Question

1. Joyce and Jane purchase only the Hampton home, not the Manhattan condo. (They rent their Manhattan condo, instead.) After purchasing the Hampton home in April, they had no plans to renovate the home, as they liked its gently worn appearance. At least, they thought they did. By September, they are tired of the look and decide that it needs substantial improvements, after all. Thus, they hire an architect, designer, and contractor to design and construct a substantial addition to the home, as well as to renovate the old kitchen and bathrooms, substantially increasing the value of the cottage. The entire project cost is $400,000, all of which is funded by a second mortgage on the home, secured by the home. Thus, in addition to the $6,000 interest paid on the first mortgage this year, they paid $16,000 interest on the second mortgager. How much of their aggregate $22,000 interest can they deduct this year under § 163(h)(3)?

Answer 1

As per section 163(h)(3), deduction shall be allowed for any interest paid or accrued during a taxable year (Qualified Residence Interest).However, in order to take the advantage of such deduction, the payment or accrual of such interest must be from either acquisition indebtedness or home equity indebtedness in respect of any qualified residence of the taxpayer. Acquisition indebtedness means indebtedness that is incurred in the acquisition, construction or substantial improvement to such qualified residence and is also secured by it. On the other hand, home equity indebtedness means indebtedness which is secured by the qualified residence to the extent of the aggregate amount is not higher than 1) FMV if such qualified residence less: 2) amount of acquisition indebtedness in respect of such residence.

From the facts given in the question, it seems as if it is a case of acquisition indebtedness, therefore, full deduction can be made of the aggregate interest of $22,000 during the taxable year. The reason is that the aggregate amount that is considered as acquisition indebtedness should not be higher than $1,000,000 ($500,000 in case of a married individual who is filing a separate return) and in the given case, it is within the above-mentioned limits.