rule Loan proceeds can be allocated to expenses paid from any account(or in cash) if expenses are paid within 30 days before or after the loan proceeds are deposited into an account (received in cash). Interest paid on loan proceeds received in cash is generally treated as personal interest When the loan proceeds are deposited into an account, the interest paid is treated as investment interest expense whether or not the account pays the interest. When the loan proceeds are withdrawn, the interest is reallocated based on the use of funds. Rules for Reallocation Debt When proceeds of a loan are shifted to a new use, the interest paid on the debt must follow. Most common: Money withdrawn from an account Asset sold and debt not paid off Withdrawing loan proceeds from an account Use of funds determines classification of interest Order of allocating withdrawals -If an account contains borrowed and non borrowed funds: Withdrawals first from loan proceeds Proceeds from more than one loan Withdrawals allocated in order loans taken out Order of allocating deposits Two or more loans deposited on the same date, loan incurred first is deemed deposited first, etc Order of withdrawing interest/principal- If an account contains only one loan and interest is earned on the proceeds of the loan, a withdrawal from the account can be treated as coming first rom the interest and then from the loan. Date of withdrawal- withdrawn on date check is written if check is delivered in a reasonable amount of time 5
Brunhilde's Account An example On January 9. Brunhilde opened a checking account. Transactions are: 1. 1/9 deposit $500 from Loan A investment interest expense 2. 1/9 deposit $1000 own money 3. 1/14 deposit $500 from Loan B bring total borrowed to $1000 investment interest expense 4. 2/19 used $800 for personal purposes, $500 Loan A, $300 Loan B, Leaving $200 from Loan B 5. 2/27 $700 used for passive activity, $200 from Loan B, $500 own money leaving $500 own money in account- Loan A and B used now 6. 6/19 deposit $1000 from Loan C 7. 11/20 used $800 for an investment All from Loan C, leaving $700, $200 Loan C, $500 own money 8. 12/18 used $600 for personal purposes $200 from Loan C, $400 own money, leaving $100 9. Interest paid on money in account is investment interest Trans A Int Int B's B's Running Transaction Amount Date Loan A A Bal Int Loan B B Bal Int B Split B Loan C C Bal Int C Split C Money balance Bal Deposit $500 9-Jan $500 $500 I $500 Deposit $1,000 9-Jan $500 $1,000 $1,000 $1,500 Deposit $500 14-Jan $500 I $1,000 $2,000 $500 $500 I 100 Personal ($800) 19-Feb $0 P ($300) $200 B/I 60/40 $1,000 $1,200 ($500) Passive ($700) 27-Feb $0 P ($200) $0 B/P 60/40 $500 $500 ($500) Deposit $1,000 19-Jun $0 P $0 B/P 60/40 $500 $1,500 $1,000 I 100 Investment ($800) 20-Nov $0 P $0 B/P 60/40 ($800) I 100 $500 $700 $200 Personal ($600) 18-Dec $0 P $0 B/P 60/40 ($200) $0 B/I 20/80 ($400) $100 $100 Allocating Principal Repayments If loan proceeds are used to acquire both personal and business-use property, principal amounts repaid are treated as repaid in the following order: Personal expenditures Investment and passive activity expenditures Rental real estate with active expenditures Former passive activities Trade or business expenditures Example: Richard borrows $100000 and uses the proceeds to buy a duplex. 40% is used as his personal residence, 60% as rental property. Richard pays 10% Interest on the loan. All principal payments are allocated to the personal portion of the loan until that part is paid off. So rental interest expense remains the same each year until the personal portion of the loan principal is paid off. Loan Amount $100,000 Personal Percentage 40% Rental Percentage 60% Interest Rate 10% Yr Beginning Principal Principal Payment Interest Payment Total Payment Total Loan Payment 1 100,000 15,000 10,000 25,000 2 85,000 16,500 8,500 25,000 3 68,500 18,150 6,850 25,000 4 50,350 19,965 5,035 25,000 5 30,385 21,962 3,039 25,000 6 8,424 15,005 842 9,266 Payments Allocated to the Personal Part 1 40,000 15,000 4,000 19,000 2 25,000 16,500 2,500 19,000 3 8,500 8,500 850 9,350 4 0 0 0 0 5 0 0 0 0 6 0 0 0 Payments Allocated to the Rental Part 1 60,000 0 6,000 6,000 2 60,000 0 6,000 6,000 3 60,000 9,650 6,000 15,650 4 50,350 19,965 5,035 25,000 5 30,385 21,962 3,039 25,000 6 8,424 15,005 842 9,266 6