Debt on Home Purchase Can Be Home Equity Debt and Acquisition Debt As Well

November 3, 2010

As a result of a new revenue ruling, taxpayers can now deduct the interest on up to $1.1 million of debt securing the purchase of a principal residence. The ruling states that acquisition indebtedness incurred by a taxpayer to buy, build, or substantially improve a qualified residence can also qualify as home equity indebtedness under to the extent it exceeds $1 million.

Acquisition indebtedness is indebtedness incurred to buy, build, or substantially improve an individual's qualified residence that is secured by the residence. Prior to now, the total amount treated as acquisition debt could not exceed $1 million for any period ($500,000 for a married individual filing separately). The total amount treated as home equity indebtedness for any period cannot exceed $100,000 ($50,000 for a married individual filing separately). Unlike acquisition debt, home equity indebtedness generally may be used for any purpose without affecting its deductibility. However, where not used to acquire or improve the residence, it may not be deductible for alternative minimum tax purposes if the borrowing cannot be traced to a deductible use.

In Peter S. Pau, et ux. v. Commissioner, TC Memo 1997-43, the Tax Court addressed the issue of whether a taxpayer who purchased a principal residence with a mortgage in excess of $1,100,000 could not deduct the interest on more than $1,000,000 of such borrowing. The Tax Court did not allow any deduction for interest on the portion of the borrowing in excess of the $1 million acquisition limit, indicating that home equity indebtedness is debt other than acquisition
indebtedness. The IRS had also previously ruled that interest on any portion of a home acquisition loan, or loans, in excess of $1 million was not deductible as qualified residence interest.

On October 14, 2010, the IRS issued Revenue Ruling 2010-25 in response to this and another earlier case. The ruling concluded that a hypothetical taxpayer purchasing a $1,500,000 principal residence for $300,000 in cash and a mortgage of $1,200,000 may deduct the interest paid on $1 million of the loan because it is acquisition debt, and that such taxpayer may also deduct the interest paid on $100,000 of the remaining debt of $200,000, since it is home equity debt.

In Revenue Ruling 2010-25, the IRS formally states that it will not follow the holding of the Tax Court in Pau because the Tax Court's holding was based on the incorrect assertion that taxpayers must demonstrate that debt treated as home equity indebtedness "was not incurred in acquiring, constructing or substantially improving their residence." The definition of home equity indebtedness in IRC Sec. 163(h)(3)(C) contains no such restrictions, and as a result, the IRS indicated it will determine home equity indebtedness consistent with Revenue Ruling 2010-25.

Taxpayers that limited their qualified residence interest deductions in line with the Tax Court's position should consider filing amended returns for open years.

For more information, please contact your Perelson Weiner partner.

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