Special Situations for Deducting Home Mortgage Interest

The tax rules seem pretty straightforward when it comes to deducting home mortgage interest. Homeowners can deduct interest on acquisition indebtedness (a loan to buy, build, or substantially improve a principal residence and one other personal residence designated annually by the homeowners) of up to $1 million ($500,000 for married filing separately). They can also deduct up to $100,000 of home equity debt (any other debt secured by the residence) ($50,000 for married filing separately). Simple enough, except when it comes to real-life situations. Here are some recent cases that explored the boundaries of these rules in the context of somewhat unusual situations.

Co-owners not married to each other

Two individuals who were not married to each co-owned two homes with indebtedness of about $2.7 million. Each wanted to deduct interest on $1.35 million (no more than $1 million would have be applied by each owner for a residence).

Here, the Tax Court imposed a per residence limit on the deduction for mortgage interest. This means that no more than $1.1 million of total indebtedness (acquisition and home equity) can be taken into account for the principal residence or for the designated second residence.

Nonowner who pays the mortgage

Parents purchased a home as a family residence and their son contributed toward the purchase price. However, only the parents were on the title to the home. He orally agreed to be responsible for the mortgage payments with the understanding that he would later be given a legal interest in the property (which he was given). He lived in the home and made the mortgage payments; he deducted the interest.

Here, the Tax Court allowed him the take the deductions because he was viewed as the “beneficial owner” of the property. He had rights and responsibilities that made him the equitable owner.

Married filing separately

A taxpayer purchased a home with her father-in-law. She used her own funds to make the purchase and paid all of the interest on the $1 million mortgage. She lived in the home with her husband, who did not own any other home. She deducted all of the interest, arguing that the married-filing-separately limit did not apply to her because her husband did not take any mortgage interest deduction. She reasoned that the purpose of the limitation was to prevent married persons who filed separately from each using the $1 million limit.

Here, the Tax Court says no way! The black letter of the law is clear: Married people who choose to file separate returns are subject to a $500,000 acquisition indebtedness limit.

Figuring interest in the face of excess debt

When the debt exceeds the allowable limits, figure the mortgage interest deduction using any reasonable method. The regulations provide two methods; IRS Publication 936 has one method. For example, in this publication, a homeowner figures the qualified loan limit, which cannot be more than $1.1 million ($550,000 if married filing separately). Then this amount is divided by the average balances on all mortgages on all qualified homes. The result, rounded to three places, is used to multiply the amount of interest paid to find your deductible home mortgage interest. When in doubt, consult with a tax advisor.