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Arthur Rubin
Arthur Rubin, Tax Preparer
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Experience:  22 years of tax preparation experience, including individual, trust, and estate returns.
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I got a home equity loan from my primary residence to buy land

Customer Question

I got a home equity loan from my primary residence to buy land that I am buiding my primary residence on. Is the interest 100% deductible or it is considered investment and only $100,000 of the $780,000 can be deducted? the land was purchased to build my primary residence on.
Submitted: 4 years ago.
Category: Tax
Expert:  Jesse Handel replied 4 years ago.

HelloCustomer Thank you for coming to Just Answer and allowing us to help you with your tax question. The IRS mortgage interest deduction is allowed for two homes as long as you will be residing in both (such as a main home and a vacation home). Since the home equity loan was used to buy land and to build a home that you will be residing in, the interest on the loan will be a 100% deductible, even if you are subject to the Alternative Minimum Tax. You need to be sure that you actually show progress in building your home. If you sell the land without building a home or making progress towards building a home, then the interest will not be deductible as home mortgage interest and could be viewed by the IRS as investment interest. That is based on federal tax law. I have not reviewed California law per your information, so you may need more information about California tax treatment of the interest.

 

One possible problem that you may need to keep in mind is that as of the 2009 tax code, home acquisition interest debt is limited to a loan of $1 million dollar. That will include the cost of the land and the home. If you exceed the $1 million dollar loan threshold, any interest on the amount greater than $1 million dollars won't be deductible.

 

I hope this satisfactorily answers your question. If you need further clarification, I will be happy to provide more information. Since your question is listed twice on the question list, I will arrange to have the duplicate question closed. If you did intend to list it twice, then you can relist it again. Thank you for letting me help you.

Customer: replied 4 years ago.

Ok so it does not matter that it is land and I am building on it for myself. So I will not be subject to the limitation of $100K, I am building on the home and now the IRS says that I am subject to limitation of $100K as I used the home equity loan and not a straight mortgage. They are disallowing the deduction, The loan is for $780,000 which is well below the $1m limitation.

The exact words of the IRS officer is: That the loan obtained in the amount of $780,000against your residence is not considered acquisition indebtness because it was not obtained for acquiring or improving such residence. Instead it is equity loan where the proceeds were used for another purpose (in this case to purchase land. Nor is it second residence as land does not qualify as residence. Because the indebtedness is home equity indebtedness, youur deduction is limited to interest paid that is attributable to $100,000 of the total debt only.

I am not sure this IRS officer knows what she is talking about and makes me nervous to go along with her findings when I explicitedly told her I had begun construction and it will be my primary residence.

Does this finding make sense?

Thanks,

Expert:  Arthur Rubin replied 4 years ago.

I'm afraid the other expert's answer is incorrect, and the IRS agent's answer is correct, but not complete. The loan you describe is considered a home equity loan, as it's secured by your first primary residence to build a second residence. To the extent secured by the land or new property, it could be considered a mortgage loan if the new residence becomes "a qualified residence" (your main residence, or the designated second residence) within 24 months.

 

See the flowchart on page 3 of IRS publication 936 (Home Mortgage Interest Deduction), where one of the questions is:

 

Were all of your home mortgages taken out after 10-13-87 used to buy, build, or improve the main home secured by that main home mortgage or used to buy, build, or improve the second home secured by that second home mortgage, or both?

As you fail that question, some of the interest is considered "home equity" interest (deductible only up to $100,000) rather than "acquisition interest" (deductible up to $1,000,000).



Edited by Arthur Rubin on 7/3/2010 at 4:02 PM EST
Customer: replied 4 years ago.
However, I dont believe it is right, because this that the the IRS has rejected is for 2005 and 2006 when the land was purchased to build the home. How does what you say come to play. Please explain. I will look at the publication as well.
Customer: replied 4 years ago.
I believe it is acquistion interest. That home is mine and being constructed on. Never for investment purposes . Would i not qualify under grandfathered debt.
Expert:  Arthur Rubin replied 4 years ago.
In no particular order.

In order for it to be "acquisition debt", it must still be secured by the same qualified home, and must be used to purchase the house. (There are some circumstances where a "bridge loan" not secured by the property is taken, but then refinanced by a loan secured by the property, may be considered "acquisition debt" rather than "home equity debt", but that doesn't seem to be on the table, either.) "The "grandfathered debt" clause only applies to mortgages taken out before 1987 (1982 for AMT purposes).

And the 24-month rule runs from the time the loan was taken out, so it appears that it wouldn't help you, either.

Finally, the same box as I quoted above is on Chart A of the 2005 Publication 936, although the clarifying text doesn't seem to be there. I see no indication that the law has changed.

Edited by Arthur Rubin on 7/3/2010 at 5:05 PM EST
Customer: replied 4 years ago.

ok so basically what you are saying is that I cannot deduct all the interest, I am limited to $100k. So the iRS is correct? So I lose?

I find that sttrange as this is my primary residence and I didnt just buy land to keep it.

I looked at the chart and seems to be in doubt for me.

