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Refi Interest Trap?


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2008 Mar 28, 1:30am   52,755 views  354 comments

by Patrick   ➕follow (55)   💰tip   ignore  

trap

A reader writes:

Word from the IRS is that they are auditing people based on refiances on their house. If you refied and pulled money out of the house and use for other purposes than home improvement you can not claim that as Mortgage Deduction, needs to be claimed as Interest expense. Guess what, they want proof of home improvements... Just wait -- how many toys people bought using their house as a ATM machine will be for sale on CraigsList?

Anyone know if this is true? And what's the difference between the mortgage interest deduction and interest expense?

Patrick

#housing

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1   DennisN   2008 Mar 28, 1:38am  

I remember reading IRS pub. xxx which discusses mortgage interest deductability a few years ago.

IIRC you can deduct the mortgage interest in three cases:

1) any interest in an original purchase mortgage,
2) any interest in a re-fi IF the proceeds are for home improvements, and
3) any interest in a re-fi up to a principle balance of $100K even if you blow the proceeds on toys.

Let me go find the IRS pub number.

I would guess that "interest expense" would be if you used the MEW to fund a business.

3   DennisN   2008 Mar 28, 1:55am  

See Fig. A on pp 3 for a flowchart concerning deductability.

It looks like my #3 in the first post may be further limited. See the worked example on pp 9 in the Home Equity Debt section.

4   DinOR   2008 Mar 28, 2:01am  

DennisN,

I WILL take the time to read that in it's entirety but I believe in there some where is a "lifetime cap". For some reason I thought it was 100k?

Either way, certainly looks like there's ample room to game the system.

5   Peter P   2008 Mar 28, 2:54am  

I will not rely on IRS for policing.

They should go after those tax-evading underground cash businesses instead.

Flat tax!!!

6   Duke   2008 Mar 28, 2:55am  

Read the sectin on page 9 about Home Equity Debt.
It is limited by the FMV of the home in excess of the original mortgage.
So, if you are a part of the 0 down club and bought in the last few years, bad news dudes, NONE of those toys are being subsidized by your fellow taxpayer.
Example: Bought $1M home with 80/20 loans totaling nothing down in 2005. HELOC'ed the house to take out $100k as the home rose in value. to $1.1M. The FMV value of the house is now $1M. That $100k, if spent on anything other then home improvement (not maintenance) is not deductable. At all.
I wonder how long it will take to game this round of appraisals?

7   Peter P   2008 Mar 28, 3:02am  

This argument is not useful.

If homeowners believe that a deduction is possible and rightful, they are going to take it. Now, this is clearly illegitimate but who is going to stop them?

8   DinOR   2008 Mar 28, 3:14am  

Peter P,

I think all the reader is pointing out is that the IRS believes it merits a closer look. .... Now since a lot of these people are/or flirting w/ default I agree, it can become moot. However if you have a solvent serial re-fi'er and they can in no way shape or form back their claims that said funds were used for home improvement they may have issues going forward?

Oh and you can't say buying a motor home to cover the oil stain on the driveway qualifies as "home improvement"! I think this is interesting and would like to see where it leads us?

9   Peter P   2008 Mar 28, 3:28am  

However if you have a solvent serial re-fi’er and they can in no way shape or form back their claims that said funds were used for home improvement they may have issues going forward?

True, but will the enforcement be there?

Perhaps we need lower tax rates and more enforcement.

10   DennisN   2008 Mar 28, 3:36am  

Patrick sez.... "Anyone know if this is true?"

Is what true? Is it true that mortgage interest deductions have limits? Yes.

Is it true that the IRS is targetting MEW taxpayers? Beats me.

The IRS has red-flags for triggering an audit. I would assume re-fi mortgage interest deductions may serve as one red-flag. IIRC mortgage interest is still deductable for AMT taxpayers so it would be a good target for audit purposes.

11   patseajul   2008 Mar 28, 3:38am  

The letter that came from my tax lady this year said this:

Some more bad news, California is starting to do audits. They have targeted tax free exchanges, sales of personal residences (they will want receipts to prove your basis), dependents, and the big one-mortgage interest. If you have a loan on your house that is more than $1 million, you will be audited. If you have frequently refinanced and the loans are more than $100,000 over your purchase price you may be audited.

12   Duke   2008 Mar 28, 3:38am  

I am guessing this whole topic is yet more evidence of 'unintned cosequences'
I mean, why on earth, would Congress want to give you up to $100k of your equity to blow on toys and have the interest on that equity loan be deducatable? I can only guess Uncle Sam wanted you to buy more stuff. The fact that MEW is a huge shoe yet to drop is just another 'oopsie'.

