Deductible Mortgage Interest Questions w/ Balances Above $750k, Exact Method

[hbomb272]

For tax year 2023 I owned a condo which was my primary residence until I purchased a house on 8/29/23. When I purchased the house that residence became my primary residence and the condo became my second home. Neither home is rented for any portion of the year.

Below are the terms of the loans for 2023. Based on the origination dates I am subject to the combined $750,000 cap on mortgage amount for the mortgage interest deduction.

Condo Loan (Original Primary Residence but became Second Home on 8/29/23)

Origination Date – August 2021

Average balance for 2023 - $458,000

Interest Rate – 2.625%

Interest Paid in 2023 – $12,048 (Monthly Average of $1,004)

Home Loan (New Primary Residence)

Origination Date – 8/29/23 (1st Payment in October 2023)

Average balance for 2023 – $725,000

Interest Rate – 6.875%

Interest Paid in 2023 - $12,465 (3 Months starting in October, Monthly Average of $4,155)

Since the new house/mortgage is at a much higher interest rate I want to claim 100% of this mortgage interest as deductible and then claim any remaining balance up to the $750k limit from the second home/other mortgage. Logically this makes a lot of sense, since my primary residence is the basis for the majority of the deduction, not my second home.

Initially I read Publication 936 which would divide $750,000 by the combined balances of the mortgages together to determine an eligible percentage, and then apply that percentage the combined total interest paid. However, this would result in a lower deduction than what I proposed above, both this year and especially in future years, since my condo/second home loan is at such a lower interest rate. It also doesn’t work correctly for 2023 since I didn’t own both residences for the entire year.

From there I scoured forums and the internet to see if there are other options and learned of the "exact method" of calculating the mortgage interest deduction when more than one house is involved. As I understand it, it works by figuring the deduction on a debt-by-debt basis relative to the limit and you can take this a step further and look at it on a month-by-month debt-by-debt basis.

I also read the IRS Letter Ruling (Number: [removed], here: https://www.irs.gov/pub/irs-wd/1201017.pdf) and IRS Temporary Reg 26 CFR § 1.163-10T (here: https://www.law.cornell.edu/cfr/text/26/1.163-10T). While these both predate the most recent tax law changes, it appears that the rationale remains valid, and the Letter Ruling even explains how the Temporary Regulation remained applicable through one change in how the mortgage interest deduction worked.

I also found reference to this document from 2018 and on page 14 and 15 the exact method is referenced with an example (not specific to a second home, however). https://cdn.ymaws.com/www.oatc-oregon.org/resource/collection/E359D405-F529-4348-B521-421CFD25FA2B/H...

Based on these sources and the related forum discussions it appears that the taxpayer must use a reasonable method to apportion interest, and that Pub 936 and the Temporary Reg provide options that a taxpayer *may* use, but isn't required to use. They also reinforce that a taxpayer may make these determinations on a loan-by-loan and residence-by-residence basis.

My key questions are:

Am I understanding the rules and intent correctly?

Is the below a correct application of the “Exact Method”?

Is the below an accurate and acceptable way to calculate deductible mortgage interest for tax year 2023?

How do I enter this amount into TurboTax?

Can I use the online version or does it have to be the desktop version?

January through September - $1,004 deductible interest each month ($458k Average Balance (on my then Primary Residence) is below the $750k Cap) for a 9-month total of $9,036

October through December - $4,210 deductible Interest each month ($725k Average Balance on my new Primary Residence @ $4,155 Average Monthly Interest PLUS $25k/$458k of my Second Home = 5.459% x $1,004 Average Monthly Interest = $55) for a 3-month total of $12,630

TOTAL Deductible Interest = $21,666 for 2023

[zomboo]

The Tax Reform Act of 1986, made personal interest nondeductible The temporary regulations (1.163-9T & 1.163-10T) came out shortly after the 1986 tax reform, and proposed the qualified home limit be equal to the home value when the mortgage was secured plus additional expenses to improve the home. Most of the temporary regulations became obsolete when the 1987 Tax Cuts and Jobs Act was enacted which imposed $1,000,000 limit on acquisition debt and $100,000 limit on equity debt but left the mortgage limit tied to the value.

The memorandum that you site (https://www.irs.gov/pub/irs-wd/1201017.pdf) provides advice on the temporary regulation 1.163-10T mortgage deduction limit. It concluded that, until further regulation is passed, the provisions of 1.163-10T apply, provided the current limit of $750,000 is substituted in place of the home value.

Note, however, that none of the information provided in these resources speaks to your situation of having both a main and second home. All of the examples are for multiple mortgages secured by the same home. If you follow the debt-by-debt approach, each mortgage is under $750K and, therefore, all of your interest would be deductible. This is not the intent of Pub 936.

You chose to follow the debt-by-debt approach as if both mortgages are secured by the same home, but you didn’t do it correctly. Here is my interpretation on how that would work:

Condo Mortgage:

Origination Date – August 2021

Average balance for 2023 - $458,000

Interest Paid in 2023 – $12,048

Deductible Interest: Balance below $750K all year so all interest is deductible

Main Home

Origination Date – 8/29/23 (1st Payment in October 2023)

Average balance for 2023 – $725,000

Interest Paid in 2023 - $12,465

Deductible Interest: ($725K -$458K)/$725K = 36.8% of $12,465 = $4,587

Total Deductible Interest: $12,048 + $4,587 = $16,635

But this too is not the intent of Pub 936.

You can override the deductible interest in Turbo Tax with your calculated value. That’s up to you. You just need to be prepared to explain how you got your value in the unlikely event someone asks. For the record, if you follow Pub 936 you get:

$725K/$1.183M = 61.3% of ($12,048 + $12.465) = $15,026

[hbomb272]

Thank you very much for the reply and insight. Are you claiming the Condo Mortgage in its entirety since it was owned all year versus the new primary home for only 3 months?

