Deduction Of Refinanced Mortgage Interest Clarified By The IRS |
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It is estimated that Alternative Minimum Tax (AMT) will affect more than 3 million taxpayers in 2005, and in 2006 when certain AMT temporary provisions expire, nearly 15 million will be affected. The impact of AMT on certain types of otherwise-deductible
mortgage refinancing interest could be substantial due to the combination of fast increasing AMT exposure for all taxpayers and mortgage refinancing caused by years of record-low interest rates. Revenue Ruling 2005-11 has clarified the limited deductibility of mortgage interest for taxpayers who are subject to AMT. For tax purposes, mortgage refinancing can be availed in two ways, as defined in the Internal Revenue Code under Section 163. The first way is a loan that is used to acquire, build, or substantially improve a residence. This is known as acquisition indebtedness and the interest on this is up to $1,000,000 deductible for taxpayers who itemize their deductions. Home equity indebtedness is the second type of mortgage interest which is any kind of borrowing against your residence that is not used to acquire, build, or substantially improve that residence, for tax purposes. This also includes the typical home equity line of credit, and the cash-out portion of cash-out mortgage refinancing, up to the limit that the extra borrowing is not used to substantially improve the home. Interest on up to $100,000 of home equity indebtedness is deductible. Home equity indebtedness deductions have to be added back to income, when a taxpayer becomes subject to the AMT. However, for AMT taxpayers, they are not deductible. Debt is classified as acquisition or home equity indebtedness based only on what the funds are used to acquire, build, or substantially improve the home, or for anything else, irrespective of what a bank might call a particular loan. New Revenue Ruling 2005-11 clarifies how these rules are applied, and what is considered acquisition versus home equity indebtedness, in the event that a mortgage is refinanced or even rerefinanced as a result of the high volumes of mortgage refinancing and additional equity borrowing in recent years. Any mortgage refinancing will continue to be seen as acquisition indebtedness to the extent of the original mortgage, if a mortgage was originally classified as entirely acquisition indebtedness. Any extra indebtedness will be considered home equity indebtedness, if it is not specifically used to substantially improve the residence. This is, however, subject to the $100,000-of-debt-principal restriction for regular tax purposes, and non-deductibility for AMT purposes. To find out how these rules work, let's take a real-life example. If a taxpayer had taken out an initial mortgage of $150,000 to buy a house, the full amount of the mortgage interest would be considered acquisition indebtedness. In 2003, the taxpayer refinanced the initial mortgage, which by that time had a reduced balance of $140,000, and took out a new mortgage for the same $140,000 at a lower interest rate. This way, the refinanced mortgage interest is eligible to be treated under the more favorable acquisition indebtedness rules, since the entire mortgage refinancing amount was attributable to the remaining acquisition indebtedness. Let us now assume that in 2004, the taxpayer again refinances and he takes out a mortgage for $140,000 although the remaining balance has reduced to $135,000 by that time. By doing so, the mortgage interest on the first $135,000 of debt principal will be still considered acquisition indebtedness, but the interest on the additional $5,000 will be subject to the home equity indebtedness rules. Irrespective of the fact that the additional $5,000 of debt went to pay off other expenses (e.g., a credit card balance or the down payment on a car), or even just to wrap the mortgage refinancing costs into the new loan balance, the home equity indebtedness rules will still apply. The loan is considered home equity indebtedness, with the concomitant restrictions, unless the funds are used specifically to substantially improve the residence. Many people now carry a mix of acquisition and home equity indebtedness and many people will find that a portion of mortgage interest that was deductible under the regular tax system will be deductible no longer. |
