Mortgage Interest Limitations under IRC §163(h)(3) Part I: The Personal Mortgage Interest Deduction

The ability to deduct the interest on a mortgage is one of the most commonly utilized tax breaks available to homeowners in the United States.  Aimed at encouraging Americans to buy a home, this deduction also happens to be among the largest of the federal tax expenditures, costing the federal government an estimated $70 billion each year in tax revenues.

Under IRC 163(h), homeowners may reduce their taxable income by deducting the amount of interest they pay on a mortgage secured by their principal or secondary residence.  Under IRC 163(h)(3), there are some limitations to that deduction:

  1. Payments must be made on a “qualified residence.” A “qualified residence” is defined in IRC 163(h)(4)(A)(i) as a taxpayer’s principal residence or another residence that meets the requirements of IRC 280A(d)(1) (a second home which is used for personal purposes for at least 14 days per year or 10% of the number of days it is rented during the course of a year).
  2. The interest must be “qualified residence interest.” This means that the interest must be paid on either (1) “acquisition indebtedness” (loans taken in order to purchase or improve an existing property, or for new construction) or (2) “home equity indebtedness” (loans for any other purpose – e.g., to buy furniture or other assets) – that is secured by the residence.  See IRC 163(h)(3)(A), (B) and (C).
  3. The amount of the personal mortgage interest deduction is limited. Only the first $1,000,000 of acquisition indebtedness ($500,000 for each married person filing separately) and the first $100,000 of home equity indebtedness ($50,000 for each married person filing separately) are deductible.  See IRC 163(h)(3)(B)(ii) and (C)(ii).  In Parts II and III, we will discuss how these limits may be applied in light of a recent Ninth Circuit decision.

As a general rule, a taxpayer cannot deduct interest on a debt that he or she does not owe.  However, per Treas. Reg. Sec. 1.163-1(b), mortgage interest that is paid by a taxpayer who is the (legal or equitable) owner of the property is deductible, even if that taxpayer is not directly liable on the bond or note that is secured by the mortgage.

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