So in plain nutshell I cannot deduct all and need to pay back the deduction that I took?

No other loopholes?

Customer: replied 4 years ago.

Also, need to say that I have refinanced this loan. I am very confused. When I took this loan I ws told I could deduct it fully up to $1m as I am building formy primary residence.

I did a refinance on my home.I even called the iRS as well.

Is there no defense?

Expert:  Arthur Rubin replied 4 years ago.
If the new property were to be considered an investment property,then the interest would investment interest; still not immediately deductible, but deductible as investment income (of any sort) is received. However, you might have had to make a timely election to waive the mortgage interest deduction in order to do this. This seems too complicated for me to handle at the moment. It also appears not to match the fact pattern, as you describe it.

If the loan were refinanced by a loan secured by the property financed, then it might be considered an acquisition loan from that point forward, provided it was "soon" after the original loan. I'd have to research Revenue Rulings on that aspect, but I'd need more specifics on the refinancing to determine whether there is any point.

Edited by Arthur Rubin on 7/3/2010 at 6:45 PM EST
Customer: replied 4 years ago.

My property was debt free. I took out a home equity mortgage of $780,000 to purcahse the land. The land is used to build my primary residence.

I got the home equity loan in May 2005 from First Federal based on the equity from my primary residence, a sub zero loan, and refinanced to mortgage loan in 12/2006 from Citi Mortgage.

The full intention is to build my primary residence, which I am still constructing.What other info do you need?

Customer: replied 4 years ago.

Let me clarify, I took it as mortgage interest deduction, that is NOT ALLOWED. Correct for the entire $780,000, it is limited to $100K. So IRS is Correct?

 

Customer: replied 4 years ago.

I was resaerching somewhat and so what does this mean?

Home equity debt means any loan whose purpose is not to acquire, to construct, or substantially to improve a qualified home, or any loan whose purposes was to substantially improve a qualified home but exceeds the home acquisition debt limit.

So basically I acquired the loan to construct so I should qualify, as it does not construe, so should be considered an acquisition indebtedness?

Customer: replied 4 years ago.

Some more research. What does all this mean by IRS:

In a recent memorandum, the IRS Office of Chief Counsel reinterpreted the definition of acquisition indebtedness secured by a residence.

Taxpayers are normally allowed to deduct interest on two categories: acquisition indebtedness and home equity indebtedness. Acquisition indebtedness is indebtedness to acquire, construct, or substantially improve a residence, but the amount cannot exceed $1 million. Home equity accounts for indebtedness other than acquisition indebtedness, but the amount cannot exceed $100,000.

Under the IRS's new interpretation, the $1 million limit is an element of the definition of "acquisition indebtedness." Any amount of a mortgage in excess of $1 million is not acquisition indebtedness because, by definition, only the first $1 million is acquisition indebtedness.

Customer: replied 4 years ago.

The exact words of the IRS officer is: That the loan obtained in the amount of $780,000against your residence is not considered acquisition indebtness because it was not obtained for acquiring or improving such residence. Instead it is equity loan where the proceeds were used for another purpose (in this case to purchase land. Nor is it second residence as land does not qualify as residence. Because the indebtedness is home equity indebtedness, youur deduction is limited to interest paid that is attributable to $100,000 of the total debt only.

The word missing Acquisition indebtedness is indebtedness to acquire, construct, or substantially improve a residence, but the amount cannot exceed $1 million.

IS what the IRS say in the line that I purcahsed land. She failed to say that I wanted to build my home. Or does that even matter if she missed some words.

Customer: replied 4 years ago.

The exact words of the IRS officer is: That the loan obtained in the amount of $780,000against your residence is not considered acquisition indebtness because it was not obtained for acquiring or improving such residence. Instead it is equity loan where the proceeds were used for another purpose (in this case to purchase land. Nor is it second residence as land does not qualify as residence. Because the indebtedness is home equity indebtedness, youur deduction is limited to interest paid that is attributable to $100,000 of the total debt only.

The word missing Acquisition indebtedness is indebtedness to acquire, construct, or substantially improve a residence, but the amount cannot exceed $1 million.

IS what the IRS say in the line that I purcahsed land. She failed to say that I wanted to build my home. Or does that even matter if she missed some words. Also she missed Construct. Does that even matter? The law is what the law is?

Customer: replied 4 years ago.

What does all this mean?

 

The amount of mortgage interest you can deduct each year is limited. There is one limit for loans used to buy or build a residence -- called "home acquisition debt." And there is another limit for loans not used to buy or to build a residence -- called home equity debt. All loans, whether secured by your main home or your second home, are subject to the same overall limitations.

Home Acquisition Debt
You may not deduct interest on more than $1,000,000 of home acquisition debt for your main home and secondary residence. Home acquisition debt means any loan whose purpose is to acquire, to construct, or substantially to improve a qualified home. The limit is reduced to $500,000 if you are married filing separately.

Expert:  Arthur Rubin replied 4 years ago.
The land could be considered "your home" if it had been completed in 24 months; but it still only counts as acquisition mortgage interest if the loan is secured by the property purchased.

