Question

On January 1 of year 1, Arthur and Aretha Franklin purchased a home for $2.83 million by paying 330,000 down and borrowing the remaining $2.50 million with a 8.8 percent loan secured by the home. The Franklins paid interest only on the loan for year 1 and year 2 (unless stated otherwise).

a. What is the amount of interest expense the Franklins may deduct in year 2 assuming year 1 is 2017?

b. What is the amount of interest expense the Franklins may deduct in year 2 assuming year 1 is 2018?

c. Assume that year 1 is 2018 and that in year 2, the Franklins pay off the entire loan but at the beginning of year 3, they borrow $420,000 secured by the home at a 9 percent rate. They make interest-only payments on the loan during the year. What amount of interest expense may the Franklins deduct in year 3 on this loan? (Assume the Franklins do not use the loan proceeds to improve the home.)

Answer 1

a) $96,800

Tax Consequences of Home Ownership Because the acquisition indebtedness limit ($1,000,000) and the home-equity indebtedness limit ($100,000) are two separate limits, the maximum amount of debt on which a taxpayer may deduct qualified residence interest is $1,100,000 as long as the Tax Consequences of Home Ownership value of the taxpayers residence (or residences) is at least $1,100,000. Since the Franklins home is worth $2.83 million, they can deduct interest on up to $1.1 million. Thus, the amount of deductible interest on the loan is calculated as follows:

Total interest expense = total loan principal x interest rate

= $2.83 million X 8.8% = $2,49,040

Deductible interest expense = Qualified debt/Total debt x total interest expense

= [$1.1 million/2.83 million] $2,49,040 = $96,800

b) $8,800

Once acquisition indebtedness is established, only payments on principal can reduce the indebtedness and only additional indebtedness secured by the residence and incurred to substantially improve the residence can increase it. In this case, the Franklins reduced their original acquisition indebtedness to zero. Because the Franklins do not use the additional loan in year 3 to substantially improve their home, the loan cannot be classified as acquisition indebtedness. Thus, the interest on the loan can only be deducted to the extent that it qualifies as home-equity indebtedness. $100,000 of the loan qualifies as home-equity indebtedness and the Franklins may deduct $8,800 of interest paid on the loan (100,000 X 8.8%)

c) $37,800

Similar to part b above, the new loan can only be classified as acquisition indebtedness to the extent that the loan proceeds are used to substantially improve the residence. However, in this scenario, the Franklins will be able to deduct the full $37,800 ($420,000 X 9%) paid in interest because even though the loan proceeds are not used to substantially improve the residence, the full amount of interest is deductible because it qualifies as home-equity indebtedness and the amount of the loan is less than $100,000. home-equity indebtedness and the amount of the loan is less than $100,000