Money Matters/The IRS appears to have changed its stance on the mortgage deduction

Brad and Melissa recently bought a house. At well over $1 million, it may have been a bit of a risk, given the local real estate market. But their family was growing and both considered it their dream home. With the closing behind them, the couple sat down with their financial adviser to discuss the tax impact of their mortgage.

Their adviser began by noting that Brad and Melissa had picked a good time to buy a house -- at least from one tax perspective.

Shifting its stance

For a long time, the IRS typically stuck to the rule that taxpayers may deduct the interest on up to $1 million in debt used to buy, build or improve a home, known as "acquisition indebtedness." In addition, they could deduct interest on an additional $100,000 in home equity debt, known as "equity indebtedness" -- but only if that amount wasn't used to acquire the home.

The IRS now seems to have shifted its stance. Recent cases indicate that any debt used to buy, build or upgrade a home may be defined as both acquisition and equity indebtedness. Thus, the couple should be able to deduct interest on the full $1.1 million amount.

Readying for a refi

Given the low interest rate on their mortgage, Brad and Melissa figured it was unlikely they'd ever refinance. But their adviser said that she'd refinanced twice in 2011, and it would be worthwhile for the couple to at least know the basics.

If Brad and Melissa opted to simply replace their loan, they'd borrow an amount equal to their previous mortgage's remaining balance. They'd be able to fully deduct the mortgage interest, as long as their total acquisition indebtedness didn't exceed $1.1 million.

Should the couple prefer a cash-out refi, they'd borrow in excess of their remaining balance. The tax impact would vary depending on how they put that extra cash to use.

If they spent it on home upgrades, the IRS would allow them to deduct interest on up to $1.1 million of their total mortgage. If they used it for something else, such as a vehicle purchase or tuition payment, the agency might take its previous stance, classifying the cash-out amount as equity indebtedness and limiting their deduction on that portion of the mortgage to interest on $100,000.

Minding the details

This has been a general discussion of what can be a complex subject and is not intended as advice to anyone. Always consult your financial advisers about your particular circumstances before taking any actions.

Norm Grill is a certified public accountant and managing partner of Grill & Partners LLC, accountants and consultants to closely held companies and high-net-worth individuals, with offices in Fairfield and Greenwich. He can be reached at: n.grill@GRILL1.com