Home Mortgage Tax Traps

Money is getting cheaper. so says a report from Freddie Mac.

These rates continue to encourage homeownership, driving a housing boom that shows few signs of easing. It also makes refinancing existing homes attractive. But as home values go up, and refinancing amounts increase, homeowners may inadvertently find themselves in a tax trap.

In 1986 the IRC was amended to limit deductibility of personal interest expense. An exception was made for mortgage interest; however limits were placed on the allowed deductible amounts. At the time, these limits seemed plenty generous. Today, mortgage amounts have materially increased. but the 1986 limits have not, thereby setting the stage for potentially nasty tax consequences.

The 1986 limits allowed deductible interest on home mortgage principal debt up to $1,000,000 when secured by a personal residence for the purposes of building, buying or substantially improving a personal residence. If the taxpayer owns a primary residence and a second home not used for rental, the $1,000,000 can be the sum of the two mortgages.

If the residence was refinanced, any borrowed amount in excess of the acquisition mortgage balance plus $100,000 will not be considered qualified for interest deductibility.

The interest paid on the excess $100,000 is considered an Alternative Minimum Tax adjustment item, and added back to income for the AMT calculation.
According to the Tax Policy Center , more than 15 million taxpayers will be affected by the AMT in 2006 when AMT temporary relief rules expire.

To understand how these rules apply, lets look at a few examples.

First, assume I bought my home in 1990, taking out a $300,000 mortgage. My mortgage balance is now $200,000 and I decide to refinance, borrowing $400,000. I use $50,000 to build a deck and barn for my horse. I use another $50,000 for family expenses.

I can deduct the interest on $200,000 plus $50,000 improvements as qualified acquisition debt. I can deduct the interest on the next $100,000 providing I am not an AMT taxpayer. Finally, the interest on the last $50,000 is not deductible.

Now, assume that I want to refinance my primary residence and use the $200,000 to buy the lot next door. I intend to build a home on the lot, and my contractor determines that he can finish the house within 24 months.

With these facts, the interest on the debt used to buy and build the new home, providing the project is finished within 24 months of the loan origination, count as an acquisition loan and the interest is deductible.

On the other hand, if I intend to hold the property for investment purposes, the interest is deductible as investment interest if I itemize my deductions.

Assume that I sold my home first and used the cash from the home sale to build the home. At completion the new home is paid for and I have no mortgage. However, I decide I want a mortgage, and I use the funds to buy boats, planes and automobiles.

As long as the mortgage is taken out within 90 days after buying or building a home, it counts as an acquisition mortgage and the interest is deductible as qualified mortgage interest. If I happened to wait beyond 90 days, the mortgage would be considered a home equity loan and subject to home equity limitations for deductibility.

Visit www.freddiemac.com for additional information about this subject.

Keith W. Springer, President of Capital Financial Advisory Services is a Registered Investment Advisor and a Mortgage Broker here in Natomas, located on the river at 1383 Garden Hwy. You can contact him at 916-925-8900 or keith@capfas.com