Question on Re-fi and home improvement

[JG EA]

I have a client whose mortgage interest is severely limited due to many refi's where there was extra money taken each time. Most of this money was for paying off credit cards and so on. He also has AMT affected by these re-fi's.

He is going to do another re-fi in 2012. In 2011 he did some major improvements to his home. I would think the extra money and the improvements would have to be in the same year in order to count the re-fi money toward deductible interest. What do you think?


I'm asking now because he asked me now.

[Koss]

Home Acquisition Debt

JG EA wrote:

I would think the extra money and the improvements would have to be in the same year in order to count the re-fi money toward deductible interest.

I don't think it has to be in the same calendar year. Someone might apply for a loan in November or December, but not actually start the home improvement work until January, even if the loan proceeds were disbursed in December. That shouldn't disqualify the loan.

With that being said, it sounds like your client waited too long. The calendar year is not relevant, but there is a 90-day window for this sort of thing.

See Publication 936:

Mortgage treated as used to buy, build, or improve home. A mortgage secured by a qualified home may be treated as home acquisition debt, even if you do not actually use the proceeds to buy, build, or substantially improve the home. This applies in the following situations.

1. You buy your home within 90 days before or after the date you take out the mortgage. The home acquisition debt is limited to the home's cost, plus the cost of any substantial improvements within the limit described below in (2) or (3). (See Example 1 below.)

2. You build or improve your home and take out the mortgage before the work is completed. The home acquisition debt is limited to the amount of the expenses incurred within 24 months before the date of the mortgage.

3. You build or improve your home and take out the mortgage within 90 days after the work is completed. The home acquisition debt is limited to the amount of the expenses incurred within the period beginning 24 months before the work is completed and ending on the date of the mortgage. (See Example 2 below.)

Example 1.

You bought your main home on June 3 for $175,000. You paid for the home with cash you got from the sale of your old home. On July 15, you took out a mortgage of $150,000 secured by your main home. You used the $150,000 to invest in stocks. You can treat the mortgage as taken out to buy your home because you bought the home within 90 days before you took out the mortgage. The entire mortgage qualifies as home acquisition debt because it was not more than the home's cost.

Example 2.

On January 31, John began building a home on the lot that he owned. He used $45,000 of his personal funds to build the home. The home was completed on October 31. On November 21, John took out a $36,000 mortgage that was secured by the home. The mortgage can be treated as used to build the home because it was taken out within 90 days after the home was completed. The entire mortgage qualifies as home acquisition debt because it was not more than the expenses incurred within the period beginning 24 months before the home was completed.

How much would it really help him, even if it was within the proper time frame? The refi would be a mixed-use mortgage, where part of the debt would not qualify, because it was used to pay off a previous loan that was not home acquisition debt. I don't think the entire cost of the home improvements would automatically qualify as acquisition debt.

There are very complicated interest tracing rules involved, although I'm not sure Pub. 936 actually uses that term. The interest has to be prorated based on what portion of the loan qualifies as home acquisition debt.

Suppose the refi is a half-million dollar loan, and $100,000 is used for improvements, while $400,000 is paying off the existing loan. Of the $400,000, only $100,000 was qualifying debt. I don't think you can jump to the conclusion that 40% of the interest on the new loan is deductible. I think it gets a lot more complicated than that.

There are tables and formulas in Pub. 936.

BMK

[JG EA]

Thank you very much for drawing my attention to the 90 days thing - just what I needed.

I don't think it has to be in the same calendar year. Someone might apply for a loan in November or December, but not actually start the home improvement work until January, even if the loan proceeds were disbursed in December. That shouldn't disqualify the loan.

With that being said, it sounds like your client waited too long. The calendar year is not relevant, but there is a 90-day window for this sort of thing.

See Publication 936:



How much would it really help him, even if it was within the proper time frame? The refi would be a mixed-use mortgage, where part of the debt would not qualify, because it was used to pay off a previous loan that was not home acquisition debt. I don't think the entire cost of the home improvements would automatically qualify as acquisition debt.

I believe it would. Buy, build, improve.

Refinanced home acquisition debt. 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. Any additional debt not used to buy, build, or substantially improve a qualified home is not home acquisition debt, but may qualify as home equity debt (discussed later).

Bold mine.

There are very complicated interest tracing rules involved, although I'm not sure Pub. 936 actually uses that term. The interest has to be prorated based on what portion of the loan qualifies as home acquisition debt.

Suppose the refi is a half-million dollar loan, and $100,000 is used for improvements, while $400,000 is paying off the existing loan. Of the $400,000, only $100,000 was qualifying debt. I don't think you can jump to the conclusion that 40% of the interest on the new loan is deductible. I think it gets a lot more complicated than that.

There are tables and formulas in Pub. 936.

BMK

This part I don't understand. Of the home acquisition debt in your example of $100,000 out of $400,000, are you saying that that part doesn't retain its 100,000? I would however take that 100k and add it to the major improvement part of the money taken out in the re-fi first. The worksheet in the pub would then apply. (I use taxtools) It takes into account average balances for the year. That way it limits the amount of interest taken and also calculates the addition to AMT. .

[Koss]

Equity Debt

I agree that in principle, any amount borrowed that is used for home improvement does qualify. And if it is within the 90 day window, then it would work.

I still say that the refi, on your facts, would be a mixed-use mortgage, where some of the loan proceeds would be treated as used for home improvement, and some of the loan proceeds would be treated as paying off a previous mortgage that was not acquisition or equity debt.

I think we agree on that point.

I may be confused about how you determine what portion qualifies as deductible interest. Maybe it's not as complicated as I thought. If you've reviewed it and it makes sense, then your software is probably using a valid method of proration.

BMK