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Home Acquisition Debt

Home acquisition debt is debt incurred to purchase, construct or substantially improve a taxpayer’s principal home or second home. It must be secured by the home(s). Combined home acquisition debt on the two homes can’t be more than:

  1. For Debt Incurred Before 12/16/2017: $1,000,000 ($500,000 for married separate).
  2. For Debt Incurred After 12/15/2017: $750,000 ($375,000 for married separate).

Pre-Dec. 15, 2017 Binding Contract Exception

Taxpayers who entered into a binding written contract before Dec. 15, 2017 to close on the purchase of a principal residence before January 1, 2018, and who purchase such residence before April 1, 2018 are not subject to the $750,000/$375,000 limitations and instead are subject to the $1,000,000/$500,000 limitations. (IRC Sec 163(h)(3)(F)(i)(IV) as amended by TCJA §11043)

Home Debt Purchase Can Be Home Equity Debt as Well as Home Acquisition Debt

In a 2009 Chief Counsel Advice (CCA 200940030) the IRS made it clear that acquisition indebtedness that is incurred by a taxpayer to acquire, construct, or substantially improve a qualified residence can also qualify as home equity indebtedness under Code Sec. 163(h)(3)(C) to the extent it exceeds $1 million. As a result, a taxpayer can deduct interest paid on up to $1.1 million of the debt securing the purchase of his principal residence. This has been reinforced by Rev Ruling 2010-25. However, this ruling has no effect for 2018 through 2025 when there is no deduction allowed for home equity debt.

Refinanced debt can also qualify as home acquisition debt, if it doesn’t exceed the amount of the old home acquisition debt just before the refinancing. Home acquisition debt is deductible against both the regular tax and the AMT.

Acquisition Debt Timing

In most cases, a loan to purchase a residence is secured at the closing of escrow. But what happens when a loan is secured later, does it still qualify as acquisition debt? For example, an individual pays cash for a residence and then later finances it.

Our research found the issue was included in Notice 88-74. Here is what the Notice had to say on the issue:

  1. Acquisition - In the case of the acquisition of a residence, debt may be treated as incurred to acquire the residence to the extent of expenditures to acquire the residence made within 90 days before or after the date that the debt is incurred.
  2. Construction or Substantial Improvement - In the case of the construction or substantial improvement of a residence, debt incurred prior to the time the residence or improvement is complete may be treated as being incurred to construct or improve the residence to the extent of any expenditures to construct or improve the residence which are made no more than 24 months prior to the date that the debt is incurred. Debt incurred after the residence or improvement is complete, but no later than the date 90 days after such date, may be treated as being incurred to construct or improve the residence to the extent of any expenditures to construct or improve the residence which are made within the period beginning 24 months prior to the date the residence or improvement is complete and ending on the date the debt is incurred.

The Notice goes on to say regulations will be issued, but that has never happened. Notices can be relied on and cited as precedent by taxpayers. IRS is bound to what it says in an announcement or notice to the extent it would be with a Revenue Ruling or Revenue Procedure.

HELOCs Can Be Home Acquisition Debt

Over and over individuals are assuming a home equity line of credit (HELOC) is by definition equity debt. That is simply NOT true! A HELOC can be acquisition debt or equity debt. IRC Sec 163(h)(3) does not even refer to the term HELOC.

Section 163(h)(3)(B) provides this rule...

(B) Acquisition indebtedness

(i) In general, the term “acquisition indebtedness” means any indebtedness which—

  • is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and
  • is secured by such residence. Such term also includes any indebtedness secured by such residence resulting from the refinancing of indebtedness meeting the requirements of the

preceding sentence (or this sentence); but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.

Does $1 Mil of Acquisition Debt Limit Apply to Residence or Individual Co-Owners?

According to a Chief Counsel Advice (CCA 200911077) where two or more individuals own a residence with acquisition debt in excess of $1 Million dollars, the individuals jointly can only deduct the interest on the first $1 Million of acquisition debt.An appeals court overturned an earlier Tax Court ruling (C. J. Sophy, 138 TC No. 8, Dec. 58,965) and took the same position the IRS put forward in the 2009 Chief Counsel Advice cited above.  However. . .   The Ninth Circuit Court of Appeals reversed the Tax Court’s decision and the IRS has announced its acquiescence with the Ninth Circuit’s decision. Under this interpretation, unmarried co-owners are collectively limited to a deduction for interest paid on a maximum of $2.2 million, rather than $1.1 million, of acquisition and home equity indebtedness (Voss - IRB 2016-31, p. 193).   This can have significant implications for unmarried co-owners of a home.It is presumed this will also apply to the lower $750,000 acquisition debt limit included in the TCJA. 

Acquisition Debt Declines Over Time

Acquisition indebtedness is reduced as payments of principal (amortization) are made and cannot be increased by refinancing, except if indebtedness is incurred to substantially improve the residence. (H Rept No. 100-391, Part 2 (PL 100-203) p. 1033) Generally, acquisition debt will decline as illustrated in Figure #1.  As shown, the original acquisition debt balance was $200,000, and it steadily declines over the term of the loan until it reaches zero at the end of the loan term (30 years). The amount and remaining term of the acquisition debt at any point in time always follows the curve of original acquisition debt.    

