In year 1, Abby 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. On January 1, year 4, when her home was worth $300,000, Abby refinanced the home by taking out a $120,000 mortgage at 5 percent. With the loan proceeds, she paid off the $40,000 balance of the existing mortgage and used the remaining $80,000 for purposes unrelated to the home. During year 4, she made interest-only payments on the new loan of $6,000. What amount of the $6,000 interest expense on the new loan can Abby deduct in year 4 on the new mortgage as home-related interest expense?

Question

Quizplus · Accepted Answer

Abby can only deduct interest on the portion of the new loan that is used to improve her home or purchase her home. Since Abby used $40,000 of the new loan to pay off the existing mortgage on her home, and the existing mortgage was for the purpose of purchasing her home, Abby can deduct the interest on that $40,000 portion of the new loan. The interest on the remaining $80,000 that was used for purposes unrelated to the home cannot be deducted as home-related interest expense. Therefore, Abby can deduct $2,000 of the $6,000 interest expense on the new loan in year 4 as home-related interest expense.

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