Multiple 1098 due to refinance with principal paid down

[razor5]

I am using TurboTax Desktop on Mac Home and Business with all latest updates. 

I am having trouble understanding how TurboTax is calculating the mortgage interest deduction and average principal. Below is an example scenario similar to mine:

Let's say home was originally purchased in 2019 for 1,000,000. Refinanced in 2020 which was reported in 2020.

Refinanced again in 2021 generating two 1098 forms. But during the refinance to get lower rates I paid down the principal during closing. i.e  the refinanced loan balance + my extra payment during closing paid off the existing loan. The originating principal on most recent 1098 is lower than the pay off on earlier loan.

Loan A

Pay off: 9,000,000

Paid off on: 02/10/2021

Loan B (latest refinance of loan A): 

Loan amount: 850,000

Extra payment made by me during closing: 50,000

So loan A existed almost a month i.e. in January.

When I use TT and file in the two 1098 separately and then look at the Deductible Home Mortgage Worksheet I see that only one loan (Loan B) is mentioned in Part 1 Home Mortgage Loan Information under Loan 1. Loan A is not present there at all. 

In Part 2. Deductible Home Mortgage Interest the average balance is just Loan B originating amount i.e. (850,000 + balance on Jan 2022) /2. It does not factor in the principal of Loan A at all. 

The total amount of interest on line 14 is sum of the interest paid towards Loan A and Loan B and then it goes about dividing 750,000 with the average balance and multiplying with the interest to find the deductible.

This seems wrong to me as it is not factoring in the Loan A principal neither the principal payment paid down by me.

[RaifH · Accepted solution]

The IRS is not very clear on how to determine your average loan balance when you do not carry the loan the entire year. One of the instructions in the IRS publication is "Figure the average balance for the current year of each outstanding home mortgage." It explains different ways of determining the average loan balance, one of which is the first and last month divided by two that TurboTax is using on your most recent loan, but it doesn't explain what it means by outstanding. The software is just not including your paid-off loan in the calculation at all. This may be because your new 1098 has a mortgage acquisition date which tells the software that the old loan is not in effect anymore. 

You can override TurboTax if you want to use a different IRS-approved method to calculate your average loan balance. Often, I recommend the average of monthly statements, but in your case, I'm not sure the result would be better. You would calculate that by taking the outstanding mortgage principal of the first loan which you paid off in February multiplying it by 2 and then dividing by 12 to determine the average monthly balance. If you have the actual monthly balances, you can use those as well so it would be January balance + February balance / 12. 

For the new loan, you would take the 850,000 and multiply by 11 then divide by 12. You would then report those calculated numbers in Box 2 of Form 1098 and as the balance on January 1, 2022. 

The IRS specifically says you can only use the interest-rate method if the loan is carried all 12 months of the year, so that one is out. 

The principal payment you made during the refinance will not be deductible. Only interest payments are deductible.

[razor5]

Thanks for the response and help. 

Okay so, I am planning to leave it as TurboTax is doing right now in its default behavior i.e

1. It has calculated the interest paid across two loans by adding them up. 

2. It has calculated the average based on most recent loan first and last month omitting the previous loan 1098.

Yes, the refinanced loan 1098 has an origination date mentioned on box 3 in 1098.

3. After calculating the above, since my original loan was taken after 2017 I am only qualified for deduction on 750k. So it does (750,000/avg. balance) * total interest paid across two loans and mentions that as the federal deductible.

Can you please confirm that it okay to file the taxes with this calculations which TT is doing by default? 

Thanks. 

[JillS56]

Yes, it is okay to leave the calculations as TurboTax has calculated.  