If the land were adjacent to your home, in which case the two properties might be considered one for IRS purposes, even if not considered as such by the (respective) lenders. But you didn't say that, and it probably isn't the case.

And, as I said before, if the land were investment property, then the excess interest would be investment interest, deductible as you received investment income.
Customer: replied 4 years ago.

Home Equity Debt buy, and both having reasonable knowledge of

all relevant facts. Sales of similar homes in your

If you took out a loan for reasons other than to area, on about the same date your last debt was

buy, build, or substantially improve your home, it secured by the home, may be helpful in figuring

may qualify as home equity debt. In addition, the FMV.

debt you incurred to buy, build, or substantially

improve your home,

I am still confused.

No the property are not side by side. I refinaced the home equity debt as mortgage loan in 12/2006. The loan is no longer secured by theresidence I am living in such as home equity. It says in all research I have done that if the home equity was not to improve, build or acquire than the entire balance is deductible. DO I NOT FALL IN THESE CATEGORIES> So, botXXXXX XXXXXne I need to pay back the IRS? Correct?

Customer: replied 4 years ago.
Sorry I meant to say that if the home equity was for improve construct or acquire than I can deduct, for any other purpose I cannot. I am restricted to $100K. Is that correct?
Customer: replied 4 years ago.
Please reply as to what if any recourse I have or simply I owe the money back?
Customer: replied 4 years ago.
I am somewhat confused by what you are saying. Simply I need to pay back? Right?
Customer: replied 4 years ago.

Can you explain why I dont fall within these IRS guidelines

 

Acquisition debt is debt acquired after October 13, 1987 to buy, build, or substantially improve your main residence or a qualified second home. A "substantial improvement" is one that adds value to the home, prolongs the home's useful life, or adapts the home to new uses. The amount of interest that you can deduct on acquisition debt is limited to $1 Million ($500,000 if Married Filing Separately) of principal. Qualified acquisition debt also cannot exceed the cost of the home plus the cost of any "substantial" improvements.

Home equity debt - debt secured by a principal residence or second home that is not used to buy, build, or substantially improve the property. Why dont I fall here. I used to buy land to build so I should b eable to deduct all?

Customer: replied 4 years ago.

Why dont I fall under these IRS guidelines

 

You may not deduct interest on more than $100,000 of home equity debt for your main home and secondary residence. Home equity debt means any loan whose purpose is not to acquire, to construct, or substantially to improve a qualified home, or any loan whose purposes was to substantially improve a qualified home but exceeds the home acquisition debt limit.

Acquisition debt is debt acquired after October 13, 1987 to buy, build, or substantially improve your main residence or a qualified second home. A "substantial improvement" is one that adds value to the home, prolongs the home's useful life, or adapts the home to new uses. The amount of interest that you can deduct on acquisition debt is limited to $1 Million ($500,000 if Married Filing Separately) of principal.

I would qualify for 100% deductible under these guidelines? If no, why not?

Expert:  Arthur Rubin replied 4 years ago.
Under those circumstances, the loan is a home equity loan against the first home from May 2005 through December 2006, and it appears that the refinanced loan may be an acquisition loan on the second property from December 2006 onward, provided that the cost of the land plus construction costs from December 2004 onward exceed the value of the refinanced loan, and the completion date of the second home is between September 2006 and March 2007 (within 90 days of the loan "refinance" date).

I cannot find any justification for it to be considered an acquisition loan between May 2005 and December 2006.
Customer: replied 4 years ago.
Somehow this whole answers from you are confusing. I know that I have to pay. But I am at a loss as to why?
Expert:  Arthur Rubin replied 4 years ago.
It seems simple to me. To qualify as an acquisition loan, the loan must:
(1) Be used to purchase, construct, or substantially improve a qualified home.
(2) Be secured by that qualified home.
(3) Be no more than the cost of that home plus the cost of substantial improvements.

Point (1) can be retroactive 90 days, under certain circumstances, which don't seem to apply to your situation., but not the other points. The details of "qualified home" are more complicated than can be described as simple points, but your second home would be retroactively qualified if you move in within 24 months of the start of construction.

From May 2005 through December 2006, (1) applies to your second (named) home, but (2) to your first.
Customer: replied 4 years ago.

So what are you saying. The IRS is wrong and that I can deduct 100% of the loan interest?

 

Expert:  Arthur Rubin replied 4 years ago.
No. You can (probably, if the loan is for less than 100% of the cost of the new property) deduct all the interest corresponding to the period when the loan was refinanced in December 2006 onward. For May 2005 to December 2006, you can only the interest corresponding to $100,000 of principal. Since you said the audit was for 2005 and 2006, this should produce additional deductible interest in 2006 above the IRS agent's report, and your analysis would be correct for 2007 onward.
Customer: replied 4 years ago.

I am even more confused. The refinance occured for one month in Dec2006.

So I just want to know the interest from May 2005 to Dec 2006 when I was with First federal is definitely only deductible for the $100K? The interest for Dec 2006 is small. That is probably mute at this point.

Expert:  Arthur Rubin replied 4 years ago.
Yes, that's correct.

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