Question

On January 1 of year 1, Arthur and Aretha Franklin purchased a home for $1.86 million by paying 260,000 down and borrowing the remaining $1.60 million with a 5 percent loan secured by the home. The Franklins paid interest only on the loan for year 1 and year 2 (unless stated otherwise). (Enter your answers in dollars and not in millions of dollars. Do not round intermediate calculations. Leave no answer blank. Enter zero if applicable.)

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 $330,000 secured by the home at a 5 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

Answer to que a. is $55,000

Limit on loans taken out on or before December 15, 2017.

For qualifying debt taken out on or before December 15, 2017, you can only deduct home mortgage interest on up to $1,000,000 ($500,000 if you are married filing separately) of that debt.

Additionally, to above, Home equity debt other than home acquisition debt taken out after October 13, 1987, up to a total of $100,000. The limit is $50,000 if you're married filing separately. Home equity debt other than home acquisition debt is further limited to your home's fair market value reduced by the grandfathered debt and home acquisition debt.

So the home-equity indebtedness limit is ($100,000), the maximum amount of debt on which a taxpayer may deduct qualified residence interest is $1,100,000 as long as the value of residence is at least$1,100,000.

Since the Franklin’s home is worth $1.86 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

= $1,600,000 × 5%= $80,000

Deductible interest expense

= Qualified debt/Total debt x total interest expense

= [$1,100,000 /1,600,000] × $80,000= $55,000

Since the Franklin’s make only interest payment the outstanding principal remains same. Hence interest expense deductible for Year 2 remains same

Answer to que b. is $37,500

Limit on loans taken out after December 15, 2017.

For qualifying debt taken out after December 15, 2017, you can only deduct home mortgage interest on up to $750,000 ($375,000 if you are married filing separately) of that debt. Further additional limit of home-equity has been removed.

So the maximum amount of debt on which a taxpayer may deduct qualified residence interest is $750,000

Thus, the amount of deductible interest on the loan is calculated as follows:

Total interest expense

= total loan principal x interest rate

= $1,600,000 × 5%= $80,000

Deductible interest expense

= Qualified debt/Total debt x total interest expense

= [$750,000 /1,600,000] × $80,000= $37,500

Since the Franklin’s make only interest payment the outstanding principal remains same. Hence interest expense deductible for Year 2 remains same

Answer to que c. is $ 0

Qualifying debt

You can only deduct home mortgage interest to the extent that the loan proceeds from your home mortgage are used to buy, build, or substantially improve the home securing the loan ("qualifying debt").

Once acquisition indebtedness is established, only payments on principal can reduce the indebtedness and only additional indebtedness secured by the residence and incurred to substantiallyimprove 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 cannot be deducted.