Ownership

• Jurisdiction: Maryland

III. OWNERSHIP

A. Interest and Taxes

1. [§ 8.16] Generally

As stated in § 8.1 of this chapter, the scheme of federal and state income tax is designated to facilitate homeownership, and the government gives an economic incentive through the tax system which encourages the residential renter to become an owner. Homeownership holds a special place in the American taxpayer's psyche and expectations and, therefore, in our legislators' hearts. This is seen again and again in the survival of this social engineering. While severe limitations now generally apply to the deduction of interest, interest on an individual's home mortgage and second home mortgage remains largely protected.³⁷ The survival of the residential mortgage interest deduction is to be contrasted with the disallowance of "personal interest," i.e., installment debt interest on other consumer purchases, and the matching of the deduction for "investment interest" only against "investment income."

2. [§ 8.17] Personal interest

The 1986 Tax Reform Act added I.R.C. § 163(h) which disallows a deduction for personal interest paid or accrued by noncorporate taxpayers. For purposes of I.R.C. § 163(h), the term "personal interest" generally includes any interest allowable as a deduction for income tax purposes other than a list of exceptions. One important exception is "qualified residence interest."³⁸ I.R.C. § 163(h)(3) defines "qualified residence interest" as interest paid or accrued during the taxable year on debt that is either (1) "acquisition indebtedness," or (2) "home equity indebtedness" with respect to any qualified residence. Qualified residence interest is limited to an aggregate principal amount of acquisition indebtedness of $1 million ($500,000 for a married individual not filing a joint return), except that for tax years 2018 through 2025, I.R.C. § 163(h)(2)(F), which was added to I.R.C. § 163 as part of the tax legislation informally known as the Tax Cuts and Jobs Act, Pub. L. No. 115-97 ("TCJA"), reduces this amount for certain indebtedness to $750,000 ($375,000 for a married individual not filing a joint return).³⁹ Home equity indebtedness is limited to the aggregate principal amount of indebtedness of $100,000 ($50,000 for a married individual not filing a joint return),⁴⁰ except that for tax years 2018 through 2025, I.R.C. § 163(h)(3)(F)(i)(I) (added as part of the TCJA) bars deductions for interest paid or accrued on home equity indebtedness.

3. [§ 8.18] Acquisition indebtedness and home equity indebtedness interest

Subject to the limitations described above, interest paid or accrued on acquisition indebtedness and home equity indebtedness is deductible generally to the extent that the debt does not exceed the purchase price plus improvements. In particular, the term "acquisition indebtedness" means any indebtedness which is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer and is secured by such qualified residence.⁴¹ The term also includes any indebtedness secured by such residence resulting from the refinancing of indebtedness meeting the above requirement, but only to the extent that the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.⁴² Thus, acquisition indebtedness cannot be increased by refinancing, but can be increased by amounts expended for substantial improvements to a qualified residence. Similarly, the term "home equity indebtedness" means any indebtedness (other than acquisition indebtedness) secured by a qualified residence to the extent that the aggregate amount of such indebtedness does not exceed the fair market value of such residence, reduced by the amount of acquisition indebtedness with respect to such residence.⁴³ Thus, interest upon a second mortgage will qualify to the extent the new mortgage is equal to the equity in the home (up to a maximum of $100,000, and subject to the limitations described above). For example, if a taxpayer has an acquisition indebtedness mortgage balance of $80,000 on their home which has a fair market value of $290,000 as of January 1, 2026, and they obtain a home equity indebtedness second mortgage of $150,000, interest on up to $100,000 of the new mortgage is deductible; interest on the remaining $50,000 is personal interest.⁴⁴

4. [§ 8.19] Pre-Oct. 13, 1987 indebtedness

In the case of any pre-Oct. 13, 1987 indebtedness, the $1 million limitation of I.R.C. § 163(h)(3)(B) is subject to further reduction.⁴⁵ In such case, the $1 million limitation shall be reduced (but not below zero) by the aggregate amount of outstanding pre-Oct. 13, 1987 indebtedness.⁴⁶ Qualified residence interest, computed based upon the above limitations, has no bearing upon the computation of the taxpayer's passive activity loss.⁴⁷

