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A recent U.S. Tax Court ruling clarified the IRS position that the $1.1 million limit for mortgage interest deduction applies per residence and not per taxpayer as some high-priced homeowners were hoping.
A married homeowner filing jointly can have fully deductible interest on a mortgage of up to $1,000,000 of acquisition debt and up to an additional $100,000 of home equity debt. If the married couple files separately, each party is limited to deducting the interest on half of those maximum amounts.
The court case came about when two unmarried individuals who owned a home together as joint tenants felt that they were entitled to deduct the interest on $1.1 million of debt each. IRS did not agree with their understanding and neither did the Tax Court. The Court ruled that the limits apply per residence, not per taxpayer even if a home is co-owned by unmarried taxpayers.
The result for the taxpayers in this case was that their deduction was cut in half resulting in much more income tax due. While this situation only affects a few taxpayers, homeowners in this position should have a discussion with their tax professional.
It all seems perfectly reasonable: one person is not satisfied with what he can earn currently in the market and another wants to find the most attractive mortgage to purchase their home. It can be a good match but the IRS has specific rules that govern the transaction.
The loan must be done in a business-like manner with a written note specifying the loan amount, interest rate, term and collateral. IRS requires that the mortgage be a recorded lien in order to allow the interest deduction.
Sometimes, these friends and family situations have a less than normal interest rate on the mortgage. However, the rate charged in the note is regulated by the minimum applicable federal rate which is published monthly by IRS according to current Treasury securities. For October 2011, the rate is 2.95% for terms over nine years.
The seller must report the interest paid to them along with the name, address and Social Security number on schedule B when the buyer uses the property as their principal residence.
A mortgage between family and friends can be good for both parties. It may allow the borrower a slightly lower rate without the expenses of a traditional lender while giving the note holder a higher rate than they can earn in available investments. Your tax professional can guide the transaction whether you're a buyer or seller and your real estate professional can help arrange to have the documents drawn and filed.
The IRS has given special consideration regarding the sale of their jointly-owned principal residence after the death of a spouse. If the surviving spouse does not remarry prior to the sale of the home, they may qualify to exclude up to $500,000 of gain instead of the $250,000 exclusion for single people.
If you have been widowed in the last two years and have gain in your principal residence, it would be worth investigating the possibilities. Contact your tax professional for advice about your specific situation. Contact me to find out what your home is worth in today's market. See IRS Publication 523 - surviving spouse.
