Home mortgage worksheet appears incorrect

[cinmon428]

Has anyone ever tried to use the mortgage worksheet? The calculations appear wrong. If you enter new mortgage principal (say, from a refi), and indicate that some of the money went towards buying, building, or improving an existing house, and some of the money did not, the program calculates a PERCENTAGE of the "qualified interest" which is deductible. However, this is NOT correct. See Publication 936, "mixed mortgages" or the IRS regulations. There is an ORDER in which mortgage interest must be deducted with mixed mortgage. The first type of interest would be home equity interest, that is, ANY interest from principal NOT used to buy, build, or improve. That includes things like buying a car, or even closing costs for the refi. (The closing costs were not used to build, buy, or improve the house. They were used typically to get you a better rate.) In other words, until you get rid of the home equity debt, you have a zero amount deduction on Schedule A. But the program does not do it that way. 

[TaxGuyBill]

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@cinmon428 wrote:

There is an ORDER in which mortgage interest must be deducted with mixed mortgage. ... In other words, until you get rid of the home equity debt, you have a zero amount deduction on Schedule A. But the program does not do it that way. 

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No.  There is an "order" to how the PRINCIPAL payments are applied.  The deductible interest is correctly based on the percentage of the average principal amounts.

[cinmon428]

From Publication 936:

A mixed-use mortgage is a loan that consists of more than one of the three categories of debt (grandfathered debt, home acquisition debt, and home equity debt). For example, a mortgage you took out during the year is a mixed-use mortgage if you used its proceeds partly to refinance a mortgage that you took out in an earlier year to buy your home (home acquisition debt) and partly to buy a car (home equity debt).
Complete lines 1, 2, and 7 of Table 1 by including the separate average balances of any grandfathered debt and home acquisition debt (determined by the date the debt was acquired) in your mixed-use mortgage. Don’t use the methods described earlier in this section to figure the average balance of either category. Instead, for each category, use the following method.
Figure the balance of that category of debt for each month. This is the amount of the loan proceeds allocated to that category, reduced by your principal payments on the mortgage previously applied to that category. Principal payments on a mixed-use mortgage are applied in full to each category of debt, until its balance is zero, in the following order.
First, any home equity debt not used to buy, build, or substantially improve the home.
Next, any grandfathered debt.
Finally, any home acquisition debt.
Add together the monthly balances figured for b and c in (1).

If the principal payments are applied to home equity debt first (which is not deductible), how do you come up with your percentage result? Can you cite a reference for this?

[cinmon428]

If principal payments are applied in an order, then interest payments must relate to that order as well. I can’t see a different set of rules for interest. All principal reductions are for home equity debt first. That must mean all payments for that principal which are for interest must be for the same home equity debt. That’s simple logic. 

[TaxGuyBill]

Think of it logically.

If the average balance of the Acquisition debt is $80,000 and the debt for purchasing a car is $20,000, you are paying interest on $100,000.   How is paying interest on $100,000 non-deductible when there is only $20,000 of non-qualified debt?

If you re-read the instructions and fill things out in the instructions, it should make sense.

[cinmon428]

The answer is, because it’s a mixed mortgage and because the IRS has specific rules for payoff of that mixed mortgage. You may not line the rule, but it’s there for everyone to see. 

[cinmon428]

Sorry, I meant you may not like the rule, but it’s there and it’s quite clear. I doubt many people are paying attention but I think they’re at risk. 

[TaxGuyBill]

You are misreading it.  Go back and re-read it and actually fill out the numbers  in the worksheet.  Line 14 does the percentage.

https://www.irs.gov/pub/irs-pdf/p936.pdf#page=12

Again, think of it logically.  If there were two separate loans, the loan for Acquisition Debt would be deductible.  That isn't going to change just because two loans are combined into one loan.

[cinmon428]

You know as well as I do that logic doesn't always work with IRS rules. And:

Complete lines 1, 2, and 7 of Table 1 by including the separate average balances of any grandfathered debt and home acquisition debt (determined by the date the debt was acquired) in your mixed-use mortgage. Don’t use the methods described earlier in this section to figure the average balance of either category. Instead, for each category, use the following method.
Figure the balance of that category of debt for each month. This is the amount of the loan proceeds allocated to that category, reduced by your principal payments on the mortgage previously applied to that category. Principal payments on a mixed-use mortgage are applied in full to each category of debt, until its balance is zero, in the following order.
First, any home equity debt not used to buy, build, or substantially improve the home.
Next, any grandfathered debt.

[cinmon428]

To spell it out, they don't want you to use the table or percentages when you figure a mixed mortgage. It's right there in simple English.

[cinmon428]

Unfortunately, it is going to change when two loans, one of which is not acquisition debt, are combined. 

[TaxGuyBill]

While I was wrong about Line 14 of the Table doing that percentage, I just don't understand WHERE you are interpreting that about the interest. 

NOWHERE does it say what you are thinking it says.  NOTHING you have cited shows that.  The only think you have cited is the order for the payments for PRINCIPAL (and you are correct about that).

WHERE do you interpret the the INTEREST is allocated that way?

I really hope you haven't been doing this on clients' tax returns.

[cinmon428]

I really hope you have. 

There are articles about this in the literature. I'm not asking if it's right or not. I know it's right. Interest follows principal. I didn't raise the question to see whether or not I was right. I raised it because the software does it incorrectly. Do a little more research and you will find I'm correct. 

