On January 1 of year 1, Arthur and Aretha Franklin purchased a home for $1.5 mil
ID: 2765582 • Letter: O
Question
On January 1 of year 1, Arthur and Aretha Franklin purchased a home for $1.5 million by paying $200,000 down and borrowing the remaining $1.3 million with a 7 percent loan secured by the home.
What is the amount of the interest expense the Franklins may deduct in year 1?
Deductible Interest Expense: ?????
Assume that in year 2, the Franklins pay off the entire loan but at the beginning of year 3, they borrow $300,000 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 (the Franklins do not use the loan proceeds to improve the home)?
Deductible Interest Expense: ?????
Assume the same facts as in (b), except that the Franklins borrow $80,000 secured by their home. What amount of interest expense may the Franklins deduct in year 3 on this loan (the Franklins do not use the loan proceeds to improve the home)?
Deductible Interest Expense: ?????
On January 1 of year 1, Arthur and Aretha Franklin purchased a home for $1.5 million by paying $200,000 down and borrowing the remaining $1.3 million with a 7 percent loan secured by the home.
Explanation / Answer
Ans)The United States allows a home mortgage interest deduction, with several limitations.
First, the taxpayer must elect to itemize deductions, and the total itemized deductions must exceed the standard deduction (otherwise, itemization would not reduce tax). Second, the deduction is limited to interest on debts secured by a principal residence or a second home.
Third, interest is deductible on only the first $1 million of debt used for acquiring, constructing, or substantially improving the residence, ($500,000 if filing separately) or the first $100,000 of home equity debt regardless of the purpose or use of the loan.
As per these limitations (a) The acquisition indebtedness limit ($1000000) and the home equity indebtedness limit($100000) so the maximum amount of debt on which Franklin may deduct qualified residence interest is 1,100,000.Thus the amount of deductible interest expense on a loan is calculated as follows:
Total Interest Expense:
Purchase Price:$1,500,000
Down Payment:$2,00,000
Loan Amount : $1,300,000
Interest Expense:$1,300,0000*7%=$91000
Deductible interest expense: $91000*1,100,000/1,300,000=$77,000
(b) In this case Franklin reduces their original acquisition indebtedness to zero. Franklin do not use the additional loan in year three to improve the home, the loan cannot be classified as additional indebtedness. Thus interest on a loan can only be deducted to the extent its qualifies as home equity indebtedness. $1, 00,000 qualifies as home equity indebtedness and franklin may deduct $7,000($1, 00,000*7%) as interest Expense.
(c ) Similar as part( b) Franklin do not use the additional loan in year three to improve the home, the loan cannot be classified as additional indebtedness. Thus interest on a loan can only be deducted to the extent its qualifies as home equity indebtedness. $1, 00,000 qualifies as home equity indebtedness but in that case Franklin borrowed $80,000 so maximum deductible interest expense should be ($80,000*7%)=$5600
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