Acquisition Debt vs Home Equity Debt & Cash Out Refinancing

The third paragraph should have read:

"..... and how much interest expense is deductible as mortgage interest or investment interest.

Acquisition debt: $200k. (on main home) Equity debt: $100k. (on main home) Non-qualified debt: $50k. (NO interest deduction)

Not too hard.

I really d Refinanced Home Acquisition Debt Any secured debt you use to refinance home acquisition debt is treated as home acquisition debt. However, the new debt will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing. Any additional debt not used to buy, build, or substantially improve a qualified home is not home acquisition debt, but may qualify as home equity debt (discussed later).

Notice that it says that any excess over the old balance that is used to "buy" a qualified home will count as acquisition debt. My concern is the timing. Clearly, you can't borrow more than the balance and wait 10 years before you buy that second home and say that the debt for those 10 years was acquisition debt. So... what is the time period you are allowed to have either before you buy the home or after you buy the home to take out the loan and have it treated as acquisition debt?

In addition, if my friend parks the money in an account that is generating interest or dividend income why wouldn't the interest expense be investment interest and deductible to the extent that he has investment income?

Why doesn't he just get a 150k mortgage for the vacation home, and leave the main home alone? Then total loans for 2 home is for 350k of loan and all can be deducted. The way he's doing it above is changing mortgage on main home to 350k and no mortgage on second home. It looks equivalent. Per the substance over form doctrine, it looks like the entire new 350k mortgage is deductible.

Maybe for those 90 days, or however long it took him to close on the

2nd home, a portion of the mortgage interest is non-qualified debt, so he should reduce the amount of the 1098-M (the form for mortgage I think) on his Schedule A. The calculation is complicated. You can divide the total interest by 12 to get the average per month (although to be exact the mortgage interest changes each month), or you can look at the monthly statements which often say what the interest was for that month, then get the total interest for those 3 months and call this I, and multiply I by 200/350 and call the result M1, and the reduce the mortgage interest on 1098 by this amount M1. As long as the 150k was in a tax bearing account then consider 100k as equity debt so multiple I by 100/350 to get M2, and this is home equity interest deduction which is not allowed under AMT. The remaining I*50/350 is lost.

No, if I were an IRS agent. Requiring them to create a new account to hold the 300k seems retarded, but seeing that is so easy to open an account these days, and maybe get $100 bonus for doing so, why not go for it?

The interest rate on current loan is 5.75%. He can refi at 3.9%. Better to have a 350K loan at 3.9% then a 200K loan @ 5.75% and a 150K @ 3.9%.

Here's the problem I am having. If I was going to buy a new home and take out a mortgage, there is some period of time both before and after the closing that I can get the loan and have it treated as acquisition debt. The IRS Pub (page 9) says that the window is plus or minus 90 days from the closing.

I have always assumed that if you met the 90 day window before closing, you could deduct all the interest you paid before the closing. I wasn't sure what happened if you missed the 90 day window (hence my original example). Is it that if you miss the 90 day window, it is gone and (using my example) you have this 4 month period that has to be accounted for? I know he can treat 100K as HE debt for that period and deduct the interest. I'm almost sure he can treat the 4 months of interest on the $50K as investment interest expense as long as he keeps it invested. (No one has replied to this part of my original post.)

But... the IRS pub also says that a mortgage that fails the test for acquisition debt can qualify later as acquisition debt. So.. does this mean if the $150K is not acquisition debt for the 4 month period (it's HE and Investment Interest) and then upon closing it becomes acquisition debt and reduces his HE debt back to zero?

A friend wants to buy a vacation home (second home) by refinancing the mortgage loan on his main home. Here is the plan:

Refinance main home loan by paying off the $200K balance with a new $350K loan secured by his main home with $150K cash out. Assume the loan closes on March 1, 2012. The $150K will be parked in a savings account pending the purchase of the vacation home. He makes an offer on May 15,

2012 to buy a home. He closes on the new home on June 30, 2012. He pays $300K for the home by withdrawing the $150K he borrowed on his main home and adds to that $150K that he has.

