another complicated mortgage interest question

Hello,

This is one of those situations where I get new and different information from the client every time I ask a questions... I am confident he's not lying, but he hasn't given me the whole story, or maybe I just haven't asked the right questions.

Client acquired his personal residence in 2007 for $825k and has taken cashout refi's several times since then. With his most recent refi (late 2017, about $1.2m) he told me that about $400k of the proceeds went into his investment account for stock purchases.

We went back and forth a few times discussing how much he could claim as home mortgage interest and how much he could (or couldn't) claim as investment interest (... some of you might recall my post from a few weeks ago on this issue: excess mortgage interest taken as investment interest?)

Now client tells me that starting in 2016 he demolished and then rebuilt this personal residence. Between 2016 and 2020 he paid the architect and contractor $1.2M for the rebuild

So now I'm confused... I see two issues:
1- can we associate the $1.2M rebuild with the debt reported on this 1098 since the property securing the loan was the one that was rebuilt? Or do we have to acknowledge that if we traced the proceeds they would go towards stock market investments, not the home rebuild. This presumes the cash for the rebuild came from some other "pot of money"

2- if we can associate the rebuild with the debt, can we claim the $1M + $100k as home mortgage interest since the loan originated before 2018? Or, since some of the money was paid to the architect and contractor after 1/1/2018 are we constrained to some extent by the post-2017 limits?

Any thoughts?

Deb

What is the 1098 showing as mortgage balance in 2020 and in prior years? Did you ask for the refi papers when client told you he did a refi?

The other thing you may want to do is to ask for the invoices for the rebuilt. No one looses a $1.2 M invoice ... Tell your client you need the invoices to keep track of the basis of the home in case in gets sold, disappears in a disaster, man- or nature-made. You can also google the address. A 1.2M demolishing and rebuilding project leaves a big paper trail in permits, re-assessed property taxes (which are available online).

That will take care of the confusion ... which may be your client's. Story doesn't add up: 400K first taken out as investment interest per your client and now it turns into a home demolishing and rebuilding project which started in 2016 and included the $400K which client told you first was investment interest... if I'm understanding it correctly.

Andrew... i've already decided that I believe him... his w2 income plus the rest of his tax return makes the story credible, even thought it took a while to squeeze all the information out of him.

I'm leaning toward claiming the $1.1m deduction. Does that seem reasonable?

Deb

$1 million.

I would want to see the "actual" tracing, to make sure that if either everything is traced to the acquisition/construction directly, or fall under 90-day refi exception for HELOC or 2-yr exception for a construction loan, and that there was no commingling with any other personal funds, unless specific exception is met for each commingled cash flow.

Also, the loan balance could not be allowed to go up (or mortgage term extended) after Dec 2017, and make interest on that additional borrowing deductible, even if it's an acquisition debt.

Maria, thanks very much.

Please clarify... are you suggesting that if the proceeds of the most recent refi (from 2016) can be traced to the investment account, and not to the payments for the house demo/rebuild (although the client did indeed spend that money) that the client may not claim the interest on $1m as attributable to buying/improving the secured property?

Deb

Andrew... i've already decided that I believe him... his w2 income plus the rest of his tax return makes the story credible, even thought it took a while to squeeze all the information out of him.

I'm leaning toward claiming the $1.1m deduction. Does that seem reasonable?

Deb

Interest tracing is advisable. Even when you have decided that the client is right, it may be good advise to trace the interest. Most clients will not read the IRS tax code. But maybe your client has.

Deb,

Yes, if by following the actual proceeds tracing, you see that it went into an investment account, then it was not directly used for home acquisition/construction and is not deductible. The tracing rules require tracing of actual cash flows (not just matching equivalent amounts, and prohibit commingling with one's other personal funds). There are a few exceptions: last-in/first-out of the account and the 90-day exception). Otherwise, the client should have planned better and talked to you before taking out the loan.

Maria U. Ku, CPA
Oakalnd, CA