Home Purchase Debt can be Equity and Acquisition Debt

A new IRS interpretation 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 163 if it exceeds $1 million. As a result, a taxpayer can deduct up to $1.1 million of the debt securing the purchase of his principal residence.

Generally, Personal interest is nondeductible but qualified residence interest, which includes interest on acquisition indebtedness and home equity indebtedness, is deductible. Acquisition indebtedness is indebtedness incurred to buy, build, or substantial improve an individual’s qualified residence that is secured by the residence. The total amount treated as acquisition debt can’t exceed $1 million for any period ($500,000 for a married individual filing separately). Home equity indebtedness is indebtedness (other than acquisition indebtedness) secured by taxpayer’s qualified residence, to the extent the aggregate amount of the debt doesn’t exceed the fair market value (FMV) of the residence, as reduced by the amount of acquisition indebtedness on it. The total amount treated as home equity indebtedness for any period can’t 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.

In Pau, TC Memo 1997-43 and Catalano, TC Memo 2000-82 , the Tax Court addressed the issue of whether a taxpayer’s indebtedness on the purchase of a residence in excess of $1 million could qualify as home equity indebtedness. The Tax Court decided it could not. Based on the definition of home equity indebtedness, which in turn is based on the definition of acquisition indebtedness, the Court said home equity indebtedness as defined in 163 is debt other than acquisition indebtedness. Thus, no deduction in excess of the $1 million acquisition limit was allowed where the debt was incurred in acquiring, constructing or substantially improving their residence. (In Field Service Advice 200137033 , IRS had also 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.)

Facts. In 2009, Taxpayer bought a principal residence for $1,500,000, paying $300,000 in cash and borrowing the remaining $1,200,000 through a loan that was secured by the residence. Taxpayer has no other debt secured by the residence.

Taxpayer-favorable result. IRS opinion states that Taxpayer may for 2009 deduct the interest he pays on $1 million of the loan because it is acquisition debt under 163. He also may for 2009 deduct the interest he pays on $100,000 of the remaining debt of $200,000, since it is home equity debt. The $200,000 (a) is not acquisition debt, and (b) does not exceed the FMV of the residence reduce by the acquisition debt secured by the residence.

IRS formally states that it will not follow the holding of the Tax Court in Pau and Catalano. IRS says that 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 in163 contains no such restrictions, and as a result, IRS will determine home equity indebtedness consistent with  its opinion, notwithstanding the decisions in Pau and Catalano.

Taxpayers that restricted their qualified residence interest deductions in line with the Tax Court’s position in Pau and Catalano should file amended returns for open years.