I'm trying to figure out come July 1, 2012, how much acquisition debt he has and how much home equity debt he has (if any) and how much interest expense is deductible as mortgage interest.

What are his options for deducting interest expense during the 4 month period that the $150K was sitting in a savings account?

Would it matter if he closed on the new home within a shorter period of time, say less than 90 days after borrowing the money?

What if he deposits the $150K loan proceeds in a savings account that contains $200K, bringing the balance to $350K. Is there any tracing problem when he withdraws the $300K to purchase the vacation home?

UNTIL The second home is purchased, he has - $200K acquisition debt - fully deductible on Schedule A $100K in equity debt - fully deductible on Schedule A BUT an ADD BACK for AMT calculations $50K in excess equity debt - no deduction anywhere.

AFTER he actually buys the second home, he has: $200K acquisition debt on his main home - fully deductible on Schedule A; $150K of acquisition debt on he second home - fully deductible on Schedule A; $0 excess equity debt - no deduction and no add backs for AMT.

You have to follow the IRS "tracing rules" for equity debt to see where it goes and how to report it.

Gene E. Utterback, EA, RFC, ABA

Why can't the 50k be investment interest. For that matter, why not the entire 150k be investment interest -- fully deductible on Schedule A, no itemized deduction phaseout, no AMT? Is there a definition of investment interest somewhere?

That's why the $200k on the main home remains acquisition debt.

That's your misinterpretation. Money "borrowed" to buy a second home is not acquisition debt because it's not secured by the SECOND home, but the first. The code says "secured by SUCH residence[,]" not secured by any qualified residence.

To be acquisition debt, the debt must be secured by the residence which the debt acquired (purchase or built), including a refinancing of such prior debt.

I disagree. The $150k with which he acquired the second home is actually debt secured by the first home, so NONE of it is acquisition debt. Your answer above under "until" (which matches my answer) remains as the answer for the "after" section too.

Which you disregarded after the purchase of the second home.

Investment interest must be tied to portfolio income. Use of real-estate as a residence is personal use which disqualifies any "investment use."

Regardless, any use as an investment with NO income generated by it would defer any interest expense deduction until its future sale [at a recognized profit], thus denying any current deduction.

The 150k of money is sitting in a bank account earning interest, and thus it is portfolio income. So the interest on this 150k ought to be investment interest.

Are you saying the the investment interest is on a per item basis? Meaning that investment interest on stock A is limited to the investment income from stock A, with the excess being carried over? I thought that instead it worked like this: investment interest on stock A is limited to investment income from all stocks -- which is what form

suggests. So if yourincome from stock A is zero, interest on it is 20k, and you have 21kin 1099-INT income, you can still deduct the full 20k of interest.

Here is the section you cite:

(B) Acquisition indebtedness (i) In general The term ?acquisition indebtedness? means any indebtedness which? (I) is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and (II) is secured by such residence.

I th (4) Other definitions and special rules For purposes of this subsection? (A) Qualified residence (i) In general The term ?qualified residence? means? (I) the principal residence (within the meaning of section 121) of the taxpayer, and (II) 1 other residence of the taxpayer which is selected by the taxpayer for purposes of this subsection for the taxable year and which is used by the taxpayer as a residence (within the meaning of section 280A (d)(1)).

Note that the definition uses the word "and" not "or". Any time you see the words "qualified residence" it means one home or two homes.

Therefore, as a "qualified residence" takes the mean Refinanced home acquisition debt. Any secured debt you use to refinance home acquisition debt is treated as home acquisition debt. However, the new debt will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing. Any additional debt not used to buy, build, or substantially improve a qualified home is not home acquisition debt, but may qualify as home equity debt (discussed later)

Notice that it says any new debt that is not used to "buy, build or substantially improve a qualified home is not acquisition debt." So, if you use the new debt on a refinanced loan to buy a second home, it is acquisition debt.