13   Peter P   2008 Mar 28, 3:38am  

I doubt there is the political will to crackdown on popular behaviors like MEW deductions and cash businesses. :(

Flat tax is the answer but nobody wants to listen. :(

14   DinOR   2008 Mar 28, 3:39am  

Peter P,

I think (and if I understand DennisN's link correctly) this is about re-categorizing, not putting people in the pillory.

Dear Mr. Smith,

In 2005 tax filing our records indicate you refinanced your home. In the process you took $279,000 in equity out of your home and have claimed that as deductible mortgage interest. We are requesting that you provide receipts for ALL home improvement expenses you incurred. Provide you can produce said documentation your mortgage deduction will stand and no further adjustments to your return are required.

HOWEVER....!

What's so difficult about THAT!?

(I get those letters all the time) :(

15   Peter P   2008 Mar 28, 3:39am  

I can only guess Uncle Sam wanted you to buy more stuff.

No duh.

16   DinOR   2008 Mar 28, 3:41am  

patseajul,

I rest my case.

17   Peter P   2008 Mar 28, 3:46am  

Some more bad news, California is starting to do audits. They have targeted tax free exchanges, sales of personal residences (they will want receipts to prove your basis), dependents, and the big one-mortgage interest.

Bad news? We should rejoice! :)

18   patseajul   2008 Mar 28, 3:49am  

Peter P

I was thinking the same thing, but that is how she wrote it!

19   DennisN   2008 Mar 28, 4:01am  

She may have been thinking this: tax preparers may be somewhat overly "aggressive" in claiming deductions, but they may have future liabilities if caught.

20   Duke   2008 Mar 28, 4:32am  

I am trying to understand the genesis of MID.
Suppose the interest portion of your mortgage is $3k a month and you are in the 28% fed, 9.3% tax bracket CA. What does a fellow taxpayer get for the $13k+ you get to write off your taxes?
Is it that ownership encourages people to treat their homes better, demand that their neighbors treat their homes well, and that society work to ensure their neighborhood holds its value?
Or is it that home buyers are effectively capitalizing banks so they can fund companies that then give jobs?
Really, I am trying to figure why the govenment is in the business of giving home owners tax breaks.

21   DennisN   2008 Mar 28, 4:37am  

Duke,
I actually looked into the history of the MID last year. After the XVI Amendment (1913) made income tax Constitutional, all sorts of interest payments were quickly made deductable under the theory they were in general a "business expense". Hence the MID pre-dated the New Deal.

As time went on, OTHER forms of interest deduction (e.g. credit card interest, car loan interest) were phased out leaving the MID standing alone. There never was any government theory on why the MID made - or makes - sense.

22   OO   2008 Mar 28, 4:43am  

Government always wants the society to have more homeowners, through tax rebate or stamp duty exemption, or outright first-time home buyer subsidy. More homeowners means more stability, a homeowner is essentially "chained" down to his house for at least 15-30 years, at least mentally so, so he is more likely to support status quo, because, he is already, uh, a homeowner (never mind how much equity he has in the home).

Other governments have similar approached to encourage home ownership, although not all in the form of MID. Subsidized interest rate, first-time home purchase grant, tax write-off, you name it. In this particular respect, the US government is just following the norm of all governments.

23   OO   2008 Mar 28, 4:47am  

With the current housing mess we are facing, I think MID will only get bigger, because the government would hate to see under-water borrowers walk. Those who walk become a destabilizing element for the society.

Debt is a form of slavery, if you don't know how to take advantage of debt for strategic purposes. Having your debtors go into debt mindlessly is a great way of manipulating them. The best manipulation is not to make them broke, but to keep them on the brink of insolvency all their life.

24   Peter P   2008 Mar 28, 4:48am  

Debt is a form of slavery, if you don’t know how to take advantage of debt for strategic purposes.

But if you know how to take advantage of debt for strategic purposes...

Debt = Wealth
Slavery = Freedom :)

25   OO   2008 Mar 28, 4:50am  

People who mastered the art of indebtedness will not be talking on this blog, they are already running this country.

26   Peter P   2008 Mar 28, 4:52am  

People who mastered the art of indebtedness will not be talking on this blog, they are already running this country.

Well said.

27   DennisN   2008 Mar 28, 4:54am  

Here's the link to a history of the MID that I posted in an earlier thread.

www.taxfoundation.org/blog/show/1382.html

28   Peter P   2008 Mar 28, 4:57am  

The existence of deductions merely illustrates the excessiveness of taxation.