[jxman]

I disagree and believe that TurboTax is doing the wrong calculation.  If you follow the official IRS publication 936, it includes both a worksheet and examples on page 13 on how to calculate the "Average Balance".  Line 7 of the worksheet says "... Enter the average balance of all your home acquisition debt incurred after December 15, 2017 ..".  The key take for me is the word "ALL" and if you are like where I had 3 mortgages on the same property with the principal paid down, I need to do this calculation for each.  I used the "Interest paid divided by interest rate method." and did that for each 1098 and then added them up to come up with my average balance.   The calculation was simple, where you divide the total interest paid by the interest rate on that mortgage.  I took that number and completed the worksheet to come up with the number that should be used on Schedule A with form 1040.  Now I am trying to figure out how to best manually file and apply these numbers, but this I believe is the correct and easiest way to calculate the number needed.

https://www.irs.gov/pub/irs-pdf/p936.pdf

[RaifH]

The IRS language is pretty unclear in Pub 936, but one thing it does clearly state is that the interest rate method can only be used "if at all times in 2021 the mortgage was secured by your qualified home and the interest was paid at least monthly."

In your case, assuming you did not carry all three mortgages for the year, I would use the monthly statement method if you do not feel comfortable with TurboTax's method of calculation. The easiest way to calculate that is to take the outstanding mortgage principal in box 2, multiply it by the number of months you carried the loan, and divide by 12. For a better and more accurate result, you can actually refer to your monthly statements, as your principal will decrease each month. 

To get TurboTax to use your calculated number rather than have it calculate using the average of the first and last month only on outstanding loans, you can mark every loan as outstanding by answering Yes to Let's see if this is the most recent form for this loan. For Outstanding mortgage principal in Box 2, you would enter your calculated amount for each loan. You would enter this again when it asks for the balance on January 1, 2022. 

[jxman]

Thanks for the reply on the interest rate method.  Where does IRS Pub 936 mention that you can use ".. average of the first and last month only on outstanding loans"?  I dont see any mention outstanding loans, however that certainly would make that easier to calculate. 

[jxman]

Mortgage A (principal over $750K) was sold and became Mortgage B in February.  In October I refinanced Mortgage B to Mortgage C and paid down the principal to be under $750K.  Using TurboTax it will only calculate my average balance on Mortgage C which was under $750K and ignores the balances from A and B.  Based on the worksheet and IRS Pub 936 you need to include all home acquisition debt and that makes the calculation on TurboTax wrong.  What am I missing?

[RaifH]

On the instructions for Line 12 on the worksheet for calculating your average loan balance, the IRS states to use only your outstanding home mortgage. As far as I can tell, this is the only mention of only using outstanding mortgages, not all mortgages you carried during the year. It seems a little counter-intuitive to me, but TurboTax seems to be following the letter of the law by using only the outstanding balances. 

@jxman

[jxman]

The instructions for line 12 on the worksheet are fairly straight forward where you just add 1,2 and 7.  Using the word outstanding in the detailed instructions is a bit misleading, however those balances where outstanding during the year of 2021 and should be included in the average balance.  

I believe excluding them from your calculation would be wrong.

[jxman]

Another danger here is using "Outstanding" would be bad assuming you payoff a loan over $750K during the year and had nothing outstanding.  What would you then do to calculate your average balance.  Not an easy calculation here, but I think TurboTax has is wrong.  

[RaifH]

You can override the TurboTax calculations using the instructions above if you are not comfortable with how TurboTax calculates the average balance. The IRS certainly won't trouble you if you are deducting less interest than you would be eligible for. 

I don't disagree with your interpretation of the average balance. Intuitively, it makes more sense to me. IRS Publications can't be used to justify tax positions, you would have to dive into the actual Internal Revenue Code (which I don't think is any more clear) and any previous treasury regulations or rulings to see how they have interpreted this in the past. 

@jxman

[jxman]

So after agonizing over this for a number of days I decided to go with the "Statements provided by your lender." option from 936.  At this point it makes the most sense and it didn't take too long to add each monthly balance from my 3 mortgages held during the year and divided that number by 12.  The number was actually more favorable that using my interpretation of the "Interest paid divided by interest rate method."  Thanks for all the help and I hope someone else might find this useful.