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real-estate

Just because it earns interest in the meantime (i.e. while in escrow) while waiting for the end purchase (it's real purpose) does not make it an investment. However, I shan't say that the interest expense on $50k of it (from the example) isn't deductible as investment interest expense (up to portfolio income) while it is waiting to be used. I do say that the $100k is not investment interest expense because it qualifies for deductibility without regard to that provision as equity interest expense.

That is correct - ONLY the residence acquired and secured by the debt counts.

Which forbids the securing of the debt to another qualified residence.

Dictionary: "such" adj. being the same as that which has been mentioned.

This means that the debt must be secured by the same qualifying residence as that which was acquired or constructed, not the taxpayer's other qualifying residence (as a taxpayer, later in 163(h) can only have two - his principal residence and one other).

This is where I disagree. "(II) is secured by such residence" does not say "such qualified residence" which could refer to either (or even "either qualified residence"), but refers IN THE SINGULAR to the same residence acquired/constructed which happens to be a qualified residence.

Although a taxpayer may have two qualified residences, either one independently of the other is a single qualified residence.

No, it's not. The new debt on a refinanced loan with respect to the first residence is secured by the first residence, not the second. To qualify as acquisition debt, the new debt with regard to the acquisition of the second residence must be secured by the second residence ONLY, not the first.

Well, what was it INVESTED in? From what I read the money was parked in a bank account awaiting the purchase of a second home. This does NOT meet the definition of an investment.

Additionally, investment interest expenses is ONLY deductible to the extent that you have investment income. So even if it qualified as investment interest he can only deduct the interest IF he BOTH had investment income and was able to itemize.

You can check the IRS publications for a definition of Investment Interest - start with IRS Form 4952 I think.

Gene E. Utterback, EA, RFC, ABA

Debt that you deposit in a bank account is considered investment property. The bank account doesn't even have to pay interest. The interest expense on that debt is investment interest expense. To the extent that you have investment income on the first page of the 1040, you can deduct that interest.

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As frequently happens, it looks like we have a disagreement between learned professionals. This is one of the problems with all laws and regulations. They are written by folks based on info available at the time and interpreted much later by different folks based on a situation that wasn't considered when written. Here's my take:

to deduct mortgage interest the loan must be secured by either your first or second home

to deduct equity interest the loan proceeds must be BOTH secured by either the first or second home AND the money must be used to either buy or improve your home, or second home.

In the OPs case, he has currently has an equity loan that was NOT used to buy or improve anything - hence only partially deductible and an add back for AMT.

But IN MY OPINION, once he buys the new home - AND AS LONG AS HE HAS SUFFICIENT EQUITY IN THE MORTGAGED HOME - he CAN deduct the interest in full with no AMT issues.

In my opinion the trick here is that the proceeds are being used to BUY a home that qualifies as a qualified residence, under the second home rules. The TRAP I capitalized in the preceding sentence - he must retain sufficient equity in the mortgaged property to deduct the interest.

And no, I cannot give you a hard citation to a code section, Treasury Regulation, Revenue Regulation, Revenue Proc. or anything else that supports this position. I will try to look and see what I can find, but it is tax season - so don't hold your breath.

Gene E. Utterback, EA, RFC, ABA

I have decided that you are correct as I can not find any other authority to support my position... including one of my most trusted advisors. Therefore, I will advise my friend to only borrow 100K over the balance if he wants to refi. Otherwise, he should take out a mortgage on the second home.

(I) is house2, and the (II) the debt is secured by house1, so therefore it is not deductible.

However, when the issue boils down to a close reading of the grammar, we must look at the underlying law. For example

says, among otherthings, that there may be a mismatch between the underlying law andthe statute as shown by this sentence "This is a problem because thereappears to be a mismatch between what Congress intended with this ruleand the language that appears in the law." Thus we should look at the underlying law of this 163(h).

If Stussy is right, it means that the publication may be wrong -- ie. it is too generous.