Published On: March 16th, 2013 / Categories: Mortgage deductions /

One of the most popular and well-known advantages of home ownership is the income tax deduction you can take for the interest you pay on your home mortgage.  Less well known, however, are the limitations placed on this deduction.  In Silicon Valley, where home values and the mortgages used to acquire those homes are significantly higher than in many other areas of the United States, these limits could have a significant impact on the value to you of this deduction.

Home Mortgage Interest DeductionThe general rule is that this deduction is allowed for interest you pay on a “qualified residence,” which is defined as your principal residence together with one other residence.  The second residence is often, but not always, a vacation home. The key to whether a second residence qualifies for the deduction is usually your using the second residence for your own enjoyment as opposed to using it to generate income by renting it out to others.

Even for a qualified residence, however, this deduction is not unrestricted.  What you may not know is that the amount of interest you can deduct has a cap, which is based on the principal amount of the mortgage outstanding.  Roughly speaking, you can deduct the interest you pay on up to $1,100,000 in mortgage debt. Here’s how to calculate it:

First, the amount of the deduction for “acquisition indebtedness,” which is the mortgage debt you incurred to acquire, construct, or substantially improve a qualified residence, is limited to the interest you pay on debt up to $1,000,000.

Second, the amount of the deduction for “home equity indebtedness,” which is any mortgage debt secured by the qualified residence other than the acquisition indebtedness, is limited to whichever is less of a) the interest you pay on the $100,000 in debt, or (b) the amount of the fair market value of the qualified residence in excess of the amount of your acquisition indebtedness.

Now, this is all well and good for someone who buys a $2,000,000 home here and takes out $1,000,000 in acquisition indebtedness and $100,000 in home equity indebtedness: all of the interest on this mortgage debt is deductible.  But what happens if two unmarried people decide to buy a $4,000,000 home here and jointly take out a total of $2,000,000 in acquisition indebtedness and $200,000 in home equity indebtedness?

You might think that each person would be allowed to deduct all the interest on his or her $1,000,000 share of the acquisition indebtedness and his or her $100,000 share of the home equity indebtedness. But you’d be wrong.  According to a recent U.S. Tax Court case, the cap on the home mortgage interest deduction would not be applied to each person’s share of the debt. Instead, the deduction would be applied based on the total amount of debt against the residence.  In the example above with the two unmarried home buyers, each of them would be able to deduct $500,000 of his or her $1,000,000 share of the acquisition indebtedness only $50,000 of his or her $100,000 share of the home equity indebtedness, effectively cutting in half the total deduction allowed.

The case is Voss v. Commissioner, 138 T.C. No. 8 (Mar. 5, 2012):


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