Mortgage interest & negative amortization

[Jeff]

Is negative amortization of 10000 on an original home acquisition loan considered home acquisition debt or home equity debt?

Would the interest attributed to that negative amortization be deductible on Line 10 of Form 8829 or would it be considered to have come from a mortgage loan that did not benefit the residence?

My initial take on this is that the interest attributable to the negative amortization would be considered home equity debt that would not be deductible on Line 10 of Form 8829.

Any other opinions?

[Koss]

Other opinion

Is negative amortization of 10000 on an original home acquisition loan considered home acquisition debt or home equity debt?

Would the interest attributed to that negative amortization be deductible on Line 10 of Form 8829 or would it be considered to have come from a mortgage loan that did not benefit the residence?

My initial take on this is that the interest attributable to the negative amortization would be considered home equity debt that would not be deductible on Line 10 of Form 8829.

Any other opinions?

Acquisition debt is defined on page 8 of Publication 936 as:

a mortgage you took out after 10/13/87 to buy, build or substantially improve a qualified home.

Negative amortization means that unpaid interest on the original loan is capitalized and added to the principal balance of the loan. This often results in the borrower owing more principal at the end of the year than they did at the beginning. Even though they made some payments during the year, the principal balance increased instead of decreasing.

But the fact remains that the mortgage loan still appears to be acquisition debt. You have an interesting point, in that when negative amortization occurs, the taxpayer is borrowing additional money to pay interest on the original loan, and in some sense this might be construed as a new loan. If this is indeed the case, I would concede that the new loan is not "a mortgage you took out after 10/13/87 to buy build or substantially improve a qualified home."

But there is at least one loophole. The next paragraph on page 8 of Pub. 936 says:

[b]If the amount of the mortgage is more than the cost of the home plus the cost of any substantial improvements, only the amount that is not more than the cost of the home plus improvements qualifies as home acquisition debt.[b]

So...

If the taxpayer is borrowing additional money to pay interest on the mortgage, but the "new loan" is actually part of the same mortgage, which was indeed taken out to buy the home...

then the additional amount borrowed is still acquisition debt as long as the total principal balance does not exceed the cost of the home.

In othe words, If he bought a house with a purchase price of $100,000 and made an $8000 downpayment, taking a $92000 mortgage, and then borrowed an additional $1200, within the same mortgage, in order to pay interest on the $92000 loan, the interest on the "new loan" of $1200 is still considered acquisition debt because it is part of the principal loan balance, and the principal loan balance will still be under the home's cost of $100,000.

My considered opinion is that your client may have some wiggle room if he made any kind of meaningful downpayment when he bought the house.

If your client bought the house in a "no money down" type of deal, then...

well, then, I guess it sucks to be him.

:-)

Burton

[S T]

Confusion

I am confused. How can you deduct mortgage interest on negative loan amortization? The t/p didn't pay all the mortgage interest, and therefore it is added to the outstanding loan balance.
I have seen several of these new "type" loans over the last 3 years in Calif what with all the creative financing.

Isnt' the T/p only allowed to deduct the actual mortgage interest paid, not any that might be deferred as negative?

Sandy

[jainen]

I think

>>If he bought a house with a purchase price of $100,000 and made an $8000 downpayment, taking a $92000 mortgage, and then borrowed an additional $1200, within the same mortgage, in order to pay interest on the $92000 loan, the interest on the "new loan" of $1200 is still considered acquisition debt because it is part of the principal loan balance<<

Isn't this what points are? You borrow an additional to buy down the interest rate. In that cas the IRS concedes you can pretend you made a smaller down payment in order to pay the negative amortization, but the underlying idea is similar, I think.

[Koss]

Capitalized interest

I am confused. How can you deduct mortgage interest on negative loan amortization? The t/p didn't pay all the mortgage interest, and therefore it is added to the outstanding loan balance.
I have seen several of these new "type" loans over the last 3 years in Calif what with all the creative financing.

Isnt' the T/p only allowed to deduct the actual mortgage interest paid, not any that might be deferred as negative?

Sandy

You're asking a good question, and I admit that it is counterintuitive. But here's how I think it works:

The "unpaid" interest is actually paid because it is capitalized as a "new loan." The taxpayer is literally borrowing more money in order to pay the interest. I've seen exactly the same thing happen with student loans. The taxpayer didn't make a single payment during the year, because he had some sort of deferment, and the accrued interest is treated as a new loan, and becomes part of the principal.

One reason this works, and may actually begin to make sense when you think about it, is this:

If the lender is somehow allowing the taxpayer to skip payments, or make payments that are not even enough to cover the current interest, let alone pay down principal, and the unpaid interest is added to the loan balance, then the taxpayer will ultimately be paying interest on the interest.

After the interest is added to the principal, it is considered paid. If the taxpayer cannot deduct that interest now, in the year it was "paid" by being added to the principal, then when will he ever get to deduct it? In all future years that sum of money will be treated as principal.

Burton

[Snaggletooth]

Solution

lies in the definition of principle and interest. Burton, your well-thought-out expostulation allows the lender's definition to take priority over what is really happening.

Taxpayer borrows $120,000 on a home worth $120,000. The easy pay arrangement causes the principle to rise to $125,000 by the end of the first year and $128,000 by the end of the second year, from that point forward, payments are sufficient to process the loan conventionally. However, this principle is defined by the bank's definition of payments failing to meet the calculated interest rate, thus the difference forces itself into new corpus.

Burton's last question is very germane. "If the taxpayer can't deduct this new payment NOW, then when can he deduct it?" There doesn't appear to be any opportunity if the IRS limits the interest to that which can be calculated on basis.

But lets change the perspective. Treat the loan under definition that $120,000 is principle forever. Throw out the bank's stated interest rate, and let's recalculate this thing with a fixed payment over 30 years (or whatever length), and using typical "discounted value of money" calculations, determine the rate of return for the lender. This will be the REAL interest rate, and should not differ much (if at all) from the stated rate. Treat the $120,000 as constant principle, no matter what the payment shortage may be in early years.

Use this calculated rate over the 30 year period to calculate the interest, whether paid or unpaid. Then for each year, deduct only the amount paid, but roll the unpaid portion into the succeeding year's pool of interest. At some point in the loan the payments will begin eat into the pool of unpaid interest, and this residual interest will be totally consummated at the end of the 30 years.

You see, we are so accustomed to payment shortages becoming "new" money that we deprive ourselves of thinking outside the box that the banks and mortgage companies have created for us. And who allows us to treat the $120,000 as constant principle? Why the IRS of course! They are the ones that forbid interest on amounts which exceed the basis, and the borrowers have not really borrowed any "new" money!!! All of the extra principle which the bankers publish on their amortization schedule was still accrued on the same loan transaction. It does not have to be "extra principle." Why can't it be "accrued interest?"

[Jeff]

Thanks

Thanks for the help. I now see it is not unreasonable to conclude that since this is the original loan and there was a substantial down payment, the current loan balance including the negative amortization constitutes acquisition debt. Do we all agree that if my client refinanced into a new negative amortization loan additional negative amortization would then be considered home equity debt since the balance owed on the new loan would soon exceed the final loan balance of the original loan?


Jeff