Managing Money : New Rules to Clarify Mortgage Deductions
Buying or refinancing a home is a complicated process, and tax-law changes last year involving mortgage interest deductions didn’t make matters any easier. Some homeowners have discovered to their dismay that their loans may not qualify for full interest deductions.
Fortunately, the Internal Revenue Service recently announced preliminary details of new rules soon to be published that will help clarify what can and cannot be deducted. These rules may particularly help you if you pay all cash for your home, build it yourself or buy out your divorcing spouse’s interest in your home.
The new rules will “allow for more flexibility in purchasing a house,” said Harvey Gettleson, tax partner in Century City for the accounting firm of Ernst & Whinney.
The rules will clarify restrictions passed by Congress late last year affecting mortgages taken out on or after Oct. 13, 1987. Interest on mortgages taken out before then remain fully deductible under old rules existing before the Tax Reform Act of 1986.
Under the new restrictions passed by Congress, original mortgages taken out after Oct. 13, 1987, are eligible for full interest deductions only up to a balance of $1 million for single individuals or couples filing joint tax returns, or $500,000 for members of couples filing separately.
Congress also limited the amount of second mortgages or home equity loans eligible for full interest deductions to $100,000 for singles or couples filing jointly, or $50,000 for members of couples filing separately, regardless of what the proceeds are used for. Amounts above those limits can also be eligible for deductibility if proceeds are used for home improvements.
But Congress left unclear whether you can combine the amounts eligible for your first and second mortgages into a new, larger, fully deductible first mortgage.
Fortunately, the upcoming IRS rules say you can. So let’s say you have a home valued at $250,000, with an outstanding balance of $50,000 on your original first mortgage. You can keep the original first mortgage and get a home equity loan or second mortgage for $100,000, or you can get a new first mortgage for $150,000.
You can even take out a bigger loan and have it fully deductible if you plan to use the excess proceeds for home improvements. So, in the above example, if you plan to make $10,000 in improvements, you can take out a new first mortgage for as much as $160,000, or a home equity loan for $110,000, and either is eligible for full deductibility.
You also can take out a bigger loan and have a shot at full deductibility if you use the excess for investments, a business or other purposes under which interest is deductible, notes Donald Stearns, partner at Kenneth Leventhal & Co., a Los Angeles accounting firm. (In general, investment interest is deductible only against investment income.)
So, in the above example, if you want to borrow $10,000 to buy stocks on top of the $10,000 for improvements, you could take out a new first mortgage for $170,000 or a home equity loan for $120,000. Interest on the last $10,000 will be subject to rules governing deductibility of investment interest.
The anticipated IRS rules also clarify what happens if you pay cash for your home, such as with money you already have or funds from an unsecured short-term loan, say from your Uncle Jimmy or your employer.
Such all-cash purchases are common, particularly in California. For instance, you may need to pay all cash to get the house over other potential buyers. Or you may get a better price if you buy on an all-cash basis. Or you may be relocated by your employer, who gives you a short-term loan to buy a house.
Under the coming IRS rules, if you apply for a long-term loan within 90 days of closing of escrow to, in effect, reimburse yourself or pay off the short-term loan, the new loan can qualify for interest deductions. It must be funded within 30 days of approval and be secured by your home.
If you wait longer than 90 days, you’re out of luck. Your loan will then be treated as if it’s a home equity loan or second mortgage, subject to the $100,000 limitation on deductibility.
The IRS rules will also clarify what happens if you build your home. Monies spent within 24 months of the completion of the home are eligible to be included in a fully deductible mortgage, as long as that mortgage is taken out within 90 days of completion of construction.
Say, for example, you spent $50,000 to buy a lot in January, 1989, and $100,000 to build your home between then and January, 1991, when the home is completed. You could get a loan for $150,000 to cover those costs, and all interest would be fully deductible. But if the home is finished after that date, the $50,000 for the lot may be eligible for deductibility only under certain complicated rules, IRS spokesman Jeff Krasney says.
The IRS rules also clarify what happens if you are in the process of a divorce. If you buy out your spouse’s share of your jointly owned home, you can deduct interest on a loan obtained to gain full ownership, subject to all other limitations.
