Guidance issued on interest exceeding acquisition and home equity indebtedness limitations.

• Author: Anderson, Kevin D.

The Tax Reform Act of 1986 imposed significant restrictions on the deduction of interest by enacting Sec. 163(h). Sec. 163(h)(1) provides that taxpayers (other than corporations) are not entitled to deduct personal interest. Sec. 163(h)(2) provides that the term "personal interest" means any interest other than trade or business interest, investment interest, passive activity interest, or qualified residence interest.

There are two types of home mortgage debt that produce deductible qualified residence interest: acquisition debt and home equity debt (Sec. 163(h)(3)). Acquisition indebtedness is debt secured to purchase, build, or substantially improve a qualified residence. Sec. 163(h)(3)(B)(ii) limits home acquisition indebtedness to $1 million ($500,000 in the case of a separate return filed by a married individual).

Home equity indebtedness is debt, other than acquisition indebtedness, secured by a qualified residence to the extent it does not exceed the fair market value of the qualified residence less the acquisition debt on such residence. Sec. 163(h)(3)(C) (ii) limits home equity indebtedness to $100,000 ($50,000 in the case of a separate return filed by a married individual).

Qualified residence interest is any interest paid or accrued during a tax year on debt that is secured by a principal residence and a second residence of the taxpayer. This second residence must generally be capable of being used by the taxpayer as a place to live. Temp. Regs. Sec. 1.163-10T(p)(3)(ii) defines a residence to include a house, condominium, mobile home, boat, or house trailer that contains sleeping space, a toilet, and cooking facilities.

Temp. Regs. Sec. 1.163-10T(o)(1) clarifies the term "secured debt." In general, debt is secured by a qualified residence when the property can be used to settle the debt should the borrower default on his repayment commitment. The security interest must be recorded, where permitted, or otherwise perfected under applicable state law.

Interest Allocation Issues

Interest allocation issues can generally arise when a taxpayer incurs mortgage indebtedness that exceeds the $1.1 million threshold. While temporary regulations were issued in 1987 (Temp. Regs. Secs. 1.163-9T and 1.163-10T) to provide guidance on the allocation of excess interest expense, more guidance was needed. As a result, shortly after the issuance of the temporary regulations, the IRS released Publication 936, Home Mortgage Interest Deduction, to...