A Million Dollars Isn’t Cool. You Know What’s Cool?

November 01, 2010 | Written by: Mark D. Olander, EA, USTCP
woman with calculator and tax return


We have an ongoing continuing education program at TaxResources that helps our audit representatives meet their professional licensing requirements while at the same time making them more effective at defending our members. This month’s case shows how a TaxResources audit representative with an up-to-date education provides the defense you need to win your audit.

Under examination was $80,000 of home mortgage interest claimed as an itemized deduction. While most taxpayers are allowed to deduct all of the mortgage interest they pay, more and more taxpayers are finding out that there are limits to the deduction. But the rules for determining the deductible amounts of home mortgage interest are complex; there is “acquisition debt” and “home equity” debt, and there are different limits on the deductibility of both types of debt. Since there is currently no system in place to help the IRS identify mortgage interests exceeding the limits, the Service relies on examinations to determine whether or not taxpayers are deducting more than is allowed by law. That’s why taxpayers who report high amounts of mortgage interest on Schedule A’s have a greater chance of being audited.

The first examination letter the members received in June showed an amount due of more than $37,000. The IRS disallowed the entire amount of their mortgage interest. The amount due included an interest assessment of $3,800 and accuracy penalties of $5,600.

The Audit Representative assigned to the case learned that the members had sold their home in 2007 and purchased a new one. They had taken out a bridge loan on their original residence to make a down payment on the new home. The bridge loan had been paid off when the home sold.

The Audit Representative gathered up the taxpayers’ 1098 Forms and the loan origination documents for their three loans. She created a spreadsheet showing the total average balance for each individual loan and a total average balance for the year of more than a million dollars. She sent the spreadsheet to the IRS with a letter explaining that, based on the allowable amount of $1.1 million, the entire amount of the mortgage interest deduction should be deductible.

In late August the Audit Representative received a response from the IRS. The examiner allowed the deduction for interest on one million dollars but disallowed the amount allocable to the $70,000 in additional acquisition debt. The reason given was that the amount that can be treated as home acquisition debt at any time cannot be more than a million dollars. While home equity debt is deductible up to $100,000, the letter explained, “the two types of loans cannot be combined to simply deduct interest on $1,100,000.” The letter showed the taxpayers owing the IRS about $2,000.

The Audit Representative knew right away what to do. She had recently attended a TaxResources continuing education seminar on the Home Mortgage Interest Deduction, which covered the IRS Chief Counsel’s October 5, 2009, reinterpretation of “acquisition indebtedness” under Internal Revenue Code section 163(h)(3). The reinterpretation allows a taxpayer with a mortgage larger than a million dollars to treat the first $100,000 in excess of the one million dollar limit as home equity indebtedness because it is other debt secured by the home. Under the new interpretation, a taxpayer is able to deduct interest on the first $1.1 million of the loan, the first $1 million as acquisition indebtedness and $100,000 as home equity indebtedness.

The Audit Representative submitted a letter back to the IRS disagreeing with the tax assessment proposed. She explained that, per CCA200940030, a taxpayer who borrows more than $1 million to acquire a home may treat the excess over one million dollars as home equity debt, subject to the $100,000 limitation. She included a copy of CCA200940030 with her letter.

Finally, in the middle of October, the member and the Audit Representative received the answer they had been waiting for, an IRS letter that began with the following sentence: “We are pleased to tell you we did not make any changes to the tax reported on your return.” You can certainly understand how thrilled the members were with the results of the audit, as what had started out as a bill for $37,000 ended with no amount due!
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