T RUST & TAX N OTES
Newsletter / Second Quarter 2006
The Home Mortgage Interest Deduction
For most individual taxpayers the two biggest federal income tax deductions are the itemized deductions for state
and local taxes and mortgage interest. This article will focus on some of the intricacies of the interest deduction. In
general, to be deductible as mortgage interest, the interest must accrue and be paid on debt that meets the Internal
Revenue Code definition of “acquisition indebtedness,” i.e., debt incurred by the taxpayer to finance the acquisi-
tion, construction or improvement of the taxpayer’s qualified residence. As is often true, the devil is in the detail
and careful planning pays off.
The total amount of acquisition indebtedness that will produce a mortgage interest deduction is limited under the
Code to $1,000,000 regardless of whether the taxpayer is single or married. Practically this means a taxpayer
receives no federal income tax benefit for acquisition indebtedness in excess of $1,000,000.
Example: A couple buys a home worth $2,500,000. Assuming the couple can finance as much of the purchase
price as they desire at a 6% annual interest rate, the couple’s initial mortgage interest deduction will be the
same whether they finance 40% ($2,500,000 x 40% = $1,000,000) of the acquisition price or 80%
($2,500,000 x 80% = $2,000,000) of the acquisition price because of the $1,000,000 cap placed on mortgage
debt that can generate interest deductibility. The couple’s decision of whether to finance the second $1,000,000
is purely an economic decision as there is no income tax benefit to financing more than $1,000,000 of the
In order for the debt to qualify as acquisition indebtedness, the lender must take a security interest (i.e., a mort-
gage) in the taxpayer’s residence to secure repayment of the debt. Moreover, the lender must take steps to perfect
the security interest, which usually means the mortgage must be recorded in the place adopted by the state for
recording mortgages, such as the county courthouse.
Improvements to a family’s residence bring into play similar considerations. Acquisition indebtedness is incurred
not only when a home is acquired, but also when the home is substantially improved. Again, a taxpayer receives
no federal income tax benefit if the total debt on the residence, including debt incurred to substantially improve
the residence, exceeds $1,000,000.
Example: The same couple as above decides that, rather than sell their existing residence, they will remodel
it to meet the needs of their family. Assume the couple has paid down the principal balance of the mortgage
it incurred to purchase their residence to $750,000. Assume further that the estimated cost of the improve-
ments is $500,000 and the couple is in a position to finance some or all of the cost of the improvements. The
couple will derive an income tax benefit from financing up to, but no more than $250,000 of the cost of
improvements. This is because debt incurred to finance the improvements will be deductible only to the extent
that, when added to the existing acquisition indebtedness, it does not exceed $1,000,000.
Acquisition indebtedness produces deductible mortgage interest provided it is incurred to acquire, construct or
improve a taxpayer’s “qualified residence.” The Code defines a qualified residence as the taxpayer’s principal res-
idence (i.e., the home in which the taxpayer establishes a domicile for income tax purposes) and one other resi-
dence owned by the taxpayer. For purposes of deductibility, a taxpayer can aggregate the acquisition indebtedness
of the taxpayer’s domicile plus one other home for purposes of determining deductible mortgage interest in any
Example: Assume a couple owns a primary residence with a purchase money mortgage principal balance of
$750,000 and a lake house with a purchase money mortgage principal balance of $400,000, both with an
annual interest rate of 6%. The couple can deduct mortgage interest totaling $60,000 this year ($1,000,000
x 6%) for federal income tax reporting purposes. The couple would be unable to deduct, as mortgage inter-
est, the additional $9,000 (($1,150,000–$1,000,000) x 6%) of interest paid this year.
Example: Assume the same couple owns a primary residence with a purchase money mortgage principal balance
of $450,000, a lake house with a purchase money mortgage principal balance of $350,000 and a beach house
with a purchase money mortgage principal balance of $200,000. Because the couple can only deduct mortgage
interest paid on two residences, the couple can only deduct mortgage interest paid on up to $800,000 worth of
acquisition indebtedness — the balance on their principal residence mortgage plus the higher balance outstand-
ing on their two vacation homes. One option the couple might have considered when they purchased their third
home was to finance $550,000 of the purchase price (assuming it cost at least that much) and pay off the debt
on their second home. Then their entire $1,000,000 of debt would have generated deductible interest.
Rental of Home
What if the taxpayer wants to use a second home and also rent it to others from time to time? It is possible for a
rental property to qualify as a second qualified residence provided it is used by the taxpayer for a number of days
exceeding the greater of 14 days or 10% of the number of days the residence is rented during a tax year.
