In year 1,Gabby purchased a new home for $500,000 by making a down payment of $200,000 and financing the remaining $300,000 with a loan,secured by the residence,at 6 percent.In year 3,Gabby made interest-only payments of $18,000 on the $300,000 loan.On January 1,year 3,Gabby executed two home equity loans (both secured by the home).The first was for $80,000 at an interest rate of 7 percent.The second home equity loan from a different bank (later in the day)was for $40,000 at an interest rate of 9 percent.In year 3,Gabby paid $5,600 of interest payments on the first home equity loan and $3,600 interest expense on the second.Gabby used the loan proceeds for purposes unrelated to the home.What is the maximum amount of interest expense Gabby can deduct on these loans as home related interest expense?

Question

Quizplus · Accepted Answer

The maximum amount of interest expense Gabby can deduct on these loans as home related interest expense is calculated as:

Interest on the $300,000 mortgage loan: $300,000 x 6% = $18,000

Interest on the $80,000 home equity loan: $80,000 x 7% = $5,600

Interest on the $40,000 home equity loan: $40,000 x 9% = $3,600

Therefore, the total home related interest expense is:

$18,000 + $5,600 + $3,600 = $27,200

However, since Gabby used the loan proceeds for purposes unrelated to the home, the IRS limits the deductible interest to the lesser of:
- The total amount of interest paid on the loans during the year, or
- The amount of interest paid on the loans during the year, multiplied by the ratio of the average balance of the home acquisition debt to the average balance of total debt.

In this case, the average balance of the home acquisition debt is the same as the balance of the mortgage loan: $300,000. The average balance of total debt is calculated as:

[(Beginning balance of mortgage loan + Beginning balance of home equity loans + Ending balance of mortgage loan + Ending balance of home equity loans) ÷ 2]

= [(300,000 + 80,000 + 40,000 + 300,000) ÷ 2]

= $360,000

Therefore, the ratio of the average balance of the home acquisition debt to the average balance of total debt is:

$300,000 ÷ $360,000 = 0.8333

This means that Gabby can only deduct 83.33% of the interest paid on the loans as home related interest expense. Therefore, the maximum amount of interest expense Gabby can deduct on these loans as home related interest expense is:

($18,000 + $5,600 + $3,600) x 0.8333 = $25,905

In Year 1,Gabby Purchased a New Home for $500,000 by Making