IRS Cuts Luxury Homeowners A Mortgage Break

The Internal Revenue Service has delivered a valuable gift to those with $1 million-plus mortgages on their mansions. In an internal legal memo released publicly this month, the IRS concluded that a taxpayer can deduct interest on the first $1.1 million of a home mortgage--$100,000 more than earlier legal findings allowed.

The ruling is a boon to the 137,670 taxpayers who, according to First American CoreLogic, a mortgage data firm, have mortgage balances above $1 million.

Depending on their tax bracket and the interest rate on their jumbo mortgages, the affected homeowners could save $3,000 a year or more, figures Kaye Thomas, a tax lawyer who publishes a tax guide at www.fairmark.com. Moreover, taxpayers can file amended returns for the past three years and claim thousands in refunds. "Most people would think that's worthwhile," Thomas says. (For more on time limits for filing an amended return and claiming a refund, click here.)

Here's the background. The law allows homeowners to deduct interest on two types of home debt--purchase (or acquisition) indebtedness up to $1 million and home equity indebtedness up to $100,000. Previously, two U.S. Tax Court memorandum decisions held that for a purchase of a home with a mortgage of $1.1 million, you could deduct interest on only $1 million. The reasoning: The extra $100,000 didn't count as home equity debt, but as purchase indebtedness subject to the $1 million cap. Some taxpayers have structured their affairs to claim the full $1.1 million, but others have settled for $1 million.

The IRS memo--which was sent by the IRS Office of Chief Counsel to lawyers within the IRS--states that a taxpayer who buys a $1.5 million home, borrowing $1.3 million, can deduct interest on $1.1 million. The memo recognizes that this interpretation is different than the old tax court decisions, and states: "We believe that the position in this memorandum is the better interpretation." The reasoning: The amount of a residential mortgage above $1 million can be treated as home equity debt. The first $1 million counts as purchase indebtedness, and $100,000 of the excess over $1 million counts as home-equity indebtedness.

This seems only fair. After all, if one taxpayer is able to deduct interest on an additional $100,000 of home-equity debt--on top of a $1 million first mortgage--why shouldn't the full $1.1 million be allowed for the original purchase, says Thomas. The same logic the IRS used in its memo should allow the deduction of interest on the full $1.1 million of the original mortgage when calculating the alternative minimum tax too, he adds. (That's because the $100,000 home-equity loan deduction is allowed in AMT if the money is spent on buying or improving the house; it's not allowed in AMT if the $100,000 is used for other purposes.)