The mortgage interest deduction is widely used by the majority of individuals who itemize their deductions. In fact, the size of the average mortgage interest deduction alone persuades many taxpayers to itemize their deductions. It is not without cause, therefore, that two recent developments impacting the mortgage interest deserve being highlighted. These developments involve new reporting requirements designed to catch false or inflated deductions; and a case that effectively doubles the size of the mortgage interest deduction available to joint homeowners. But first, some basics.

Mortgage Interest Deduction Ground Rules

Mortgage interest — or "qualified residence interest" — is deductible by individual homeowners. Qualified residence interest generally includes interest paid or accrued during the tax year on debt secured by either the taxpayer's principal residence or a second dwelling unit of the taxpayer to the extent it is considered to be used as a residence (a "qualified residence").

Qualified residence interest comprises amounts paid or incurred on acquisition indebtedness and home equity indebtedness. Acquisition indebtedness is debt that is both:

  1. secured by a qualified residence, and
  2. incurred in acquiring, constructing or substantially improving the residence.

Home equity indebtedness is any debt secured by a qualified residence that is not acquisition indebtedness to the extent of the difference between the amount of outstanding acquisition indebtedness and the fair market value of the qualified residence.

A qualified residence for purposes of the home mortgage interest deduction can be the principal residence of the taxpayer, and one other residence selected by the taxpayer. In other words, the deduction is limited to interest payments on two homes.

Qualified residence interest is subject to several dollar limitations:

  • The total acquisition indebtedness (principal) on which qualified residence interest is deductible is limited to $1 million ($500,000 in the case of married individuals filing separately).
  • The total amount of home equity indebtedness (principal) taken into account in calculating deductible qualified residence interest may not exceed $100,000 ($50,000 in the case of married individuals filing separately).

Information reporting. Mortgage service providers have been required to report only the following information to the IRS annually with respect to individual borrower:

  • the name and address of the borrower;
  • the amount of interest received for the calendar year of the report; and
  • the amount of points received for the calendar year and whether the points were paid directly by the borrower.

The amount of interest received by a mortgage service provider is reported on Form 1098, Mortgage Interest Statement, to the IRS. Form 1098 must also be furnished by the mortgage service provider to the payor on or before January 31 of the year following the calendar year in which the mortgage interest is received.

More Detailed Form 1098 Coming

The 2015 Surface Transportation Act (aka the Highway bill), which was signed into law on July 31, 2015, will require that Form 1098, Mortgage Interest Statement, filed with the IRS and provided to homeowners, include information on:

  1. the amount of outstanding principal of the mortgage as of the beginning of the calendar year,
  2. the address of the property securing the mortgage, and
  3. the loan origination date.

These items are in addition to the information that parties were already required to provide to the IRS and payors under existing law.

The Government Accountability Office (GAO) had expressed concern that the information reported on Form 1098 is insufficient to allow the IRS to enforce compliance with the deductibility requirements for qualified residence interest. This criticism has included in particular, but not limited to, the dollar limitations imposed on acquisition indebtedness and home equity indebtedness.

While the modifications are intended to boost compliance with the deductibility requirements for qualified residence interest, they also impose a new burden on mortgage service providers. To give mortgage service providers time to reprogram their systems, the additional reporting requirements apply to returns and statements required to be furnished after December 31, 2016.

Joint Ownership

Another major development impacting on some homeowners’ mortgage interest deduction also took place this summer. Reversing the Tax Court, a panel of the Court of Appeals for the Ninth Circuit has found that when multiple unmarried taxpayers co-own a qualifying residence, the debt limit provisions apply per taxpayer and not per residence (Voss, CA-9, August 7, 2015). The question was one of first impression in the Ninth Circuit, the court observed.

Background. The taxpayers, registered domestic partners, obtained a mortgage to purchase a house (the Rancho Mirage property). In 2002, the taxpayer refinanced and obtained a new mortgage. That same year, the taxpayers purchased another house (the Beverly Hills property) with a mortgage, which they subsequently refinanced and obtained a home equity line of credit totaling $300,000. The total average balance of the two mortgages and the line of credit during the tax years at issue was approximately $2.7 million.

Both taxpayers filed separate income tax returns. Each individual claimed home mortgage interest deductions for interest paid on the two mortgages and the home equity line of credit. The IRS calculated each taxpayer’s mortgage interest deduction by applying a limitation ratio to the total amount of mortgage interest that each petitioner paid in each taxable year. The limitation ratio was the same for both: $1.1 million ($1 million of home acquisition debt plus $100,000 of home equity debt) over the entire average balance, for each tax year, on the Beverly Hills mortgage, the Beverly Hills home equity line of credit, and the Rancho Mirage mortgage. The taxpayers challenged the IRS’s calculations but the Tax Court ruled in favor of the agency.

Court’s analysis. Code Sec. 163(h)(3), the court found, provides that interest on a qualified residence, by a special carve-out, is not considered "personal interest," which would otherwise be nondeductible by taxpayers who are not corporations. A qualified residence is the taxpayer’s principal residence and one other residence of the taxpayer which is selected by the taxpayer for the tax year and which is used by the taxpayer as a residence.

The court further found the Tax Code limits the aggregate amount treated as acquisition indebtedness for any period to $1 million and the aggregate amount treated as home equity indebtedness for any period to $100,000. In the case of a married individual filing a separate return, the debt limits are reduced to $500,000 and $50,000.

Looking at the language of the Tax code, the court found that the debt limit provisions apply per taxpayer and not per residence. There was no reason not to extend this treatment to unmarried co-owners, the court concluded. Thus, each of the homeowners were entitled to the $1 million limit.

Whether this holding will hold up in jurisdictions other than the Ninth Circuit (California and other western states, including Hawaii), and whether it will apply to joint ownership situations for vacation homes, for example, remains to be tested.

If you have any questions regarding how best to maximize your mortgage interest deduction, please do not hesitate to contact this office.