What formula should be used to calculate the allowable mortgage interest deduction when the mortgage includes both qualified and unqualified debt components?
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When a mortgage includes both qualified and unqualified debt components (i.e., the total debt secured by a qualified residence exceeds the statutory limits for acquisition indebtedness and/or home equity indebtedness), the allowable mortgage interest deduction must be calculated by allocating interest between the qualified and unqualified portions of the debt. The Internal Revenue Code, Treasury Regulations, and IRS guidance provide two principal methods for this allocation: the simplified method and the exact method. Both methods are recognized as reasonable, and the taxpayer may choose either one for any taxable year.
1. Background: Statutory Limits
- Acquisition indebtedness: For tax years beginning after December 31, 2025, the aggregate limit is $1,000,000 ($500,000 if married filing separately) for debt incurred to acquire, construct, or substantially improve a qualified residence and secured by that residence.
- Home equity indebtedness: For tax years beginning after December 31, 2025, the aggregate limit is $100,000 ($50,000 if married filing separately) for other debt secured by a qualified residence, to the extent it does not exceed the residence’s fair market value reduced by acquisition indebtedness.
2. Simplified Method (Pro Rata Allocation)
Formula:[\text{Allowable Interest Deduction} = \text{Total Interest Paid} \times \left( \frac{\text{Qualified Debt Limit}}{\text{Total Average Mortgage Balance}} \right)]
- Qualified Debt Limit: The sum of the statutory limits for acquisition and home equity indebtedness (e.g., $1,100,000 for most joint filers).
- Total Average Mortgage Balance: The sum of the average balances of all secured debts on the qualified residence(s) for the year.
Example:If a taxpayer has $1,500,000 in total average mortgage balances, but only $1,000,000 qualifies as acquisition indebtedness, and $100,000 as home equity indebtedness, and pays $60,000 in interest:[\text{Allowable Interest} = \$60,000 \times \left( \frac{\$1,100,000}{\$1,500,000} \right) = \$44,000]The remaining $16,000 is not deductible as qualified residence interest.
3. Exact Method (Debt-by-Debt Allocation)
Formula:For each debt:[\text{Allowable Interest for Debt} = \text{Interest Paid on Debt} \times \left( \frac{\text{Applicable Debt Limit for Debt}}{\text{Average Balance of Debt}} \right)]- Applicable Debt Limit for Debt: The lesser of (a) the fair market value of the residence when the debt was secured, or (b) the adjusted purchase price at year-end, reduced by the average balance of any prior debts secured by the residence.
Total allowable interest is the sum of the allowable interest for each debt.
4. Treatment of Excess Interest (Interest on Unqualified Debt)
- Interest on the portion of debt exceeding the qualified limit is not deductible as qualified residence interest.
- However, if the proceeds of the excess debt were used for business, investment, or other deductible purposes, the interest may be deductible under other provisions (e.g., as business interest on Schedule C, investment interest on Schedule A, or rental interest on Schedule E), subject to applicable limitations.
5. Summary Table of Steps
6. Authority for Methods
- Taxpayers may use either the simplified or exact method, or any other reasonable method, as confirmed by IRS Chief Counsel.
- No election is required to use these methods; the election to treat a debt as not secured by a qualified residence is only necessary if the taxpayer wants to treat the entire debt as non-residence debt for tracing purposes.
In summary: To calculate the allowable mortgage interest deduction when a mortgage includes both qualified and unqualified debt components, use either the simplified (pro rata) or exact (debt-by-debt) method as described above. The deduction is limited to the interest attributable to the qualified portion of the debt, and any excess interest may be deductible under other provisions if the proceeds were used for deductible purposes.
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