On January 1 of year 1, Arthur and Aretha Franklin purchased a home for $2.3 mil

Question

On January 1 of year 1, Arthur and Aretha Franklin purchased a home for $2.3 million by paying $220,000 down and borrowing the remaining $2.08 million with a 7 percent loan secured by the home. (Enter your answers in dollars and not in millions of dollars. Do not round intermediate calculations.)

a. What is the amount of the interest expense the Franklins may deduct in year 1?

b. Assume that in year 2, the Franklins pay off the entire loan but at the beginning of year 3, they borrow $378,000 secured by the home at a 7 percent rate. They make interest-only payments on the loan during the year. What amount of interest expense may the Franklins deduct in year 3 on this loan? (Assume the Franklins do not use the loan proceeds to improve the home)?

c. Assume the same facts as in (b), except that the Franklins borrow $98,000 secured by their home. What amount of interest expense may the Franklins deduct in year 3 on this loan? (Assume the Franklins do not use the loan proceeds to improve the home)?

Explanation / Answer

a) $77,000 The acquisition indebtedness limit ($1,00,000) and the home-equity indebtedness limit ($1,00,000) are two separate limits, the maximum amount of debt on which a   taxpayer may deduct qualified residence interest is $1,10,000 as long as the value of the taxpayer's residence (or residences) is atleast $1,10,000. Since the Arthur and Aretha Franklin's home is worth $2.3 million, they can deduct interest on upto 1.1 million. Thus the amount of deductible interest on the loan is as follows :- Total Interest expense = Total loan principal * Interest rate                                       =                          $2.08 *    7%                                  =                        145600 Deductible Interest Expense = Qualified debt/ Total debt * Total interest expense                                                  = [$1.1 million/ $2.08 million]* $1,45,600                                                  = $77,000 b) $7,000 Once acquisition indebtedness is established, only payments on principal can reduce the indebtedness and only additional indebtedness secured by the residence and incurred to substantially improve the residence can increase it. In this case, the Franklins reduced their original acquisition indebtedness to zero. Because the Franklins do not use the additional loan in year 3 to substantially improve their home, the loan cannot be classified as acquisition indebtedness. Thus the interest on loan can only be deducted to the extend that it qualifies as home equity indebtedness. $1,00,000 of the loan qualifies as home-equity indebtedness and the Franklins may deduct $7,000 of interest paid on Loan ($1,00,000 * 7%) c) $6,860 Similar to part (b) above. The new loan can only be classified as acquisition indebtedness to the extend that the loan proceeds are used to substantially improve the residence. However, in this scenario, the Franklins will be able to deduct the full $6,860 ($98,000*7%) paid in interest Because eventhough the loan proceeds are not used to substantially improve the residence, the full amount of interest is deductible because it qualifies as home-equity indebtedness and the amount of loan is less than $1,00,000.

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