Examiner possibly incorrect on suggested adjustment?

Client had a mortgage that originated on 11/01/2017 with a 2020 beginning balance of $963,000 (qualified home acquisition, and all of that).

In July of 2020, the client refinanced the loan at $960,000.

The examiner is suggesting the disallowance of the mortgage interest deduction (of about $36,000) for that year (2020), and asking for a completed loan limitation worksheet and other documentation.


I thought that, when an original loan is refinanced, that the $750,000 limitation that started in 2018 (or late 2017) did not apply.

Of course, I looked it up in the Pubs (I know the tax code is better, but with my admittedly sophomoric experience, I have trouble reading it) and I see:

Any secured debt you use to refinance home acquisition debt is treated as home acquisition debt. However, the new debt will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing.

I read that as if the refi doesn't matter - - - that the client still gets to deduct 100% of the interest even though it was after 2018 and exceeds $750,000.

Is the examiner correct in suggesting the $750,000 limit should have applied in 2020?

if so, how is it computed given the fact that the old rules (1,000,000) applied for part of the year and the new rules (750,000) applied for the remainder of the year? Is it pro-rated? The worksheet does not seem to allow for this.

You're right, examiner's wrong. Show him sec 163(h)(3)(F)(iii)(I).

(F) Special rules for taxable years 2018 through 2025

***

(iii) Treatment of refinancings of indebtedness
(I) In general
In the case of any indebtedness which is incurred to refinance indebtedness, such refinanced indebtedness shall be treated for purposes of clause (i)(III) as incurred on the date that the original indebtedness was incurred to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.

Was this a cash-out refinance?

Was this a cash-out refinance?

I thought that only mattered if your loan principle increased? I.E. if you borrowed 700k, and refinanced back to 700k after a few years then it didn't matter. But if you borrowed 700k and refinanced to 750k, the 50k had to be used for a substantial improvement.

I only recently learned about this particular catch on refinance so I don't have a good grasp.

Not a cash out, thanks. Loan value decreased. But I'll look at the statements to see if the loan costs were added to the balance. I suppose that amount could be considered to be a cash out(?)

TheGrog, the way I read s163, as posted by Nilodop, is that only the amount of acquisition debt refinanced is subject to the old limitation. In any case, OP has noted that there was no cash out. So we have acquisition indebtedness of <$1 million being refinanced. Given the dates in the OP, I think the $1 million limit applies and examiner is incorrect in disallowing any mortgage interest.

Client had a mortgage that originated on 11/01/2017 with a 2020 beginning balance of $963,000 (qualified home acquisition, and all of that). In July of 2020, the client refinanced the loan at $960,000.

There’s a high chance the loan balance (principal only), at the time of re-fi in 7/2020 was less than $960k. I mean, if he started the 2020 year at $963k and made 6-months’ worth (or so) of payments in 2020, the principal balance was likely less than $960k at the time of re-fi. In which case, some (small) part of the new loan does not represent acquisition indebtedness. Interest on that small part wouldn’t be deductible. But I wouldn’t even bring this up to the auditor. If he wants to go there, fine. Just have your calculations ready. What you need to do is determine the amount of principal paid-off (old loan) on the re-fi. The settlement statement will include accrued interest in the payoff amount, so you’ll need to look at monthly statements, the Am Schedule, or whatever to figure out the old loan principal that was paid off at re-fi. Let’s say that was $940k. That means $20k of the new $960k loan (or 2%...which is small, like I said) doesn’t represent acquisition indebtedness. Thus, 2% of the new loan interest expense wouldn’t be deductible.

As a head’s up, you need to be doing this type of calculating any time a client re-finances a loan. These IRS inquiries surrounding mortgage interest are becoming commonplace these days when we’re deducting a significant amount of interest expense. You need to be prepared. And you need to be forward looking. You need to perform initial calculations like this in anticipation of the future…thinking about a second refinancing, then a third, and so on and so forth. We had one a few months ago where we had to trace back many years in order to properly respond to the IRS. Thankfully, we had kept up with the calculations over the years and have all documentation on file. It involved a land loan, and then a construction loan, and then a consolidated loan when it all went permanent, and then a few re-fi’s in there and then a sale of the mortgage from one lender to another, etc.

You can’t just take a Form 1098, drop it into your software and move on. You need to keep notes (and often, spreadsheets) about client mortgages.

Was this a cash-out refinance?

I thought that only mattered if your loan principle increased? I.E. if you borrowed 700k, and refinanced back to 700k after a few years then it didn't matter. But if you borrowed 700k and refinanced to 750k, the 50k had to be used for a substantial improvement.

I only recently learned about this particular catch on refinance so I don't have a good grasp.

What you have to trace is the portion of the refi'd loan that is attributable to the original home acquisition loan balance at time of refi. That is to say if original acquisition loan was $700k, I pay for a few years and now the balance is $630K, I refi and borrow $700k, then only 90% of the new loan is attributable to the acquisition indebtedness. If I borrow $750k, then only 84% is acquisition indebtedness. If you have multiple refis, you want to make sure you are tracking the amount attributable to the original indebtedness. Remember or make yourself familiar with the rules for payments that are applied to home equity indebtedness first.

Hello again.

So we provided all of the documentation including the limit worksheet and a quote of from sec 163(h)(3)(F)(iii)(I).

The IRS came back with a proposal to adjust the mortgage interest deduction to half of the allowed amount that we indicated on the worksheet.

I was baffled by this response and the client insists that everything is legit and that the examiner must not be competent.

After mulling on it a bit, I looked at all of the documents once more and I JUST noticed that the first loan includes the name of his ex wife and the 2nd loan does not.

It is worth mentioning that the 1098 statements (both) only show is name.

Note that the client insists that he has been 100% legally divorced since 2016 and has been filing as single from 2017 onward.

So I don't understand why they would only allow half of the amount anyway - it should include about 90% of it.

I can't get through to the examiner by phone and the practitioner priority hotline kicks me out due to high volume.

Do you think that the removal of his ex wife's name on the refi make it something other than a refi to where any grandfathering is disqualified?

Do you think that the removal of his ex wife's name on the refi make it something other than a refi to where any grandfathering is disqualified?

It’s possible that this is the reason why the auditor is disallowing half of the interest. Perhaps the auditor is taking the position that since both spouses’ names were on the mortgage that got paid off, your client is entitled to treat only half of that mortgage as acquisition indebtedness. If that’s the reason, then you need to point out that your client was 100% responsible for the full $963k mortgage, not just half.

Since the $963k mortgage was obtained before 12/15/2017, the $1,000,000 limit on acquisition debt applies to both that mortgage and to the principal balance of that mortgage that was paid off in the refinance. See sec. 163(h)(3)(F)(iii)(I):

(I) IN GENERAL.—In the case of any indebtedness which is incurred to refinance indebtedness, such refinanced indebtedness shall be treated for purposes of clause (i)(III) as incurred on the date that the original indebtedness was incurred to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.