I am curious how you would calculate next year 2024 taxes, given similar inputs, for the debt-by-debt approach - would the primary home be the new emphasis on this methodology?

Primary Residence - $725k average balance, $4,155 average monthly interest x 12 = total interest of $49,860

Second Home - $458k average balance, $1,004 average monthly interest x 12 = total interest of $12,048

I think I understand publication 936 and it's approach - $750K/$1.183M = 63.3% of ($49,860 + $12,048) = $39,183 in deductible interest for 2024. This is lower than the interest paid on my primary residence alone.

Is it possible to omit the second home 1098 and associated interest, and only claim the 1098 interest on my primary residence? This would result in a higher deductible amount for 2024 than publication 936. Or is there any other reasonable method that wouldn't result in the second home bringing down the deductible amount?

Thank you!

[KrisD15]

YES

If you have a home loan on your main home which is fully deductible and also a home loan on a second home which would limit the interest that can be claimed for both homes, only claim the interest on the main home loan. 

[zomboo]

With respect, how can you claim it is okay to omit a mortgage or two from your taxes without declaring it as unsecured? I need a lesson here.

@KrisD15 

[zomboo]

Since I last posted, I have reviewed Tax Reg 163(h), the Omnibus Budget Reconciliation Act of 1987, and the Tax Cuts and Jobs Act of 2017. What struct me most is that these regulations do not provide information on mortgage balance averaging methods or how to handle a mortgage on a main home and another on a second home.

Mortgage averaging methods appear to have first showed up in the temporary reg 163-10T and included the exact and simplified methods as well as first and last balance, interest paid divided by interest rate, and the statement balance methods. Pub 936 included all of these except for the exact method. However, memorandum PRESP-120431-11 (2011) argues that the exact method still applies until the IRS explicitly states otherwise provided the $750,000 mortgage limit is used. I guess because Pub 936 didn’t rule it out.

I do need to make a correction in my calculation of applying the exact method as if they were secured by the same home. It should have been:

Deductible Interest: ($750K -$458K)/$725K = 40.3% of $12,465 = $5,023

Total Deductible Interest: $12,048 + $5,023 = $17,071

I claimed mortgage interest on the condo mortgage in its entirety because it the first mortgage chronologically in an effort to make it fit into the 163-10T model which is based on multiple mortgages secured by the same home.

For tax year 2024, the approach would be the same. Of course, if you applied this method first to your main home:

$750,000-$725,000 = $49,860

$25,000/$458,000 = 5.5% of $12,048 = $663

Deductible Interest = $49,860 + $663 = $50,523

This is much better right? But we are stretching the 163-10T method even more to justify a higher refund. Remember this method was left out of Pub 936, is not defined when you have mortgages secured by different homes, and the experts saying ‘I guess it’s okay if you reinterpret the limit’ since Pub 936 didn’t rule it out by name.

I now believe the intent of reg 163(h) and 163-10T is that the exact method should be applied to the combined balances of your main and second homes and not applied separately. This is only slightly better than the Pub 936 method:

$750,000/1.183M = 63.4% of $24,513 = $15,541 (simplified using $750K limit)

$725,000/1.183M = 61.3% of $24,513 = $15,026 (Pub 936 using $725K limit)

Remember, the TCJA sunsets in a couple of years, and the limits go back to the $1M level unless congress intervenes.

[KrisD15]

I believe that if a person had two mortgages, 

say one is a 15 year loan with a balance of 700,000 and at 10% interest

say one is a 30 year loan with a balance of 700,000 and at 2% interest

I think claiming only the interest on the 10% loan would be more advantageous to the taxpayer than averaging the two loans, and I think that would not violate any tax laws. 

I should add that if you make this choice, you would need to continue reporting Home Mortgage Interest this same way (by not including the second loan) in future tax years.

@hbomb272 

ACCORDING TO THE IRS:

"Choice to treat the debt as not secured by your home.

You can choose to treat any debt secured by your qualified home as not secured by the home. This treatment begins with the tax year for which you make the choice and continues for all later tax years. You can revoke your choice only with the consent of the IRS.

You may want to treat a debt as not secured by your home if the interest on that debt is fully deductible (for example, as a business expense) whether or not it qualifies as home mortgage interest. This may allow you, if the limits in Part II apply, more of a deduction for interest on other debts that are deductible only as home mortgage interest."

[zomboo]

Thank you @KrisD15 for this information. I was aware of this option but didn't give much attention because of its locked-in feature and the interest for the condo is not deductible deducted elsewhere (business, rental etc.). Let's look into applying this option:

Tax Year 2023:

Deducting Main Only: All interest is deductible = $12,465

Deducting Both Loans: $750K/1.183M = 63.4% of ($12,048 + $12,465) = $15,541

Result:  A loss of $3,076 in deductions

Tax Years 2024 & 2025:

Deducting Main Only: All interest is deductible = $49,860

Deducting Both Loans: $750K/1.183M = 63.4% of ($12,048 + $49,860) = $39,250

Result: A gain of $10,610/yr for two years

Tax Years 2026 and beyond (post TCJA):

Deducting Main Only: All interest is deductible = $49,860

Deducting Both Loans: $1M/1.183M = 84.5% of ($12,048 + $49,860) = $52,312

Result: A loss of $2,452/yr for all remaining years

If you are considering this option, it would benefit you to wait until next year to start to avoid the loss of deductions this year. Remember, if you don't apply this option, your percentage of deductible interest will increase slightly each year as the mortgage balances decrease.