Mortgage Interest Deduction Complexity, Error?

[Shonuff66]

Seems like I'm not getting the right Average Mortgage Balance in the Deductible Home Mortgage Interest Worksheet.

*Home 1 was sold/paid off in Sept 2021 (started Jan 1st with 500K principal). Home purchased in 2007, refi in 2020.

*Home 2 was bought in April 2021 (started with $2.2M Principal ended with $1.4M ). Made large principal-only payment in Sept.

The average mortgage balance TT is reporting in forms is $1.8M, which is just the "Average of first and last balance method".  This seems wrong - should it account for both mortgages and the fact that the home was owned only part of the year?

The "Home Debt Originating after Oct 13 1987..." section has loan 1 (i.e. Home 1) listed but only one field is filled in "Enter amount debt used to buy...". Why aren't the other fields filled in to calculate the avg balance there?

Seems like I'm much better off with "Interest paid divided by interest rate method", but I don't know how to do this for both loans and enter it into TT. Any idea?

[RaifH · Accepted solution]

The first and last method does not work if you make a large principal payment, and TurboTax calculates it on the assumption you carry the mortgage the entire year. Also, the IRS only allows the interest rate method to be used if you have the mortgage all 12 months. You're going to have to resort to the average monthly balance calculation for both of your homes. Home 1 you had about a 500k balance for 9 months out of 12, so your average monthly balance is ~$375k. Home 2 you had 0 balance for 3 months then 2.2 million for 5 months and 1.4 million for 4 months so you can take the average of that and report it in Box 2 as your Outstanding Mortgage Principal. If you use the monthly balance reported on your statements for both homes, it will come out a little more precise and give a better result since you pay off a little of the principal every month. Once you determine the average balance for both homes you report them in this way:

1. In the Federal > Deductions & Credits section of your return, scroll down to Your Home and click Revisit/Start next to Mortgage Interest and Refinancing (Form 1098)
2. Edit your existing 1098 or start a new one. 
3. Answer the questions and enter the information from your Form 1098s:
   1. Box 1 Mortgage interest - As reported on both 1098s
   2. Box 2 Outstanding Mortgage Principal - As you calculated above for both loans
   3. Box 3 Mortgage Origination Date - Use the original purchase date for the first home, back in 2007, use the date on Form 1098 for the new home
   4. Boxes 5 & 6 - Use the combined totals from both 1098s
   5. Make sure Box 7 is checked
4. Answer What kind of property is this loan secured by? Make sure one home is entered as primary, the other as secondary. 
5. Answer Yes or No to  We didn't pay any points.
6. Answer Yes to Let's see if this is the most recent form for this loan.
7. Answer No to Is this the original loan used to buy your property? for the first home
8. Answer Yes to Is this loan a HELOC or a refinance? for the first home
9. Answer No to Did you take cash out? (assuming you did not take cash out when you refinanced in 2020)
10. Once you are back in the Home loan deduction summary screen, click Done.
11. Answer NO to Do either of these apply to this loan? Answer No even if it does apply, by using the mortgage origin date of the original purchase back in step 3, TurboTax will correctly apply the proper mortgage limit on your home acquisition debt. 
12. Enter the calculated average as the outstanding loan balance on January 1, 2022 in the first field. Enter the sale date of the first home in the second field for that loan.

TurboTax automatically calculates the average balance by using the number you report as Outstanding mortgage principal as the beginning of the year balance and the number reported as outstanding on January 1, 2022 as the end of the year balance and takes the average of those two numbers. By reporting the same number that you calculated using the average monthly balance, it will report the correct balance for both loans and apply the mortgage interest limit correctly. 

[Shonuff66]

Since I'm entering things that don't quite match  1098, will the IRS flag this?

This method worked upon looking at the forms. I'm surprised TT doesn't figure this out for itself. So many people must be trusting how it calculates this.