What if a taxpayer wants to purchase a lake house with another purchaser? Nothing in the Code requires the tax-
payer to own the entire residence to deduct the interest incurred on a purchase money mortgage. Mortgages taken
out to purchase, construct or improve the lake house should be proportionately deductible by both co-owners of
the property provided the property qualifies as a residence. For example, if the second home is rented out period-
ically, it must meet the personal use requirement described in the preceding paragraph.
As stated above, mortgage interest is not deductible unless the mortgage is incurred to purchase, construct or
improve one or two personal residences. Many people mistakenly assume they can access the equity in their home
and deduct the mortgage interest they pay if the lender takes a mortgage against the residence. This is not neces-
sarily so, as a post-acquisition loan does not usually constitute acquisition indebtedness. Only debt incurred to
acquire, construct or improve a qualified residence is tax deductible as mortgage interest. Debt incurred very
shortly after the purchase of a home (i.e., within 90 days) can also be treated as acquisition indebtedness.
Page 2 Trust & Tax Notes 2Q/20 06
Home Equity Indebtedness
A homeowner can take out a loan against existing equity in her home, e.g., in the form of an equity line of credit,
and deduct the interest on the first $100,000 of debt regardless of how the money is used. This constitutes
deductible home equity indebtedness and, like acquisition indebtedness, is only deductible if the lender secures
repayment of the equity line by taking a mortgage on the home. Careful thought should be given before taking
out a home equity line of credit for income tax purposes. First, home equity lines are usually subordinate to a pur-
chase money mortgage, which usually results in a higher rate of interest. Second, and more importantly from a
tax perspective, interest paid on home equity indebtedness constitutes a preference item for purposes of determin-
ing a taxpayer’s Alternative Minimum Tax (“AMT”) liability.
Example: Assume the couple in the foregoing examples prefers not to carry debt of any kind. In the early years
of their marriage they conscientiously pay off their student loans, automobile loans and even the $1,000,000
mortgage they originally incurred to purchase their personal residence. Through a social contact, the wife learns
of a wonderful opportunity available to her and her husband to make what they consider a surefire real estate
investment in a land company run by a local developer. The couple evaluates their options for raising the cap-
ital to make the investment. They quickly discover they would incur significant state and federal capital gains
taxes if they liquidated their investment portfolio. And if they borrowed the funds from their parents, that
would cause their parents to recognize significant ordinary income in the form of interest payments on a per-
sonal loan. The simplest, and in this case, most economical means of raising the capital is to borrow against
the equity the couple has established in their personal residence. However, the interest they must pay on
$900,000 of the loan will not be deductible as the borrowed funds will not be used by the couple to purchase,
construct or improve a qualified residence.
What could the couple do or have done differently to maximize their after-tax accumulation of wealth? One option
available to the couple is to sell their home, purchase a new home with a purchase money mortgage, and invest
the proceeds from the sale of their home in the real estate investment partnership. A second option would have
been not to pay off their mortgage to begin with but rather to have saved their $1,000,000 and invested it con-
servatively until the investment opportunity presented itself.
There is both a financial and psychological component to living with a mortgage. Many people prefer the secu-
rity of knowing that, whatever their debts, they own their home outright. Regardless of how the numbers work
out, some people may nonetheless choose to pay off their home mortgages as soon as possible. For someone who
doesn’t mind the risk associated with carrying a mortgage debt, a tax adjusted return comparison will help decide
what to do. For example, what if the couple had not paid off their mortgage but had instead saved the money they
would have applied to pay off the mortgage. Assume their mortgage rate on the $1,000,000 mortgage was a thirty
year fixed rate of 6.50% and assume they are in a 35% combined state and federal marginal income tax rate. To
come out ahead, they would have to earn a pre-tax return on their investments of 6.5%, or an after-tax return of
4.225% (6.50% x (1-0.35)). Tax adjusting the cost of carrying the mortgage provides the couple with a bench-
mark for evaluating the investment.
As evidenced from the above examples, analyzing the tax consequences of financing real estate is very fact spe-
cific. The professionals at the Brothers Harriman Trust Companies are knowledgeable and experienced in assist-
ing you to navigate these financial decisions. We would be happy to help you assess your options.
By Brett D. Sovine, LLM, CPA
Trust & Tax Notes 2Q/20 06 Page 3
Wealth Management Planning Tips HARRIMAN TRUST
Planning Tip #533 — Tax Credit for Grandparent’s Tuition Payment (4/13/2006) COMPANIES
College savings planning tip courtesy of Kenneth Moy of Client Tax Services: Main 212.483.1818
Wealthy grandparents often find it makes tax sense to pay (directly to the col- James Bertles
lege) the college tuition expenses of their grandchildren, because these payments
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treated as if paid by the parent (if the parent claims the student as a dependent), 212.493.8988
or by the grandchild (if the parent forgoes claiming the student as a dependent).
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