The IRS has ruled that indebtedness incurred by a taxpayer to acquire, construct or substantially improve a qualified residence can constitute “home equity indebtedness” to the extent it exceeds $1 million, up to an excess of $100,000 (Revenue Ruling 2010-25).
In the fact situation discussed in the ruling, an unmarried individual purchased a principal residence for its fair market value of $1.5 million. The taxpayer paid $300,000 and financed the remainder of the cost by borrowing $1.2 million through a loan that is secured by the residence. The taxpayer has no other debt secured by the residence.
Under IRC § 163(h), taxpayers can generally deduct two types of debt secured by their residences: “acquisition indebtedness,” which is debt that is used to acquire, construct or substantially improve a residence, and “home equity indebtedness,” which is any other debt secured by the home. Acquisition indebtedness cannot exceed $1 million, and home equity indebtedness cannot exceed $100,000.
Prior interpretations of the term “acquisition indebtedness” focused on the purpose of the debt and held that acquisition indebtedness means all debt, regardless of amount, used to acquire, construct or substantially improve a residence. This was the Tax Court’s holding in Pau, TC Memo 1997-43, and Catalano, TC Memo 2000-82.
According to the revenue ruling, this interpretation is not correct. Instead, the IRS has ruled that the $1 million limit is an element of the definition of acquisition indebtedness. Any amount of a mortgage in excess of $1 million is not acquisition indebtedness because, by this definition, only the first $1 million is acquisition indebtedness. It therefore follows, according to the ruling, that a taxpayer with a mortgage larger than $1 million can treat the first $100,000 in excess of the $1 million limit as home equity indebtedness because it is other debt secured by the home. This allows the taxpayer to deduct interest on the first $1.1 million of the loan—$1 million as acquisition indebtedness and $100,000 as home equity indebtedness.
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