Calculating maximum interest deduction on 2 mortgage loans that partiallyoverlap

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gmace11
gmace11 Member Posts: 2 Newcomer
edited March 25 in Credits/Deductions

I have a situation that the software does not seem to support natively. Using more illustrative numbers to simplify the description.

There are two home loans for a primary residence property.

Loan 1:

- principal is 650K (roughly average for the year - I'm aware of the methods the IRS recommends for computing this for a single loan)

- loan was in place for all of 2023

Loan 2:

- principal: 200K

- loan was in place 1/1/2023 and was fully repaid on 5/10/2023


The software does not allow specifying date when entering the 1098 statements and it is flagging the two loans as being over the 750K single filer principal limit on mortgage interest deduction.

Any recommendations on how to determine the overall applicable % of the Internet that is deductible for the full loan? Based on some research I'm thinking of a couple of possible options:

(1) averaging the combined monthly amount of the principle over the 12 months of 2023 (I'll use 0s for mortgage 2 for the months when it was not in place after the repayment).

(2) Calculating the allowable ratio for each month and then averaging that.

Any thoughts on (1) vs (2) vs another method?

Also how do you express any of the above in FreeTaxUSA?

Thanks!

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  • RyanZ
    RyanZ FreeTaxUSA Agent Posts: 70
    edited March 26
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    Hello gmace11, and welcome to the FreeTaxUSA Community!

    That is a really great question and is one that we frequently receive in Support!

    Guidance from the IRS can be found is IRS Publication 936 - this link will take you directly to "Average Mortgage Balance"
    https://www.irs.gov/publications/p936#en_US_2023_publink1000230028

    Here are some examples I have come up with based on your information. There is more than one acceptable method, and you may choose to use the one that is most advantageous to you.

    Average of first and last balance method*
    $650,000 + $200,000 = $850,000 balance @ 1/1/2023
    $ 0 + $200,000 = $200,000 balance @ 12/31/2023
    $850k + $200k = $1,050k
    $1,050k / 2 = $525k
    - Average Balance based on first and last Balances is Less Than $750,000 allows you to claim all of the 2023 mortgage interest paid.
    *EDIT: the Average of first and last balance method does NOT apply in this situation, because one of the mortgage loans was paid off early

    Statements provided by your lender
    On January 1, 2023 Loan 1 balance (actual) was $650,000 (I'm only using your amounts as an example, you would need to look up the actual balances), Loan 2 balance (actual) $200,000. Presuming the principle on Loan 1 was reduced by $5,000 each month, I would do the following:
    $650,000 + $200,000 = $850,000 balance @ 1/1/2023
    $645,000 + $200,000 = $845,000 balance @ 2/1/2023
    $640,000 + $200,000 = $840,000 balance @ 3/1/2023
    $645,000 + $200,000 = $835,000 balance @ 4/1/2023
    $640,000 + $200,000 = $830,000 balance @ 5/1/2023
    $850k + 845k + 840k + $835k + $830k = $4,200,000 / 5 = $840,000
    $840k - $750k = $90k over the deductible limit
    $750k / $840k = 89.29%
    - Claim 89.29% of the interest paid between beginning of the year until payoff - this percentage will apply to the total interest from both loans for the 5 months, and then 100% of the mortgage interest for the remaining 7 months.

    $650,000 + $200,000 = $850,000 balance @ 1/1/2023
    $645,000 + $200,000 = $845,000 balance @ 2/1/2023
    $640,000 + $200,000 = $840,000 balance @ 3/1/2023
    $645,000 + $200,000 = $835,000 balance @ 4/1/2023
    $640,000 + $200,000 = $830,000 balance @ 5/1/2023
    $ 0 + $200,000 = $200,000 balance @ 6/1/2023
    $ 0 + $200,000 = $200,000 balance @ 7/1/2023
    $ 0 + $200,000 = $200,000 balance @ 8/1/2023
    $ 0 + $200,000 = $200,000 balance @ 9/1/2023
    $ 0 + $200,000 = $200,000 balance @ 10/1/2023
    $ 0 + $200,000 = $200,000 balance @ 11/1/2023
    $ 0 + $200,000 = $200,000 balance @ 12/1/2023
    $ 0 + $200,000 = $200,000 balance @ 12/31/2023
    ($850k + 845k + 840k + $835k + $830k) + (8 x $200k) = $5,800,000
    $5,800k / 13* = $446k Annual Average Balance
    *use 13 to account for the balance at the end of the year in this example
    - Average Balance based on Monthly Average Balances is Less Than $750,000 allows you to claim all of the 2023 mortgage interest paid.

    As you can see, using the Average of first and last balance method is simple and works in this example. The more complex methods might be advantageous to achieve a lower average.

  • gmace11
    gmace11 Member Posts: 2 Newcomer
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    Thank you for the response. The mortgages in your example are actually reversed. The 650k loan remains in place and the 200K one was only in place for the first 5 months of 2023.


    My read of the First and Last method in Publication 936 was that it is only applicable if the loans had the same duration throughout the year but maybe I'm mistaken. Also are you allowed to compute the average by adding the mortgages independently for first and last before averaging them. Seemed to imply that you do this separately for each before adding the. Can you double check?

    With the correct mortgages your example 1 calculation would look like 650 + 200 for month 1 and the n 650 (this amount will be lower but using for simplicity) for month 12. That would give an average of 750 which is just good enough.


    As for entering this software, you are basically saying that whatever I decide to use I would just adjust the amount of the interest that I believe is deductible for each when I'm entering the interest amount even if that is less than what is on the form. Is this correct?


    Thanks!

  • RyanZ
    RyanZ FreeTaxUSA Agent Posts: 70
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    Thank you for catching my error, that the Average of first and last balance method is not allowed in this situation due to the loan being paid off during the year. I will update my original response.

    Yes, you will make an adjustment to the amount of Mortgage Interest Expense, to report only the deductible portion, even if it is less than the amount reported to you on form 1098. You will probably continue to receive a Yellow Alert regarding the total of the mortgage loans being greater than $750k, which you may ignore, after you have entered the adjusted amount.