[RaifH]

The outstanding mortgage balance you calculated as well as the other information you enter into TurboTax will go onto the TurboTax worksheets, but those are not reported to the IRS. The only number reported to the IRS is the deductible mortgage interest on Schedule A, they do not get a copy of the Form 1098 you are filling out. They can question how you generated that number, so you will want to keep any notes with your tax records to remind yourself how you derived the outstanding mortgage balance for each loan. 

[jennamahoney3]

@RaifH -- would you use the individual average monthly balance calculations for each 1098 entry re: Outstanding Mortgage Principal? For example,  in your scenario, Home 1 had an average monthly balance of ~$375K.  It looks like Home 2 would have an average monthly balance of ~ $1.38M. If I'm understanding your explanation, the average monthly balance for the year would be $1.755M ($375k + $1.38M).

When I enter the 1098 for Home 1, would I put $375k as the Outstanding Mortgage Principal or would I put $1.755M? Same question for Home 2 -- would I put $1.38M or $1.755M?

Thanks in advance for any assistance! 

[DMarkM1]

Yes and no.  This is a thread from last year but the principal is the same this year.  

Yes, you figure the average balances separately and then add them together.

No, you would not change your form 1098 entries.

You will continue to enter the information from your forms 1098 just as you received them.  After completing your entries if TurboTax has calculated that your interest has been limited you will be given the opportunity to enter an adjusted amount of deductible home mortgage interest based on your calculations using Publication 936, Table 1.  

Use the sample calculations below to help you figure your mortgage interest deduction which you would then enter in the "Adjustment" box.  

As @RaifH mentioned last year the worksheets are not transmitted as part of your tax filing.  Keep your calculations with your tax records in case the question ever comes up.

Sample with general amounts. 

Loan 1 = beginning balance on 1 Jan 2022 (box 2 1098).  $585,000; ending balance (payoff $580,000)  Average mortgage balance with payoff in Aug (8 months).   585K + 580K/2 = 582.5K  (8/12) = 388,333 (Table 1 lines 2, 6)  Interest paid: 15,000

Loan 2 = beginning balance (box 2 1098) - 1.9M; ending balance 1 Jan 2023 (first statement 2023) 1.5M with 6 months interest paid (Jul-Dec) Average balance  1,900K + 1,500K/2 = 1,700,000 (6/12) = 850,000 (Table 1 line 7).   Interest paid 15,000

Add those average balances together 388,333 + 850,000 = 1,238,333 (Table 1 line 12) 

Therefore 750,000/1,238,333 = .6056 (Table 1 line 14)

Total interest paid:  30,000 (Table 1 line 13) x .6056 = 18,169 Deductible interest paid (Table 1 line 15). 

[jennamahoney3]

@DMarkM1 

[DMarkM1]

It depends.  In online versions you are limited to the step-by-step interview process.  There you will only be able to enter your calculated interest deduction in the "Adjustments" box on the Mortgage Limitation screen (see below).  

In desktop versions you have the step-by-step option but you also have the "Form View" option where one can override the total average balance in the "Ded Home Mort" worksheet.  

It would appear based on your scenario that your interest would not be limited and you would enter the full interest paid amount.

 

[tbain98]

@DMarkM1,

Is there anything from the IRS indicating that averaging the balance across all 12 months of the year (including months when the property was not owned by the taxpayer) is valid? Pub 936 says you can treat those months where the mortgage wasn't secured by a qualified home as having a zero balance, but then says "dividing that total by the number of months the home secured by that mortgage was a qualified home during the year." For a home that was bought or sold during the year, that seems like you don't get to divide by 12 but rather by the number of months you owned the home during the year.

The law (h.3.B.ii) underlying the Pub doesn't get specific about this, but does say "The aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000" (now $750k), which sounds to me like it would conflict with jennamahoney3@'s conclusion that all interest was deductible despite having a balance over $750k for a period of the year. And that makes me question the validity of the divide-by-twelve method of computing the average balance at all.

