For regular income tax purposes, qualified residence interest is deductible as an itemized deduction in computing taxable income.
Qualified residence interest is interest that's paid or accrued during the tax year on acquisition indebtedness (debt incurred to buy, construct or substantially improve a residence) or on home equity indebtedness (up to $100,000 [$50,000 on separate returns of married taxpayers]) that's incurred with respect to any qualified residence of the taxpayer.
A qualified residence includes the taxpayer's principal residence and a second residence selected by the taxpayer.
Thus, for regular tax purposes, qualified residence interest includes interest on acquisition indebtedness and on home equity indebtedness incurred with respect to both the taxpayer's principal residence and a second selected residence.
Interest on home equity indebtedness is deductible for regular tax purposes even if the debt is not used to buy, construct or substantially improve the qualified residence, e.g., the home equity loan is used to buy a new automobile.
In computing the alternative minimum tax, qualified housing interest and not qualified residence interest is deductible. To be qualified housing interest, the interest must be qualified residence interest, and be paid or accrued on indebtedness incurred in acquiring, constructing or substantially improving any property that is either the taxpayer's principal residence at the time the interest accrues, or is a qualified dwelling.
To be a qualified dwelling, it must meet the definition of a qualified residence (see above), and must also be a house, apartment, condominium or mobile home not used on a transient basis (including all appurtenant structures or other property).
Thus, the following interest secured by a qualified residence that would be deductible for regular income tax purposes is not deductible for the AMT:
* Interest on home equity indebtedness, to the extent that the debt is not used to acquire, construct or substantially improve the principal residence or qualified dwelling.
* Interest on a second residence that is used on a transient basis, such as a boat.
Example 1: Your clients take out a home equity loan of $100,000 secured by their principal residence. They use $60,000 of the loan to add another bedroom to the principal residence, and use $40,000 of the loan to buy a new auto. The entire interest paid on the home equity loan is deductible for regular income tax purposes, but only 60 percent of the interest is deductible for the AMT.
Example 2: Your clients buy a motor boat that has living quarters, including a bedroom and galley, that they plan to use for travel and as a second residence. They pay $300,000 for the boat, $200,000 of which is obtained through a mortgage secured by the boat. While the boat meets the definition of a second residence for regular income tax purposes, it is not a qualified dwelling for AMT purposes, since it is transient. Thus, while the interest on the mortgage loan is deductible for regular income tax purposes, it is not deductible for the AMT.
Qualified housing interest includes interest on any indebtedness resulting from the refinancing of indebtedness used to acquire, construct or substantially improve a principal residence or qualified dwelling, but only to the extent that the amount of debt resulting from the refinancing is not more than the refinanced debt immediately before the refinancing.
Example 3: Your clients refinance the mortgage on their principal residence when the outstanding balance of that mortgage is $500,000 and the fair market value of the principal residence is $800,000. The refinanced mortgage is in the amount of $575,000. They use the excess of $75,000 to add a new bedroom to the residence.
While only interest on $500,000 of the new mortgage is deductible for both regular income tax purposes and AMT purposes as debt resulting from the refinancing of acquisition indebtedness, interest on the remaining $75,000 of the new mortgage is deductible as home equity indebtedness. The interest on the home equity indebtedness is deductible for both regular income tax and AMT, since the home equity indebtedness is used to add a new room to the principal residence.
Example 4: The same facts apply as in Example 3, except that your clients use the extra $75,000 to buy a new Lexus. The extra $75,000 would still be considered home equity indebtedness and the interest on that debt would still be deductible for regular income tax purposes. However, the interest would not be deductible for AMT purposes, since the additional debt was not used to acquire, construct or substantially improve the residence.
Revenue Ruling 2005-11, 2005-14 IRB makes it clear that qualified housing interest also includes interest paid on a mortgage that has been refinanced more than once, to the extent that the interest on the mortgage that was refinanced is qualified housing interest and the amount of the mortgage indebtedness is not increased. The Internal Revenue Service issued this clarification because its original instructions to Form 6251, Alternative Minimum Tax - Individuals, for tax year 2004 were misleading.
The IRS says that Rev. Rul. 2005-11 may affect the amount that some taxpayers report as a home mortgage interest adjustment on Form 6251. The instructions for Form 6251 for tax year 2004 include a worksheet to help taxpayers determine the correct home mortgage interest adjustment. The IRS says that, as clarified by Rev. Rul. 2005-11, a taxpayer should include in the worksheet calculation, as interest paid on a mortgage whose proceeds were used to refinance an eligible mortgage, qualified housing interest on a mortgage that previously was refinanced. The IRS has now electronically revised the instructions to Form 6251 for 2004 to reflect the clarification.
The IRS did not change the statement in the instructions to Form 6251 for tax year 2004 that "a mortgage whose proceeds were used to refinance another mortgage is not an eligible mortgage," as that term is used in figuring the AMT home mortgage adjustment.
However, the IRS revised the worksheet so that Line 3 of the worksheet now reads: "Enter the part, if any, of the interest included on Line 1 above that was paid on a mortgage whose proceeds were used in a refinancing (including a second or later refinancing) of an eligible mortgage. Do not include any interest paid on the part of the balance of the new mortgage that exceeded the balance of the original eligible mortgage immediately before it was refinanced (or, if smaller, the balance of any prior refinanced mortgage immediately before that mortgage was refinanced)."
Before the IRS revised the instructions to add the clarifying language about prior refinancings, some taxpayers who had already filed may not have included an entry on Line 3 of the worksheet, with the result that they could have ended up with an interest adjustment on Line 4 of Form 6251, when they shouldn't have.
The adjustment would have unnecessarily increased their alternative minimum taxable income. These taxpayers should file an amended return.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
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