In year 1, Jaspreet purchased a new home for $500,000 by making a down payment of$400,000 and financing the remaining $100,000 with a loan, secured by the residence, at6 percent. In year 3, Jaspreet made interest only payments of $6,000 on the $100,000loan. On January 1, year 3 when his home was valued at $500,000 Jaspreet executed two home equity loans (both secured by the home). The first (early in the day) was for$80,000 at an interest rate of 9 percent. The second home equity loan from a different bank (later in the day) was for $40,000 at an interest rate of 7 percent. In year 3, Jaspreet paid $7,200 of interest payments on the first home equity loan and $2,800 interest expense on the second. Jaspreet used the proceeds from both home-equity loans forpurposes unrelated to the home. What is the maximum amount of interest expenseJaspreet can deduct on these loans as home related interest expense?

Question

Quizplus · Accepted Answer

Only the interest on the home mortgage (original loan) and the interest on the first home equity loan ($80,000) can be considered as home related interest expense. The interest on the second home equity loan ($40,000) cannot be considered as home related interest expense because the proceeds were not used to improve the home. Therefore, the maximum amount of interest expense Jaspreet can deduct as home related interest expense is $6,000 + $7,200 = $13,200. However, since the total interest expense paid on all loans was $16,000, Jaspreet can deduct only the proportion of the interest paid that is allocable to the home-related loans. The proportion of interest allocable to the home is calculated as follows:
($100,000 ÷ $500,000) × 100% = 20%
($80,000 ÷ $500,000) × 100% = 16%
Total allocable percentage = 20% + 16% = 36%
Therefore, the maximum amount of interest expense Jaspreet can deduct as home related interest expense is $16,000 × 36% = $5,760, which is closest to option C.

In Year 1, Jaspreet Purchased a New Home for $500,000