How do IRS rules affect the calculation of deductible mortgage interest when the mortgage includes both qualified home equity debt and unqualified personal debt?
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The calculation of deductible mortgage interest when a mortgage includes both qualified home equity debt and unqualified personal debt is governed by a combination of statutory rules, IRS guidance, and allocation methodologies. The key is to distinguish between the portions of the debt that qualify for deduction as "qualified residence interest" and those that do not, and then to allocate interest accordingly.
1. Types of Deductible Mortgage Interest
Under IRC §163(h), individuals may deduct "qualified residence interest," which includes interest paid on:- Acquisition indebtedness: Debt incurred to acquire, construct, or substantially improve a qualified residence and secured by that residence, subject to dollar limits.- Home equity indebtedness: Other debt secured by a qualified residence, up to certain limits, and subject to fair market value constraints.
Personal interest (i.e., interest on debt not meeting these definitions) is generally not deductible.
2. Dollar Limits and Definitions
- Acquisition indebtedness is limited to $1,000,000 ($500,000 if married filing separately) for debt incurred before December 16, 2017, and $750,000 ($375,000 if married filing separately) for debt incurred after that date (with certain exceptions for binding contracts).
- Home equity indebtedness is limited to $100,000 ($50,000 if married filing separately), and only to the extent the total does not exceed the fair market value of the residence minus acquisition debt.
Note: For 2018–2025, the deduction for home equity indebtedness is suspended unless the proceeds are used to buy, build, or substantially improve the home.
3. IRS Guidance on Allocation
Rev. Rul. 2010-25
- If a mortgage exceeds the acquisition indebtedness limit, the excess can be treated as home equity indebtedness (subject to the $100,000/$50,000 and FMV limits).
- Any remaining debt above both limits is unqualified personal debt, and interest on that portion is not deductible.
Publication 936 and Temporary Regulations
- When a mortgage includes both qualified and unqualified debt, the interest must be allocated between the deductible and nondeductible portions.
- The IRS allows any reasonable method for this allocation, including the "exact" and "simplified" methods in the regulations, or the worksheet in Publication 936.
4. Allocation Methods
Exact Method (Temp. Reg. §1.163-10T(e))
- For each debt, compare the average balance to the applicable debt limit.
- If the average balance exceeds the limit, only a pro rata portion of the interest is deductible as qualified residence interest.
- The formula:
Deductible interest = (Debt limit ÷ Average balance) × Total interest paid
Simplified Method
- Combine all secured debts and apply the overall debt limits.
- Any interest on debt exceeding the combined limits is treated as personal interest and is not deductible.
Interest Tracing Rules (Temp. Reg. §1.163-8T)
- If the proceeds of the excess debt are used for business, investment, or other deductible purposes, the interest may be deductible under those rules, rather than as qualified residence interest.
5. Practical Example
Suppose a taxpayer takes out a $1,200,000 mortgage to buy a home (FMV $1,500,000), with no other debt on the home:- $1,000,000 is acquisition indebtedness (deductible as qualified residence interest).- $100,000 is home equity indebtedness (deductible, subject to FMV and other limits).- $100,000 is unqualified personal debt (interest is not deductible).
If the taxpayer pays $60,000 in interest for the year:- Deductible interest: $1,100,000 / $1,200,000 × $60,000 = $55,000- Nondeductible interest: $5,000
6. Reporting and Elections
- Deductible mortgage interest is reported on Schedule A (Form 1040).
- Taxpayers may elect to treat a mortgage as not secured by a qualified residence, allowing interest to be deducted under business or investment interest rules if applicable.
7. Summary of Key Points
- Only interest on the portion of debt that qualifies as acquisition or home equity indebtedness (within statutory limits) is deductible as qualified residence interest.
- Interest on the portion of debt exceeding these limits is personal interest and not deductible, unless the proceeds are used for another deductible purpose and traced accordingly.
- The IRS allows reasonable allocation methods, and excess interest may be allocated to business or investment activities if the proceeds are so used.
In summary: When a mortgage includes both qualified home equity debt and unqualified personal debt, only the interest attributable to the qualified portion is deductible as mortgage interest. The interest on the unqualified portion is generally not deductible, unless it can be traced to another deductible use. Taxpayers must use a reasonable allocation method to determine the deductible amount.
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