Thu, September 17, 2009

GAO to IRS: Tighten Up Enforcement of Home Mortgage Interest Deduction

The GAO’s report to the Joint Committee on Taxation has a title that gets right to the point: “Home Mortgage Interest Deduction: Despite Challenges Presented by Complex Tax Rules, IRS Could Enhance Enforcement and Guidance.” That’s helpful, since most members of Congress probably won’t bother to read the whole 65-page report.

The GAO noted that current tax forms don’t point out that the mortgage interest deduction is limited; in some cases a homeowner might not be entitled to deduct his or her full interest costs for the year.  The IRS does provide Publication 936 for taxpayers who want to slog through all the mortgage interest deduction rules, but most taxpayers won’t bother reading it. 

According to the report, 12 – 14% of all taxpayers misreport their mortgage interest, with about half of that number over-reporting the deduction they deserve under the law.  In 2005, when the IRS scrutinized just 8% of tax returns for which there appeared to be a mortgage interest discrepancy, it assessed a total of $216 MM in taxes and interest.  Consequently, the GAO has recommended several changes, including some modifications to Form 1098, the report sent by mortgage servicing companies to mortgage holders.  The changes would make it easier for the IRS to detect mortgage interest errors and other discrepancies.

How Much Mortgage Interest Are You Allowed to Deduct?
Most homeowners are unlikely to exceed the basic IRS limit for a mortgage used to buy a home: in order for your interest to be fully deductible, total debt arising from the acquisition of your first home and vacation home cannot exceed $1 million ($500,000 if the taxpayer’s status is married filing separately) total.  Generally, the IRS defines “home acquisition debt” as debt taken out after October 13, 1987, to “buy, build, or substantially improve a qualified home.” Importantly, a mortgage must be secured by a qualified home in order to qualify for the deduction.

Grandfathered Mortgage Interest: The Sky’s the Limit
The IRS defines two more categories of qualified mortgage debt.  One is called “grandfathered” debt.  Prior to 1987, there was no limit on the amount of mortgage debt that could qualify for the interest deduction.  If you initiated a mortgage prior to October 14, 1987 (or in some cases, refinanced such a mortgage) and it has been continuously secured by your qualified home, it is considered grandfathered debt.  It doesn’t matter how the proceeds were used in this case, and all interest on grandfathered debt is deductible.  However, the amount of grandfathered debt that you have reduces the amount of non-grandfathered debt that can qualify for a deduction.

Home Equity Interest Deduction Rules
Finally, you may be entitled to an interest deduction for home equity debt on a first or second home.  Home acquisition debt that exceeds the $1MM limit may qualify as home equity debt, and loans taken out for reasons other than buying, building, or substantially improving a qualified home may also qualify.  Again, it must be secured by the home.  Home equity debt is limited to the smaller of $100,000 ($50K if married filing separately) or the current fair market value of the home minus any relevant home acquisition debt and/or grandfathered debt.  For example, if you own a $500,000 home with a $450K mortgage, your home equity interest deduction is limited to the interest on $50K in loans.  If your mortgage had been $400K, you’d be entitled to deduct the interest on $100K in equity loans.

Interest on home equity debt that is beyond the qualified limit is treated as personal interest (i.e. not deductible) unless the loan proceeds were used for some deductible purpose (e.g. business expenses).  One further wrinkle on home equity interest: taxpayers affected by the Alternative Minimum Tax (AMT) may lose some of their deduction.

The GAO estimates that the home mortgage deduction reduces Federal tax receipts by $80 billion.  The home mortgage interest deduction is the third most-expensive federal tax break, exceeded only by the tax rate reduction for dividends and long-term capital gains ($148 billion) and the deductions given to employers for health care, health insurance premiums, and long-term care insurance ($127 billion).  The GAO’s investigation of the mortgage deduction was initiated by the Joint Committee on Taxation with the goal of increasing federal tax revenue.  The home mortgage deduction exists to encourage home-buying; its popularity makes it unlikely to be a direct target for elimination, but the size of the revenue lost is such that heightened enforcement of deduction limits is an easy way to raise money. 

So the IRS is almost certain to pursue the GAO’s advice.  Expect to see changes in the information that you need to provide with your tax returns if you deduct mortgage interest.

Mortgage interest deduction rules are complex.  As always, tax strategies should be discussed with a qualified tax adviser in order to make sure that you do what is appropriate for your individual situation.