Deductions & credits

Thanks veroweb01! I played around with the California form some more, and here are some observations/thoughts. I am hoping a tax expert can chime in here and confirm or correct my assumptions.

For Federal taxes, the interest on a home loan is only deductible for up to $750,000 for married.  If for example the average home loan balance for the year is $1.5M, the interest paid would only be deductible for up to 50%.  (750,000 / 1,500,000 = 0.5).  So for example, if the 1098 form said that you paid $20,000 in interest across your loan(s), you could only deduct $20,000 * 0.5 = $10,000.  Turbo tax offers a simple text box to enter the negative adjustment value (e.g. -$10,000). Note that the loan balance is calculated as the average for the tax year, so for example let's say it was $1.55M on Jan 1st and $1.45M on Dec 31st, the average would be $1.5M, as used in the example above. [I should also add here that it would be nice of Turbo Tax did this calculation for you by asking for the relevant values, rather than just given you a text explanation. After all this is why people pay for tax software].

Moving on to California.  This state has a higher limit on mortgage interest deductions; it is $1M, instead of the Federal $750,000.  I believe the intention here is to calculate how much extra interest could be written off based on the higher state limit.  Here's where I'd like Intuit experts to double check my assumptions and math.  Using the same figures as above, the average loan balance was $1.5M.  The deduction multiplier based on CA limits is ($1,000,000 / $1,500,000) = 0.666...etc (Let's round up to 0.67).  So for $20,000 of interest reported on 1098,  $20,000 * 0.67 =  $13400 would be deductible. This is $3400 over the Federal deduction, so TurboTax allows you to manually enter this adjustment value (as -$3,400) later on in the mortgage section.  This manually entered value appears to override anything TurboTax calculates internally, which is somewhat opaque to the user.

Now as far as multiple loans go.  If we go with veroweb01's suggestion, and say that original loans #1 and #2 are effectively $0 at end of year, I believe what this does is skews the calculation of the average loan balance. For example, let's say the $1.55M house was funded by (#1) a $1M loan and (#2) a $550K loan, which were immediately refinanced into a single (#3) $1.55M loan:

Loan        Start Balance     EOY Balance___Average Balance

$1.0M           $1.0M              $0                     $0.5M

$0.55M         $0.55M           $0                     $0.275M

$1.55M         $1.55M            $1.45M           $1.50M

Under these assumptions, loans #1 and #2 had a combined average of $775,000, which is well below the California limit, allowing you to deduct the full interest amount. For loan $3, the calculation is the same as above, based on the ($1.0M / $1.5M) multiplier of 0.67.

If however you update the table above to reflect that Loans #1 and #2 were combined into a new loan, the numbers change quite a bit:

Loan        Start Balance     EOY Balance___Average Balance

$1.0M           $1.0M              $1.0M                     $1.0M

$0.55M         $0.55M           $0.55M                  $0.55M

$1.55M         $1.55M            $1.45M                 $1.50M

Now the interest for loans #1 + #2 is based on the average loan value of $1.55M, so it needs to be adjusted based on the CA maximum.

There are two possible adjustments that could be made here:

1. Instead of reporting the unchanged loan balance for EOY, it can be reduced by the same fractional amount of that the new loan was paid off.  So for example since the new loan went from $1.55 to $1.45, the ending balances of #1 and #2 could be adjusted to be 0.935 of their starting values. That way the interest on these two loans is deductible up to the same fraction as the interest on the new loan.

2. The average could be calculated based on the effective balance on each loan at the time they were combined into the new loan. For me personally this happened very quickly, so the balance was effectively unchanged, however one could imagine a scenario where the refinancing happened later in the year, where the loan balances were slightly over.

So summarize the options,  I still would like to know which one is correct for CA tax purposes

Option 1: report the two initial loans as having a $0 balance for end of 2019, where the average becomes (#1 + #2) / 2.

Option 2: report the two initial loans as having their initial unchanged balance for end of 2019, where the average becomes (#1 + #2).

Option 3: calculate a theoretical balance for the two initial loans, as if they had been paid at the same rate as the new loan.

Option 4: take the exact balance of the two loans at the time of refinancing, and use that value to calculate the average value for the year.

Each option leads to a different outcome. #1 gives you the most money back, #2 gives you the least. #3 makes the final numbers indistinguishable from having a single loan for the entire year, and #4 is somewhere in the middle, depending on the exact timeline of refinancing.

Thanks to all in advance!