5. [§ 8.20] Recordation and transfer taxes

State and local real property taxes may be deductible,⁴⁸ but I.R.C. § 164(b)(6), which was added by the TCJA, limits the deduction that an individual may claim for all state and local taxes under I.R.C. § 164(a) to $10,000 ($5,000 for married taxpayers not filing a joint return) for tax years 2018 through 2025. Real property taxes are deductible by cash basis taxpayers when paid and by accrual basis taxpayers when accrued. In contrast, transfer taxes incurred in buying the home, such as Maryland State Property Transfer Taxes, County Real Estate Transfer Taxes, and County Recordation Taxes are not real property taxes for purposes of I.R.C. § 164.⁴⁹ They are capitalized as part of the cost of the home.

6. [§ 8.21] The tax benefits of homeownership

The Internal Revenue Code allows for the reduction of both the costs of financing the purchase and the costs of ownership by allowing, subject to certain limitations such as those discussed above, a dollar-for-dollar reduction from gross income for all sums paid for mortgage interest and real estate taxes. This is available only to taxpayers who itemize deductions (Schedule A to Form 1040), and, since the year of purchase of a home may be the first return for which itemization of deductions would be worthwhile, other planning advice may be simply to identify allowable itemized deductions and the documentation that should be compiled to substantiate them. Since the taxpayer's failure to substantiate claimed deductions can lead to their disallowance, advice on maintaining records is valuable. This same advice should be given for the previously discussed capitalized adjustments to basis.

Where parents, for instance, want to subsidize their children's lifestyle, their payment of mortgage interest and real estate tax on the children's home does not give them the tax deduction. If, however, the parents are part owners of the home, the payments may become deductible.⁵⁰ For a taxpayer in the highest individual marginal tax bracket (37% for tax years 2018 through 2025), payment of $100 in mortgage interest or in real estate tax can be seen as effectively costing $63 since $37 would otherwise have been spent as income tax. The income tax system in effect subsidizes the homeowner by this diversion of tax money. The homeowner can live in more expensive surroundings than a renter at the same net cost since the government pays the difference. At the same time the homeowner has a capital asset which historically has been a sound investment.

7. [§ 8.22] Tax planning strategies

The subsidy of the two major carrying costs of homeownership and the allowance of a deduction for a casualty loss to a personal residence are major erosions to I.R.C. § 262, which prohibits deductions for "personal, living, or family expenses." This general rule otherwise limits the planning possibilities for seeking tax benefits from operational costs of a residence. Conversely, the sacrosanct deductibility of the home mortgage interest has spawned the "home equity" mortgage (i.e., second mortgage) for use as a revolving line of credit: paying off a credit card balance with a home equity draw makes interest deductible that would otherwise be nondeductible "personal interest." As noted above, however, this strategy is limited by the disallowance of interest deductions on home equity indebtedness under I.R.C. § 163(h)(3)(F) for tax years 2018 through 2025.

Some benefit for cash basis individuals may be achieved by timing one month's mortgage payment to come in the current or the next taxable year. The late payment fee charged by the mortgagee must be considered when evaluating the tax benefits from deferring a payment. Just as with payment of other deductible items, the deferral to a year of higher tax rates or higher marginal bracket makes the deduction save more tax. Conversely, postponement of a deduction delays the tax benefit, and the current tax savings may be more valuable than a greater benefit a year later.

An historical, time-honored planning device based upon the ruling⁵¹ of the IRS was to prepay up to five years' interest on a debt. Because interest was deductible, the prepayment would bunch the tax savings in the first year of a transaction and reduce the effective cost of the capital investment. After many years of complacency, the IRS in 1968 reversed its acceptance of this tactic.⁵² After a series of litigation victories finding the prepayment a distortion of income,⁵³ and after the passage of an amendment to the then-current Internal Revenue Code of 1954, the law is now that the interest deduction accrues rat-ably over the prepaid period, notwithstanding that the taxpayer is on the cash payment method of accounting,⁵⁴ subject to the limitations on interest deduction applicable in the year of accrual.

B. Casualty Loss

1. [§ 8.23] Generally

The other area of tax benefit allowed to the homeowner is the deduction for loss arising from "fire, storm, shipwreck, or other casualty, or from theft."⁵⁵ The excess of the loss over $100 as to each casualty is a current deduction. While the availability of the tax...