Owner Won’t Lose Mortgage Interest Deduction When Residence Drops in Value

Q I am confused about whether I may continue to deduct the interest on my home mortgage. I read recently that interest is deductible only to the extent of the value of the house. Does this mean that since my home has fallen in value to an amount lower than what I currently owe on it, I may not deduct the interest on that portion of the mortgage that exceeds the home’s present value?

--C.C.R.

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A Internal Revenue Service regulations permit homeowners who bought their homes after Oct. 14, 1987, to fully deduct the interest on a “home acquisition loan” up to a total debt amount of $1 million, provided that the loan is secured by that residence. A home acquisition loan is defined as one used to buy, build or substantially improve your principal residence or second home. In addition, homeowners may deduct interest on up to $100,000 of home equity debt, which can be used for any type of purchase, provided that the total amount of the home equity and acquisition debts do not exceed the fair market value of the home.

The real issue raised by your question is: When does the debt-to-value ceiling apply? And the answer is: when the loan is made.

The upshot? Unfortunate homeowners such as you, who have seen the value of their homes plummet in recent years to less than the mortgage amount, are not being doubly penalized by losing the mortgage interest deduction. The intent of this IRS provision is to prevent taxpayers from shifting so-called personal indebtedness (loans for cars, vacations, furniture and other major consumer purchases that are not tax-deductible) to their homes, where the interest is deductible.

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Q I remain confused about the home replacement rules. Here are the facts of my case: My husband and I purchased a residence for $100,000 on June 1, 1995, that was our second home. We continued to own a principal residence until March 1, 1996, when it was finally sold for $300,000 and we decided to divorce. I am living in the $100,000 house and am thinking of remodeling it to increase its value so it can serve as my replacement residence. How much time do I have to do this?

--S.F.

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A Palm Springs certified public accountant Howard Gordon says you should have two years from the time you sold your original principal residence, the $300,000 one, to satisfy the replacement rules. This would give you until March 1, 1998, to invest a minimum of $150,000 in a replacement home. Given the $100,000 purchase, you must make at least $50,000 worth of permanent improvements to the home to satisfy the IRS.

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Q My wife and I want to give our son some money for a down payment on a house. I can’t for the life of me understand why this gift isn’t tax-free. How can I possibly be taxed on money on which I have already paid taxes?

--F.M.L.

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A As are many taxpayers, you are confusing the taxes you pay to the Internal Revenue Service each year on your income with the estate or gift taxes levied on large sums of money given away during life or at death.

You may give your son all the money he needs for a down payment without paying a dime in income taxes. However, if the amount you give your son exceeds $10,000 per donor per year (that would be $20,000 per year from you and your wife), the excess will be deducted from the $600,000 you are allowed to give in your lifetime without being subject to the gift tax. Once that $600,000 is exhausted, Uncle Sam demands his share, but not until then.

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For the Record: Before 1996 is too much of a memory, let’s correct two mistakes from late in the year. First, durable powers of attorney no longer expire after seven years. Current law permits the principal to determine when, if ever, the document expires. Also, the head-of-household tax-filing status is available only to the taxpayer maintaining the household for a child, parent or other dependent relative. Thus, divorced parents may not exchange this filing status from year to year unless their dependent(s) actually move from household to household. Divorced parents may, however, trade any personal tax exemption the dependent(s) are entitled to.

Now, let’s hope for fewer errors in 1997.

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Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053 Or send e-mail to [email protected]