In Chief Counsel Advice (CCA), IRS has concluded that based on the legislative history of Code Sec. 163(h), until regs are issued, taxpayers may use any reasonable method in allocating debt in excess of the acquisition and home equity debt limitation, including the exact and the simplified methods in temporary regs issued under a previous version of Code Sec. 163(h), the method in Pub 936, or a reasonable approximation of these methods.
Background on qualified residence interest rule.
Generally, personal interest is nondeductible. However, under an exception to this rule, qualified residence interest (which includes interest on acquisition indebtedness and home equity indebtedness) is deductible. Acquisition indebtedness is indebtedness incurred to buy, build, or substantial improve an individual’s qualified residence that is secured by the residence. The total amount treated as acquisition debt can’t exceed $1 million for any period ($500,000 for a married individual filing separately). Home equity indebtedness is indebtedness (other than acquisition indebtedness) secured by taxpayer’s qualified residence, to the extent the aggregate amount of the debt doesn’t exceed the fair market value (FMV) of the residence, as reduced by the amount of acquisition indebtedness on it. The total amount treated as home equity indebtedness for any period can’t exceed $100,000 ($50,000 for a married individual filing separately).
Prior law and temporary regs.
The Tax Reform Act of ’86, which made personal interest generally nondeductible, allowed a deduction for qualified residence interest on indebtedness that did not exceed the basis of the residence and the cost of improvements, and on certain indebtedness incurred for medical and educational purposes. IRS issued Reg. § 1.163-9T and Reg. § 1.163-10T to explain the qualified residence interest deduction, as amended by the ’86 Act. Reg. § 1.163-10T provides two methods for determining a taxpayer’s qualified residence interest when the debt exceeds the applicable limitation: a simplified method and an exact method.
- Under the simplified method, interest on all secured debts is multiplied by a fraction, the numerator of which is the adjusted purchase price of the qualified residence and the denominator of which is the sum of the average balances of all secured debts (to take account of the OBRA changes, see below, the $1,000,000 acquisition indebtedness limit and the $100,000 home equity indebtedness limit must be substituted for the adjusted purchase price). When the simplified method is used, a taxpayer is required to treat interest on all excess debt as personal interest.
- Under the exact method, the amount of qualified residence interest is determined on a debt-by-debt basis by comparing the applicable debt limit for the debt to the average balance of each debt. The applicable debt limit is an amount that is different for each debt and is the lesser of the fair market value of the residence on the date the debt is secured and the adjusted purchase price of the qualified residence at the end of the tax year, reduced by the average balance of each debt that was previously secured by the qualified residence. If the average balance of the debt doesn’t exceed the limitation for that debt, all the interest on that debt is qualified residence interest. If the average balance of the debt exceeds the limitation, the amount of qualified residence interest is determined by multiplying the interest paid or accrued with respect to the debt by a fraction, the numerator of which is the applicable debt limit for that debt and the denominator of which is the average balance of the debt. Under the exact method, a taxpayer is allowed to treat interest on debt that exceeds the limitations according to the use of the debt proceeds under the interest tracing rules in Reg. § 1.163-8T.
The qualified residence interest deduction provision in the ’86 Act was amended by the Omnibus Budget Reconciliation Act of ’87 to allow a deduction for qualified residence interest for up to $1,000,000 of acquisition indebtedness and $100,000 of home equity indebtedness. The legislative history to the OBRA changes anticipated that IRS would issue regs describing the proper method for allocating interest on excess amounts of debt. Until such regs were issued, the legislative history provided that a reasonable method of allocation should be used.
After the OBRA changes, IRS issued Notice 88-74, 1988-2 CB 385, and published Publication 936, Home Mortgage Interest Deduction, to provide guidance the qualified residence interest deduction. Under the worksheet in Pub 936, taxpayers use a method similar to the simplified method in Reg. § 1.163-10T(d), but unlike the reg, Line 13 of the worksheet provides that the part of secured indebtedness that isn’t qualified residence interest may be allocated in accordance with the use of the proceeds of the debt.
Both Reg. § 1.163-10T(o) and Pub 936 state that taxpayers may make an election to treat a debt that is secured by a qualified residence as not secured by a qualified residence. The election must apply to the entire indebtedness, and the election is made by reporting the interest on the return as business interest or other deductible interest rather than qualified residence interest. Such an election allows interest on the debt to qualify as an “above the line” deduction (allowable in determining adjusted gross income) and also allows a debt that is allocable to trade or business expenses (and so deductible without the Code Sec. 163(h) deduction) to not “use up” the applicable limitation.
The question examined by the CCA was to what extent the temporary regs remain relevant to the calculation of qualified residence interest after the OBRA changes. For example, although the limitation is now $1,000,000 for acquisition indebtedness and $100,000 for home equity indebtedness, rather than indebtedness not in excess of basis increased by certain medical and educational debt, are the general methodologies provided in the regs still applicable, if modified to reflect the new limitations?
In the CCA, IRS concluded that since the legislative history indicates that, until regs are issued, a reasonable method of allocating debt in excess of the acquisition and/or home equity debt limitation may be used, taxpayers may use any reasonable method, including the exact and the simplified methods in the regs, the method in Pub 936, or a reasonable approximation of those methods. Further, a taxpayer may allocate the amounts that exceed the limitations in accordance with the use of the debt proceeds, as provided in Reg. § 1.163-10T(e)(4) and the instructions to line 13 of Pub 936.
Illustration: The CCA provides the following illustration of the exact method in Reg. § 1.163-10T(e), substituting the current statutory limits. A taxpayer owns one qualified residence that secures the following debts incurred in this order: first, $900,000 of acquisition debt; second, $250,000 of home equity debt allocated to personal expenditures; and third: $150,000 allocated to business expenditures The applicable debt limit for the first $900,000 debt is $1 million, all of the interest on which is deductible. The applicable debt limit for the second $250,000 debt is $100,000, 10/25ths of the interest on which is deductible. The applicable debt limit for the third $150,000 debt is 0 ($100,000 reduced by the previous $250,000 debt). However, since the third debt is allocable to business expenditures, interest on that debt would be deductible, regardless of whether the taxpayer had elected to treat the debt as not secured by the qualified residence, because under the exact method the taxpayer is allowed to treat interest that exceeds the limitation as traced to the particular expenditures for which the debt is used.
In addition, the CCA concluded that a taxpayer using the exact method, or any other reasonable method, isn’t required to make the election under Reg. § 1.163-10T(o)(5) in order to allocate the interest on the part of the debt that exceeds the qualified residence interest limitations under Reg. § 1.163-8T. Further, the Reg. § 1.163-10T(o)(5) election applies to the whole amount of a debt (not to part). When the election is made, the entire debt is treated as not secured by the residence. When the election isn’t made, only the part of the debt that exceeds the limitation is traced according to the use of the debt proceeds.
A taxpayer using the simplified method may allocate excess interest under the interest tracing rules of Reg. § 1.163-8T, as described in the instruction to line 13 of the worksheet in Pub 936, without making an election under Reg. § 1.163-10T(o)(5). The method provided for in Pub 936 is another reasonable method allowed by the legislative history.
Douglas Rutherford, CPA
© 2012 Douglas Rutherford, CPA. All Rights Reserved. Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA. Visit RealEstateAnalysisSoftwareBlog.com for more information and resources for successful real estate investing.