Question

Lauren purchased a home on January 1, 2015 for $500,000 by making a down payment of $200,000 and financing the remaining $300,000 with a 30-year loan, secured by the residence. During 2015, Lauren made interest-only payments on the loan. On July 1, 2015, when her home was valued at $500,000, she borrowed an additional $150,000, secured by the residence. During 2015, she made interest-only payments on the second loan. Which of the following statements regarding the deductibility of the interest Lauren paid is correct (assume she uses the chronological order of the loans to determine deductible interest expense if a limitation applies)?

A. Lauren may deduct all of the interest on the first loan but she may deduct only two-thirds of the interest on the second loan unless she uses the loan proceeds to substantially improve the home.
B. Lauren may deduct all of the interest on the first loan but she may deduct only two-thirds of the interest on the second loan no matter what she does with the proceeds of the second loan.
C. Lauren may deduct all of the interest on the first loan or all of the interest on the second loan.
D. Lauren may deduct all of the interest on the first loan and all of the interest on the second loan no matter what she does with the loan proceeds.

Answer 1

Lauren may deduct all interest on the first loan and potentially all interest on the second loan if it was used for substantial home improvements. If the second loan's proceeds were not used as such, only a portion of that interest may be deductible.

Step-by-step explanation:

The question pertains to the deductibility of mortgage interest on a primary residence in accordance with U.S. tax laws. According to IRS regulations, homeowners can deduct interest on up to $750,000 of qualified residence loans (this limit is $1 million if the loan was taken out before December 16, 2017) used to buy, build, or substantially improve the taxpayer's home that secures the loan. In Lauren's scenario, she may deduct all of the interest on the first loan because the loan is less than or equal to $750,000. However, the interest deducted on the second loan depends on how the proceeds were used. If the proceeds were used to substantially improve the home, she may deduct all of the interest. If the proceeds were not used for home improvements, then based on the loan amount plus the outstanding balance of the first loan exceeding $750,000, a limitation would apply.

So, the correct statement regarding the deductibility of the interest Lauren paid in 2015 would reflect that, if the funds were used for substantial home improvement, she could potentially deduct all the interest paid on both loans, otherwise, the deductibility of the second loan's interest might be limited.