29   DinOR   2008 Mar 28, 5:12am  

"I think MID will only get bigger"

OO, you may know PM/Forex inside out but you know absolutely nothing about..., ?

(Aw...you're probably right) :(

When the NAHB had their 10K CREDIT for buying a "new" home brain fart, Len Burnham of the Tax Policy Institute (that DennisN references above) was beside himself with disgust. He said, "How is it possible to extend an even more generous tax code to real estate than we already HAVE!"

30   Duke   2008 Mar 28, 5:14am  

I guess I can buy the argument that encouraging a home ownership society is stabilizing. Ummmm. When homes prices go negative on a national basis, I cannot imagine a more destabilizing problem. Perceptions of unfairness are everywhere rright now.
My current perspective is one of the tax base meeting society needs. Notably, the infrastructure of CA is deteriorating. While it does not get much press now, our levies are a disaster. Our roads are poor, our schools are underfunded, the police to resident ratio are at historic lows. Our legal system is so back-logged we now try to solve everything in arbitration.
For me, these are the biggies a society must undertake: education, security, legal recourse, public health, and infrastrucure. Since we are not providing these at acceptable levels, we need to consider, as a state, if giving big mortgage breaks is something we want to do. A great deal of revenue is lost to the MID. Of course, I will fully agree with anyone who points out that we must remove most, if not all, state spending outside these categories.

31   DennisN   2008 Mar 28, 5:16am  

Off topic, but very important.

If what's reported on here is true

www.nextenergynews.com/news1/next-energy-news2.13s.html

then this is the most important economic story of the decade.

32   DinOR   2008 Mar 28, 5:26am  

Duke,

What's worse is that NAR has brain-washed every new Realtor (TM) to "tell the tax advantages story".

Well... like that hasn't been factored INTO the asking price of the home!?

33   EBGuy   2008 Mar 28, 5:27am  

Oh man, you guys will love this. I was watching "Unnatural Causes: Is Inequality Making Us Sick?" on PBS last night. So, I kid you not, some doctors did a study where they infected subjects with a cold virus. The longer the subject's parent was a homeowner, the less likely it was for the subject to become sick. If that isn't a ringing endorsement of home ownership, I don't know what is! :-)

34   Peter P   2008 Mar 28, 5:34am  

RE: “Unnatural Causes: Is Inequality Making Us Sick?”

No, but unhappiness can certainly make us sick.

Is it just me, but I think PBS programs tend to be extremely liberal.

Again, this shows my point, that one can use "science" to support any agenda.

35   Peter P   2008 Mar 28, 5:46am  

If "equality" really means what it is, I wonder how many US liberals are willing to drastically lower their stand of living so that the third world can have their "rightful" share.

Of course not. Equality generally means that no one is allowed to be richer than me.

Argh!

36   DennisN   2008 Mar 28, 8:39am  

In regards to my Bakken Formation post several up....

Does anyone have any suggestions for North Dakota REITs? :)

37   Peter P   2008 Mar 28, 8:47am  

Here is a list:

http://www.inrealty.com/restocks/ligert.html

I don't see anything for ND and SD though.

38   OO   2008 Mar 28, 8:53am  

Rice went up 30% in a day
http://www.ft.com/cms/s/0/425a0e2e-fc6a-11dc-9229-000077b07658.html

I have long seen this coming but couldn't get a focused exposure to rice price. RJA is the best I can do which includes rice, but the component is too small to make a difference.

The rise in food commodity price is just the beginning. I hope there will be a rice ETF soon. Quite a few Asian countries are running out of rice inventory, China has exhausted almost all of its backup rice storage in the last 3 years. A further 100% hike from the current level is not unreasonable to expect.

The fact is, the $100+ oil has not seen its ripple effect in agriculture fully illustrated yet. Farmers, particularly those from developing countries, are squeezed by the soaring fertilizer price which is 90% driven by natural gas, so most of them CUT BACK their production instead of ramping up. They only grow enough for themselves to eat. The reason for the cutback is because the food commodity price in these developing countries are heavily controlled by the government so that everyone can afford some food. When you have an input price that is soaring and not controllable by the government, and output price that is subject to heavy government control, the result is even lower agriculture inventory and even higher food price.

This is only the beginning.

39   Peter P   2008 Mar 28, 8:56am  

But how do we survive trading leveraged positions in commodities?

soaring fertilizer price

Potash?

40   Peter P   2008 Mar 28, 8:58am  

I think CBOT has a rough rice contract. Is that what you want? It does not look super-liquid though.

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