Limits on Deductions for Investment and Personal Interest
The deductibility of investment and personal
interest is limited.
Investment Interest
Investment interest, generally defined as
interest used to buy or carry investment property, is deductible by noncorporate
taxpayers only to the extent of net investment income. Investment income
includes income such as dividends, interest and certain gain on the sale of
investment property but, for purposes of the investment interest deduction,
generally does not include net capital gain from disposing of investment
property (including capital gain distributions from mutual funds) or qualified
dividend income. Net capital gain is the excess of net long-term capital gain
for the year over the net short-term capital loss for the year. Qualified
dividend income is income from dividends that qualify to be taxed at the net
capital gain tax rates. However, the taxpayer can choose to include part or all
of net capital gain and qualified dividend income in investment income.
(Investment interest not allowed as a deduction for a tax year because of the
investment interest limit is treated as interest paid or accrued in the
following year and may eventually become deductible, either in the following tax
year or in some later year).
Election to Include Net Capital Gain and
Qualified Dividend Income in Investment Income
A taxpayer may elect to include all or part of
his net capital gain and qualified dividend income in investment income.
However, any amount that the taxpayer elects to include in investment income
does not qualify for the favorable maximum tax rates that apply to net capital
gain and qualified dividend income. Net capital gain and qualified dividend
income is reduced (but not below zero) by the amount the taxpayer elects to take
into account as investment income to permit investment interest deductions.
(Taxpayers in the 25% or higher brackets, who expect to have sufficient other
investment income in 2010 to take unused investment interest deductions, may
want to forego the election in 2009. In deciding whether to make the special
election, taxpayers whose marginal rate is 25% or higher should compare the
relative tax benefits of:
· postponing
the interest deduction to a later year, or
· giving
up the benefit of the maximum capital gain and qualified dividend income rate
ceilings.
Their calculations should take into account
the time value of money, the length of the deferral and the taxpayer’s top tax
brackets for 2009 and for the year that the investment interest is likely to be
deducted).
Personal Interest
Personal interest is not deductible. This
includes all interest except:
· interest
connected with a trade or business (but not interest paid on a tax deficiency
arising from an unincorporated business),
·
investment interest,
· passive
activity interest,
·
qualified residence interest,
· interest
on qualifying higher-education loans, and
·
otherwise deductible interest on
deferred estate tax payments.
Passive Activity Loss Rules
Interest may also be subject to passive
activity loss rules. The passive activity loss and investment interest rules
dovetail in such a way that any interest, other than personal interest,
qualified residence interest, estate tax interest, or interest relating to a
trade or business in which the taxpayer materially participates, is subject to
one of the two rules. The application of the investment interest limitation is
described above. Interest that relates to a passive activity is subject to the
passive activity rules.
Qualified Residence Interest
One kind of interest that remains deductible
is qualified residence interest. This term includes interest on debt secured by
the taxpayer’s principal residence and one other qualified residence (including
a trailer or houseboat). If the taxpayer has a principal residence and two or
more other residences, he can choose each year which of the other homes
qualifies as his second residence.
Qualified residence interest includes
acquisition debt and home equity debt with respect to a taxpayer’s qualified
residence. The maximum amount of acquisition debt is $1,000,000. Home equity
debt cannot exceed $100,000 (or, if less, taxpayer’s equity in the home). Under
a grandfather provision, pre-October 14, 1987 mortgage debt (regardless of
amount) is treated as acquisition debt.
Acquisition debt is debt that is incurred in
acquiring, constructing or substantially improving the principal or second
qualified residence of the taxpayer and which is secured by the residence. If
the debt to acquire, construct or substantially improve a principal and second
residence exceeds $1,000,000, then only the interest on a total principal amount
of $1,000,000 is deductible as interest on acquisition debt.
You cannot deduct the interest for acquisition
debt greater than $1 million ($500,000 for married individuals filing
separately). So, for example, if you were to buy a $2 million house with a $1.5
million mortgage, only the interest that you pay on the first $1 million in debt
will be deductible. The rest will be considered personal interest and not
deductible.
Note also that the $1 million ceiling on
deductible home mortgage debt includes both your primary residence and your
second home combined.
Acquisition indebtedness is defined by code
section 163(h)(3) as any indebtedness which is incurred in acquiring,
constructing, or substantially improving any qualified residence of the
taxpayer, and is secured by such residence. In other words if you
borrowed $500,000 from the bank and secured this loan with your primary
residence and further used the $500,000 to acquire a vacation home in Wisconsin,
a literal reading of the code would conclude that the interest expense on this
$500,000 loan would be non-deductible personal interest and this is because the
Wisconsin residence does not secure such debt. The interest on this same loan
would be fully deductible simply by securing the loan by the Wisconsin
residence.
We have seen many clients borrowing on their
principal residence in order to acquire a second home in the last few years. In
order to be able to deduct this interest expense you must make sure that the
debt is secured by the second home. While this may seem unnecessary, we have
reached our conclusions after receiving second opinions on this issue from a law
firm as well as directly from the IRS.
A residence under construction may be treated
as a qualified residence for a period of up to 24 months, but only if it becomes
a qualified residence as of the time it is ready for occupancy. The 24-month
period referred to above may begin on or after the date construction began.
Example:
X owns a residential lot. On April 20 of year 1, X obtains a mortgage loan
secured by the lot and any property to be constructed on the lot. He uses
the proceeds of the loan to finance the construction of a vacation home on the
lot. Construction commences on August 9 of year 1. The vacation home is ready
for occupancy on November 9 of year 3, and qualified as X’s second residence at
that time. Under these circumstances, X may treat the vacation home as a second
residence for any 24-month period during which it was under construction. This
24-month period may commence on or after the date construction began (August 9
of year 1). If X chooses to begin this 24-month on August 9 of year 1, the
period ends on August 8 of year 3. Whether the vacation home is a qualified
residence for the period August 9 – November 8 of year 3 is determined without
regard to the “under construction” rules.
If you are planning to refinance your
mortgage, special rules apply. If the old mortgage that you are refinancing is
home acquisition debt, your new mortgage will also be home acquisition debt, up
to the principal balance of the old mortgage just before it was refinanced. The
interest on this portion of the new mortgage will be deductible. Any debt in
excess of this limit will not be home acquisition debt. In other words, a
taxpayer who refinances cannot take down additional cash and have it count as
acquisition indebtedness. Acquisition indebtedness may be refinanced to take
advantage of lower rates or more favorable terms. As long as there is no
additional amount of indebtedness the new debt is also treated as acquisition
indebtedness. In general, points that you pay to refinance your home are not
fully deductible in the year that you paid them. Instead, you can deduct a
portion of these points each year over the life of the loan.
Home Equity Debt
Home equity debt is debt (other than
acquisition debt) secured by the taxpayer’s principal or second residence.
Interest on home equity debt is deductible even if the proceeds are used for
personal purposes.
Tracing of Interest
Temporary regs on allocating interest expense
for purposes of the limitations on passive activity losses, investment and
personal interest employ a system of tracing disbursements of debt proceeds to
specific expenditures. This generally means that the allocation of interest
depends on how the debt proceeds are used. An exception to this rule applies to
qualified residence interest, the allocation of which is governed by the
security (i.e., the residence) given for the debt. Taxpayers can take advantage
of these rules by using loan proceeds for deductible purposes, or by using home
equity debt as the source of personal expenditures.
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