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State has limit on mortgage interest deductions

The increase in recent years in the cost of California real estate has raised home valuations to record levels. These record home prices have resulted in an increase in the number of home mortgages in excess of $1,000,000.

Make your clients aware that California (through Revenue & Taxation Code Section 17201) conforms to the dollar amounts of the Federal Mortgage Interest Deduction Limitation (IRC Section 163).

We recently reviewed a sampling of Form 540 tax returns with large Schedule A mortgage interest deductions and found a 75 percent rate of non-compliance with the mortgage interest deduction limitation rules.

Here are some things to look for when calculating mortgage interest deductions:

• In general, a mortgage interest deduction is allowed for secured debts incurred to purchase a principal or second home and for home equity debts.

• The total amount of home acquisition indebtedness must not exceed $1,000,000, or $500,000 in the case of a married person filing separately, and the total

amount of home equity indebtedness must not exceed $100,000, or $50,000 for a married person filing separately.

• Mortgage interest paid in excess of the limits stated above is generally considered non-deductible personal interest.

• The term home equity indebtedness means any indebtedness, other than acquisition indebtedness secured by that residence to the extent that the total amount of such debt does not exceed the fair market value of such qualified residence.

• The term acquisition indebtedness means any debt that is incurred in constructing, acquiring or substantially improving any qualified residence and in turn is secured by that residence.

• Qualified Residence Interest for California and Federal purposes allows for a Schedule A mortgage interest deduction as home mortgage interest to the extent the amount borrowed on the mortgage does not exceed the cost of the home (qualified principal or second residence), plus the cost of improvements.

• A qualified residence can be a house, condominium, cooperative, mobile home, house trailer, boat or other similar property that has sleeping, cooking and toilet facilities. Qualified residence means your main home, generally where you spend most of your time and/or a second home. Only one second home may be designated by the taxpayer for each year.

• Refinances of existing mortgages can present a mortgage interest deduction limitation concern if the amount refinanced by the taxpayer exceeds the cost of the home.

• Special rules apply to grandfathered mortgage interest debt incurred on or before October 13, 1987 which is not subject to the $1,000,000 mortgage interest deduction limitation. The refinancing of grandfathered mortgage interest debt should be reviewed to see if it triggers any mortgage interest limitation rules.

Please see IRS Publication 936, Home Mortgage Interest Deduction, which provides the details and definitions on this interesting topic along with a worksheet to calculate your deductible home mortgage interest for the year.

Economic Development Areas manual now online

Did you know that our Economic Development Areas (EDA) manual is available for viewing online?

The EDA manual is one of several in-house resources we put online. It provides technical guidance on the tax incentives associated with the economic development areas including Enterprise Zones, Local Agency Military Base Recovery Areas, Targeted Tax Areas and Manufacturing Enhancement Areas.

In fact, several of our internal procedure manuals online for practitioners and taxpayers are available for viewing or downloading from our forms and publications website located at

Manuals you'll find there include our:

• Bank and Financial Handbook
• Collection Procedure Manual
• General Tax Audit Manual

• Multistate Audit Techniques Manual
• Water's Edge Manual

Note: The information provided in our internal procedure manuals does not reflect changes in law, regulations, notices, decisions, or administrative procedures that may have been adopted since the manual was last updated.

January/February 2001

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