I'm leaning towards allocating interest towards each of three separate time periods (when I owned only home 1, when I owned both homes 1 & 2, and when I owned only home 2) and computing Table 1 for each period and then summing them as the approach that seems most in keeping with the intent of the law. But I'm concerned about the fact that it goes against the instructions in Pub 936 which say to list all debt for the year when computing Table 1. Is there any case law or official guidance from the IRS about this specific question?

[DMarkM1]

@tbain98  You can use the different periods as you describe and you should end up with an annualized ratio as the example I shared before.   

To support an annualized calculation here is another example.  Mathematically, for a loan opened 1 March, the interest paid = [(annual interest rate)/12  X  annual loan amount] x 10 which also equals annual interest rate x [monthly loan amount x 10].

Interest rate 3%

Loan amount 800K

10 months

Interest paid = 20,000 No matter which formula above is used.

20K = [(.0025) x 800K] x 10

20K = .03 x (66,667 x 10) 

What mortgage balance to use in Table 1?   

1.  Mortgage Balance 800,000K deduction 18,750

2.  Mortgage Balance 666,667 deduction is 20,000  

So from one perspective the mortgage balance that the interest has been paid on is over $800K every month by using 1/12 of interest every month for 10 months.  

But from another perspective the aggregate mortgage balance that interest has been paid on doesn't exceed $800,000 until about month 11 with the full interest rate being used every month.  So 10 months would be deductible.   

Same loan, same interest rate, same 10 months, same interest paid every month, same total interest paid for the year. 

[tbain98]

I think what you're saying is equivalent to saying "this is the same interest that the taxpayer would have paid if they had held the loan with a lower average balance for the full year even though that wasn't the actual period the mortgage was held." And while I agree that that's mathematically true, I'm not sure why the IRS would accept that argument for why the mortgage interest shouldn't be limited, when 1) the balance was in fact over $750k at times and 2) it amortizes over months when the taxpayer didn't own the property.

The underlying law says that the limit applies to "any period," so interpreting that as "it's OK to amortize over the full year, including periods of time the taxpayer didn't own the property" seems to me like it wouldn't be consistent with the law. Unless maybe there's guidance from the IRS that indicates this is acceptable? (In which case, if the IRS says it's OK, then that's certainly more authoritative than my amateur reading of the law!)

[geniusjazz]

Any answer for this. I am having the same confusion as @tbain98 . 

Does it make sense to amortizes over months when the taxpayer didn't own the property?

I looked specifically into IRS Pub 936, and there are conflicting information as well.

On one hand, it says "For each mortgage, figure your average balance by adding your monthly closing or average balances and dividing that total by the number of months the home secured by that mortgage was a qualified home during the year.

On the other hand, there is an example in the same publication, that does amortization over the whole year. 

"In 1986, Sharon took out a first mortgage of $1,400,000. The mortgage was a 7-year balloon note and the entire balance on the note was due in 1993. She refinanced the debt in 1993 with a new 30-year mortgage (grandfathered debt). On March 2, 2022, when the home had a fair market value of $1,700,000 and she owed $500,000 on the mortgage, Sharon took out a second mortgage for $200,000. She used $180,000 of the proceeds to make substantial improvements to her home (home acquisition debt) and the remaining $20,000 to buy a car (home equity debt). Under the loan agreement, Sharon must make principal payments of $1,000 at the end of each month. During 2022, her principal payments on the second mortgage totaled $10,000. To complete Table 1, line 7, Sharon must figure a separate average balance for the part of her second mortgage that is home acquisition debt. The January and February balances were zero. The March through December balances were all $180,000 because none of her principal payments are applied to the home acquisition debt. (They are all applied to the home equity debt, reducing it to $10,000 [$20,000 − $10,000].) The monthly balances of the home acquisition debt total $1,800,000 ($180,000 × 10). Therefore, the average balance of the home acquisition debt for 2022 was $150,000 ($1,800,000 ÷ 12)."

Any ideas? @DMarkM1 @RaifH