[TaxGuyBill]

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@cinmon428 wrote:

Interest follows principal.

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Exactly.  The interest on the principal amount of Acquisition debt is deductible.

Go ahead and Google it.  I guarantee that you are wrong.

[cinmon428]

Here's a professional article for you to read so you can understand that you've probably been dong many of your clients' mortgage stuff wrong.  I want you to read it carefully and get back to me:

Flach, Robert D. "Home Mortgage: Tracking acquisition and equity debt." Taxpro Monthly, 40, 10 (October 2018), 4-6.

[cinmon428]

It's quite clear that if you have to pay down "home equity debt" first, that any payments going to reduce home equity debt will include "home equity interest," not interest for all of the kinds of debt you have in a mixed mortgage. That means that you pay home equity interest until home equity debt is paid off, and you have a deduction of ZERO. That is basic logic. 

[TaxGuyBill]

Do you have a link?  I'm not finding it via Google.

I strongly encourage you to post a question about this on other tax boards (such as TaxProTalk) and see what other tax professionals tell you. You could say something like this:

Client has a mix-use mortgage for $100,000.  $70,000 was for purchasing the home, and $30,000 was for paying off credit cards.  Total interest for the year was $10,000.  How much, if any, of the mortgage interest is deductible on Schedule A?

[cinmon428]

You might want to contact the author and discuss it. Me, I have lots of clients now so it's farewell and good luck.

Dr. Berger

[TaxGuyBill]

Back at you.  Good luck, but as I said before, I STRONGLY recommend you post a question about it on some other tax boards,  I guarantee that you will be surprised at the results.

[cinmon428]

At 70 years old, not much surprises me anymore. And the majority is often wrong. Interest follows principal. You have shown me no reason to doubt that, except that "everybody or almost everybody does it your way." That's not a reason. 

[TaxGuyBill]

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@cinmon428 wrote:

Interest follows principal.

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As I said before, exactly.

So if the principal of the loan is composed of 80% Acquisition Debt and 20% credit card debit, then the interest follows that.  So 80% of the interest would be due to Acquisition Debt and 20% of the interest would be due to credit card debt.

So if a $100,000 loan has a 6% rate ($6000 annual), then you are paying 6% on the $80,000 of Acquisition Debt, and 6% on the $20,000 of credit card debt.

[cinmon428]

Yes, 80000 of Acq debt and 20000 of credit card debt. What you keep forgetting is 1.163-8T(d), which gives an ORDER for reducing mixed mortgage principal. Now, put that together with "interest follows principal," which you apparently agree with. The first $20000 of principal needs to be paid off before a penny of that interest is deductible. All the interest on the first $20000 of principal is non-deductible. What part of that is confusing? There is nothing about "percentages" in the regulations, and Publication 936 talks about not using the table. That's because interest is tied to principal. Home equity interest is tied to home equity debt. Non of the interest is deductible, and there is an order to follow. I am through. Have a nice life. 

[TaxGuyBill]

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@cinmon428 wrote:

All the interest on the first $20000 of principal is non-deductible. 

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But you are paying interest on $100,000, not $20,000.  You can't suddenly change the terms and say you are actually paying 30% interest on $20,000, rather than 6% interest on $100,000. 

I am done too.  You are being unreasonable and are wasting my time.

[cinmon428]

I never asked for your help. I brought up the fact that the software is wrong. You are the nasty one. You never looked at my references, nor at the IRS regulations. Some tax preparer you are!!

[cinmon428]

Here ya go, pal. Here's the proof that interest follows principal, and, added to what I said, means none of the acq interest is deductible until you pay off the credit card (home equity) interest:

Reg. 1.163-7(e)(4)(3)--MANNER OF ALLOCATION: In general interest expense on a debt is allocated IN THE SAME MANNER AS THE DEBT TO WHICH SUCH INTEREST EXPENSE RELATES IS ALLOCATED. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures....

Better amend your clients that refi'ed their mortgages and got cash out for things like cars, credit card payments, and closing costs for their refi. 

[TaxGuyBill]

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@cinmon428 wrote:

Here ya go, pal. Here's the proof that interest follows principal, and, added to what I said, means none of the acq interest is deductible until you pay off the credit card (home equity) interest:

Reg. 1.163-7(e)(4)(3)--MANNER OF ALLOCATION: In general interest expense on a debt is allocated IN THE SAME MANNER AS THE DEBT TO WHICH SUCH INTEREST EXPENSE RELATES IS ALLOCATED. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures....

Better amend your clients that refi'ed their mortgages and got cash out for things like cars, credit card payments, and closing costs for their refi. 

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Sleep on it and re-read the Regulation you just posted.  You just proved my point.

That Reg says the interest is allocated as the debt is allocated.  The debt is allocated by the tracing rules.

If the tracing rules say 80% is Acquisition debt and 20% as personal debt, the Regulation you just posted say the interest is allocated "in the same manner".

[cinmon428]

You keep forgetting about the ordering rule. Or is it just that you don’t want to face the fact that you’ve been doing these incorrectly? That’s what I strongly suspect, being a retired clinician. 

[cinmon428 · Accepted solution]

I read the Publication over carefully, and I acknowledge I was wrong. The percentage method is the correct method. 

[TaxGuyBill]

Great, I'm glad we were able to get it figured out.   🙂