Interest Tracing Rules Doom Couple in Tax Court

If you own a home, you can deduct interest of up to $1 million on acquisition debt (usually your mortgage) and another $100,000 of home equity debt (a line of credit, for example).  Interest on amounts borrowed over $1.1 million is not deductible.  A couple from New Mexico tried to get around the $1.1 limit but were unsuccessful in Tax Court.

The couple had bought a home with a loan of $1.578 million.  They secured the loan partially with the house and partially with Intel stock.  On their tax returns for 2006 and 2007, they deducted the interest on the “extra” $478,000 as “investment interest.”  Investment interest can be used to offset investment income from things like interest income and dividends.

The Tax Court didn’t buy the couple’s argument.  The Court cited the interest tracing rules, which require looking at how the loan proceeds are used, rather than how the loan is secured.

Petitioners argue that interest accrued on the … loan is allocable to the Intel stock because the … loan was partly secured by the Intel stock. We disagree.  The allocation of debt and related interest is not affected by the use of property to secure repayment….

Here, petitioners used investment property to secure repayment of a loan for a personal residence ….  The use of investment property to secure repayment of indebtedness has no effect on the allocation of debt and interest. Rather, it is the “use” of the debt proceeds that determines the allocation.

So, because the proceeds were used to buy a house, the entire loan is considered to be a home loan.  That means only $1.1 million can be taken into account for determining the amount of deductible interest.  The interest on the additional amount of the loan above $1.1 million is not deductible at all.