Mortgage Interest Deduction when you Buy and Sell in the Same Year

[uncle-sam]

Hi.  I have read about this situation, but am still not really clear what to do.  I bought a new principal residence during the year in 2023, and TT is adding both loans together to really limit my mortgage interest deduction.  Here are the pertinent facts.

Loan A:

-Bought a primary residence in 2007. 

-Mortgage was refinanced a few times, but last mortgage was an interest-only $550K. 

-Interest was 13K for 2023. 

-The home was sold in September 2023. 

-I cannot calculate the average balance using the first day of the year/last day of the year and divide by two method because the principal was paid off in September 2023.

-Nor can I use the interest rate method because the loan was not outstanding the entire year.

-If I calculate monthly, using zeroes for the months after the loan was paid off (Sept-Dec), the math is 550K times 8 months divided by 12 months in the year, providing an average balance of $367K.

With the inconsistency in Publication 936 around using zero for the month the loan is not secured, but the requirement that you divide by the months the loan is secured, has this method of dividing by 12 been accepted by the IRS?

Loan B:

-Bought a new primary residence in August 2023.

-Mortgage is $1,020,000, also interest only.

-Interest was $20K for 2023. 

-Again, I cannot use the first/last day method divided by 2, nor the interest rate method.. 

-If I use the same monthly method proposed above, with all zeros from Jan-July, the average balance is $425K ($1,020,000 times 5 divided by 12). 

TT is simply adding $550K and $1,020,000 to get $1,570,000.  That is a percentage of 48% (750/1570).

If I use the method above, my percentage is 95%.

The proposed method (dividing by 12) seems to make the most logical sense for a number of reasons, but does anyone have any experience or a more dispositive answer for this situation?

[zomboo]

Pub 936 does not provide guidance on how to calculate the average balance of the two mortgages resulting from the sale and purchase of a primary residence. As you have discovered, strictly applying Pub 936 when one of the mortgage balances is more than $750K results in a significant reduction in the allowable mortgage deduction. Turbo Tax apparently takes this route.

However, in the absence of specific guidance, the taxpayer may use any reasonable method to determine the amount deductible as qualified residence interest. This includes using any reasonable mortgage balance averaging method and applying the $750 limit to the average balance.

The tax code and Pub 936 center around the concept of the taxpayer having one primary and one secondary residence and applying the $750K limit to the (aggregate average balance of primary residence mortgages) and the (aggregate average balance of secondary residence mortgages). Where the aggregate average includes the first mortgage, second mortgages, and refinances.

When you change your primary residence during the year so that you now have one mortgage on the sold home for part of the year and one on the new home for the remainder of the year, it is not only fair and reasonable but, in my opinion, the intent of the tax code to include both the sold home and newly purchased home mortgage monthly balances in the aggregate average balance of the primary residence mortgages. This is the method you are asking about.

When you use this method, the aggregate average balance of the primary residence is the sum of the monthly ending balances of the sold and purchase mortgage balances divided by the sum of the number of months each home was the qualified primary residence. The number of months could be less than 12. Do not zero out months when neither home qualified as your primary home.

Both homes cannot qualify as the primary residence simultaneously. If there is a period of overlap, the sold home qualification ends on day it was paid off or the day the new home became your qualified primary residence. One possible way to handle the mortgage balance for the month of the switchover is to use the daily average of the two mortgages or use the balance of the sold home just before payoff (not $0) for that month and the full month ending balance of the new mortgage for the following month.

Although I believe this a fair assessment, I am not a tax expert and this is just my interpretation of the tax code. I have tried and failed to find any official tax document or ruling that addresses this special situation. Still, I have advocated this method to some members of the community but also have advised @KSB78  in a similar situation as yours against it only because the difference in the percentage of interest deductible in the current year (87.2%) was much greater than the expected percentage in subsequent years on the new home alone (57.7%) and who needs questions from the IRS.