The Internal Revenue Service said that homeowners can deduct interest on up to $1.1 million in mortgage debt, $100,000 more than the previous limit of $1 million.

In Revenue Ruling 2010-25, the IRS contradicted two previous Tax Court cases from 1997 and 2000, and allowed an unidentified taxpayer who bought a $1.5 million home with a down payment of $300,000 and a $1.2 million loan to deduct interest on $1.1 million of the mortgage loan.

In the 1997 case, Pau v. Commissioner, the Tax Court limited taxpayers’ deductions for a qualified residence to the interest paid on $1 million of the $1.33 million in indebtedness incurred to purchase the residence. The court said at the time that Section 163(h) of the Tax Code restricts home mortgage interest deductions to interest paid on $1 million of acquisition indebtedness and $100,000 of home equity indebtedness. The court stated that acquisition indebtedness is defined as indebtedness that is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by the residence.  The court also said that home equity indebtedness is defined as any indebtedness (other than acquisition indebtedness) secured by a qualified residence.

The court concluded that the taxpayers failed to demonstrate that any of their debt was not incurred in acquiring, constructing, or substantially improving their residence and thus was not acquisition indebtedness.  However, the court did not address the effect of the $1 million limitation on the definition of acquisition indebtedness. The Tax Court followed the 1997 Pau decision in the 2000 case, Catalano v. Commissioner.

The IRS said in its new revenue ruling that a taxpayer may deduct, as interest on acquisition indebtedness, the interest paid in 2009 on $1 million of the $1.2 million indebtedness used to acquire the principal residence.  The $1.2 million indebtedness was incurred in acquiring a qualified residence of taxpayer and was secured by the residence. Thus, the $1 million debt is treated as acquisition indebtedness.

The taxpayer also may deduct, as interest on home equity indebtedness, the interest paid in 2009 on $100,000 of the remaining indebtedness of $200,000. The $200,000 is secured by the qualified residence, is not acquisition indebtedness, and does not exceed the fair market value of the residence reduced by the acquisition indebtedness secured by the residence. Thus, $100,000 of the $200,000 is treated as home equity indebtedness.

The interest on both acquisition indebtedness and home equity indebtedness is qualified residence interest.  Therefore, for 2009 the taxpayer may deduct the interest paid on indebtedness of $1.1 million as qualified residence interest. Any interest the taxpayer paid on the remaining indebtedness of $100,000 is nondeductible personal interest.

The IRS said it would not follow the decisions in Pau v. Commissioner and Catalano v. Commissioner. It said the holding in Pau was based on the incorrect assertion that taxpayers must demonstrate that debt treated as home equity indebtedness “was not incurred in acquiring, constructing or substantially improving their residence.” The definition of home equity indebtedness in Section 163(h)(3)(C) contains no such restrictions, and accordingly the IRS will determine home equity indebtedness consistent with the provisions of this revenue ruling, notwithstanding the decisions in Pau and Catalano.

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