IRS Expands Rules on Deductible Home-Equity Debt

By ALISTAIR M. NEVIUS - Journal of Accountancy

In Revenue Ruling 2010-25, the IRS ruled that a taxpayer can deduct as qualified residence interest up to $1.1 million of the debt securing the purchase of a taxpayer’s principal residence.

While personal interest is nondeductible, qualified residence interest, which includes both interest on acquisition indebtedness and home-equity indebtedness, is generally deductible. IRC § 163(h)(3)(B) provides that the total amount treated as acquisition indebtedness cannot exceed $1 million for any period ($500,000 for a married individual filing separately), and any indebtedness in excess of $1 million is not acquisition indebtedness. Section 163(h)(3)(C) provides that home-equity indebtedness for any period cannot exceed $100,000 ($50,000 for a married individual filing separately).

Home-equity indebtedness is indebtedness other than acquisition indebtedness secured by the taxpayer’s principal or secondary residence, to the extent the aggregate amount of the debt does not exceed the excess of the fair market value of the residence over the amount of acquisition indebtedness.

Revenue Ruling 2010-25 discusses a factual scenario in which an unmarried individual purchases a principal residence for $1.5 million with a cash down payment of $300,000 and a bank loan of $1.2 million secured by the residence. The taxpayer pays interest that accrues on the indebtedness, and there is no other debt outstanding that is secured by the principal residence. The ruling concludes that the taxpayer may deduct the interest paid on the first $1 million of the original loan balance because it is considered acquisition indebtedness, but, under the ruling, the taxpayer may also deduct the interest paid on $100,000 of the remaining debt of $200,000 because the first $100,000 loan amount in excess of home acquisition indebtedness is considered home-equity indebtedness. Any interest on the remaining indebtedness of $100,000 is considered nondeductible personal interest under section 163(h)(1) because it cannot be traced to any source other than the personal residence, which has already reached its limits.

CONCLUSION

The IRS provided much-needed clarification by issuing Revenue Ruling 2010-25, in which it states that it will not follow earlier Tax Court decisions (Pau, TC Memo 1997-43; and Catalano, TC Memo, 2000-82), which had held that indebtedness incurred to acquire, construct or substantially improve a taxpayer’s residence could qualify only as acquisition indebtedness. The IRS disagrees with the Tax Court’s holding in Pau that taxpayers must demonstrate that debt treated as home-equity indebtedness “was not incurred in acquiring, constructing, or substantially improving their residence.”

As the IRS explained, the definition of home-equity indebtedness in IRC § 163(h)(3)(C) contains no such restrictions, and, as a result, the IRS will determine home-equity indebtedness consistent with the provisions of Revenue Ruling 2010-25, notwithstanding the decisions in Pau and Catalano. Indebtedness incurred by a taxpayer to acquire, construct or substantially improve a qualified residence can constitute home-equity indebtedness to the extent it exceeds $1 million (subject to the applicable dollar and fair market value limitations imposed on home-equity indebtedness).

For a detailed discussion of the issues in this area, see “Interest on Home-Equity Indebtedness,” by Assimina D. Kiouressis in the May 2011 issue of The Tax Adviser.

—Alistair M. Nevius, editor-in-chief
The Tax Adviser