In year 1, Kris purchased a new home for $200,000 by making a down payment of$150,000 and financing the remaining $50,000 with a loan, secured by the residence, at 6 percent. As of January 1, year 4, the outstanding balance on the loan was $40,000. OnJanuary 1, year 4, when his home was worth $300,000, Kris refinanced the home bytaking out a $150,000 mortgage at 5 percent. With the loan proceeds, he paid off the$40,000 balance of the existing mortgage and used the remainder for purposes unrelated to the home. During year 4, he made interest only payments on the new loan of $7,500. What amount of the $7,500 interest expense on the new loan can Kris deduct in year 4 on the new mortgage as home related interest expense?

Question

Quizplus · Accepted Answer

Kris can deduct home related interest expense on the new loan up to the lesser of: 
1. The remaining balance on the loan used to purchase or improve the home, which is $150,000, or 
2. The fair market value of the home at the time of refinancing, which is $300,000. 
Therefore, Kris can deduct interest on the new loan up to $150,000. He used $40,000 of the new loan to pay off the old loan, so the remaining $110,000 ($150,000 - $40,000) can be considered home related interest. 5% of $110,000 is $5,500. Since Kris made interest only payments of $7,500, the portion that is deductible as home related interest is $5,500 (the remaining $2,000 is for unrelated purposes). Therefore, the answer is B ($7,000).

In Year 1, Kris Purchased a New Home for $200,000