Example #1 - After 15 years, the acquisition debt in Figure #1 has declined to approximately $150,000 and only the interest on the $150,000 is treated as acquisition debt interest. After 30 years, the acquisition debt will have declined to zero, at which point there is no deduction for acquisition debt interest on the property.

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07.05.03

Spousal Buy-Out Debt

Notice 88-74, 1988-2 CB 385 states that, in divorce situations, secured debt incurred to buy out a former spouse’s interest in a home is acquisition debt. This rule is applied without regard to Code Section 1041, which treats certain transfers of property between spouses incident to divorce as nontaxable events.

Record of Original Loan Important

As illustrated in Figure #1, should a taxpayer refinance or add home equity debt, the only way to accurately determine the deductible amount of interest is by knowing the terms of the original acquisition debt. Therefore, it is important that clients retain that information and backup documents. A form for tracking home loans is included at the end of this chapter.

Secured Debt

A secured debt has three characteristics for purposes of the home mortgage interest rules:

  • It makes the taxpayer’s interest in the home specific security for the loan;
  • If the taxpayer defaults on the loan, the home would provide satisfaction for the debt, as with a mortgage or deed of trust;
  • The debt must be recorded according to the applicable state law.

Refinancing Acquisition Debt

Prior to TCJA, taxpayers could refinance acquisition debt for the amount of the amortized balance with an unlimited extended term for the refinanced loan.

Pre-TCJA - Example #2: After 15 years, an original 30-year term acquisition debt of $200,000 has an assumed amortized balance of $150,000. Under law prior to TCJA, a homeowner could refinance that loan for $150,000 for any number of additional years and the debt continued to be acquisition debt.

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Under TCJA, the $1,000,000/$500,000 limits continue to apply to refinances of acquisition debt incurred before 12/16/2017.  However, TCJA only allows the refinanced acquisition debt to be treated as acquisition debt for the remainder of time left under the terms of the original loan (see exception below).   

Post-TCJA - Example #3: After 20 years, an original 30-year term acquisition debt of $200,000 has an assumed amortized balance of $100,000. The homeowner refinances the original loan for a new one with a balance of $150,000 and a term of 20 years. Because of TCJA’s limits on loan terms, the refinanced loan will only be treated as acquisition debt for the first 10 years (30 years – 20 years) and the interest on the last 10 years of the refinanced loan will not be deductible.

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If the principal of the original indebtedness was not amortized over its term, the loan’s acquisition debt would continue to be treated as acquisition debt through the expiration of the term of the first refinancing of the indebtedness (or if earlier, the date that is 30 years after the date of the first refinancing). (Code Sec. 163(h)(3)(F)(iii)(II)) as amended by TCJA §11043)

Commentary

Where a home acquisition debt is refinanced for an amount more than the current amortized balance of the loan it will result in a loan that is part acquisition debt and part equity debt. When this occurs, you basically treat the debt as two loans, one being acquisition debt and the other equity debt. The interest is allocated, proportionally between the two debts, per Reg. Sec. 1.163-8T interest allocation rules, resulting in deductible acquisition debt interest and equity debt interest. See Chapter 215 – Interest Tracing Rules.

Example #4 – Post-2017 Refinance: Married taxpayers have an acquisition debt loan with a balance of $175,000. They refinance that loan for $400,000 and do not use any of the proceeds to make improvements to the home. As a result, the taxpayers have a mixed debt loan consisting of:     
Home Acquisition Debt…. $175,000       Home Equity Debt…………. 225,000    
Total Refinanced Debt……$400,000      
The interest on the $175,000 portion of the debt is deductible as home acquisition debt interest. The balance of the refinanced debt, $225,000, is excess debt and the interest on this portion of the loan is deductible only if its use can be traced to another deductible use.

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Increasing Acquisition Debt

If a home mortgage debt is refinanced, to the extent the new debt replaces the prior acquisition debt and any additional loan proceeds are used to substantially improve the residence, the new debt continues to be home acquisition debt so long as the $1 Million/$750,000 acquisition debt limits are not exceeded.

Refinanced Debt Loan Term

If the term of home acquisition debt is extended beyond its original term, the following rules apply:

  • Refinanced before December 16, 2017 – Where a home acquisition debt was refinanced before December 16, 2017, the loan continues to be home acquisition debt for the term of the refinanced loan.

Example #5: In 2015, the taxpayer refinanced his home acquisition loan, which at the time had an unpaid balance of $835,000 and was amortized over a 25-year period ending in 2030. The new loan is amortized over a 30-year period ending in 2045. The interest on the loan continues to be qualified home mortgage interest until the loan is paid off in 2045.

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  • Refinanced after December 15, 2017 - Where a home acquisition debt was refinanced after December 15, 2017, the loan only continues to be home acquisition debt for the term of the original loan.     

Example #6: In 2019, the taxpayer refinanced his home acquisition loan, which at the time had an unpaid balance of $835,000 and was amortized over a 25-year period ending in 2030. The new loan is amortized over a 30-year period ending in 2049. However, the interest on the loan only continues to be qualified home mortgage interest until 2030, the date the original refinanced loan would have been paid off.

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