Not all 'mortgage' interest is tax deductible '125 LTV,' which gives more cash than home is worth, draws IRS scrutiny

Nation's Housing

December 14, 1997|By Kenneth R. Harney

THE INTERNAL Revenue Service is throwing cold water on the hottest mortgage product of 1997: the so-called "125 percent loan-to-value" (125 LTV) financing that provides homeowners with more cash than their homes are worth.

In its first public comments directed at the "125 LTV" loan boom, the IRS this month warned homeowners that deducting mortgage interest on loan amounts exceeding the fair market value of their homes is prohibited. In an interview, Assistant IRS Commissioner for Examinations Thomas G. Smith urged homeowners "to exercise caution" when they load debt on their homes far beyond market value.

"People [might] assume that if it's a mortgage, then the interest is always deductible," said Smith. But under the federal tax code, interest "attributable to debt in excess of fair market value is not deductible."

The explosion in home lending above fair market values has caught the attention not only of the IRS, but of Congress as well. Sen. Lauch Faircloth, Republican of North Carolina and a member of the Senate Banking, Housing and Urban Affairs Committee, has asked the General Accounting Office (GAO) to look into the rapid growth of 125 LTV lending nationwide. A staff assistant to Faircloth said the senator is particularly concerned by the potential negative effects on the safety and soundness of financial institutions making mortgages that are not backed by real estate equity.

In the event of a foreclosure, the aide said, "the lender would recover nothing" from these mortgages.

Home loans above property value generally take the form of "home equity" or second mortgages or deeds of trust that are extended on top of an existing first mortgage. The combined principal balances of the first and second loans total more than what the house is worth.

Heavily promoted on television and by telemarketers as debt consolidation tools, the new "high LTV" loans are designed for homeowners who have built up large credit card and other consumer debts at high interest rates, and need relief.

An estimated $10 billion to $11 billion of these loans will be closed during 1997, according to Wall Street securities firms, up from just $3 billion two years ago.

Here's how they work: Say you have a home worth $100,000 that you bought a couple of years ago with a $90,000 (90 percent LTV) first deed of trust. Because you and your spouse haven't been disciplined in your credit-card use, you're carrying $25,000 in debt at 19 percent.

Thanks to your solid monthly combined incomes, you've never missed a payment on either your mortgage or your credit card balances. But you're nearing the precipice.

Christmas shopping debts you expect to rack up in the next few weeks could push you over the brink -- and into default.

The answer: You see a TV pitch for "debt consolidation" that seems to solve your problems. The lender will give you a second mortgage of $35,000 at 14 percent, plus some fees. You can use the money to pay off all your credit cards, plus you have extra cash left over. At closing, you end up with a mortgage debt of $125,000 -- a $90,000 first and a $35,000 second -- on a house worth $100,000.

How do you handle your interest deductions when you file your federal tax return? Lenders who specialize in 125 LTV mortgages usually advise borrowers to "consult your tax adviser." But some lenders acknowledge that they do nothing to advise borrowers that under federal tax law the interest payments they will make on portions of their debt will not be deductible. Nor do the lenders disclose that they themselves treat the "mortgages" as unsecured consumer debt -- not a home equity loan -- and price them accordingly.

How to handle

How should borrowers who are contemplating -- or have already taken out -- 125 LTV mortgages handle the deductibility issue? For starters, be aware that as a general rule, you can't write off unsecured consumer debt, even if it's marketed as mortgage. Second, do precisely as the lender suggests -- talk to your tax adviser -- for guidance on how to establish the line at which your deductible mortgage debt stops, and your nondeductible "mortgage" debt starts.

For example, in the case above, it's likely your tax adviser would take $100,000 as your fair market value, and define the $25,000 in debt above that line as nondeductible. In other words, the first $10,000 of your new $35,000 loan would probably be deductible; the $25,000 balance would not.

What is the IRS prepared to do when auditors find taxpayers breaking the rule by writing off the entire annual interest payments on 125 LTV loans?

Assistant Commissioner Smith outlined these steps: First, your "excess interest deduction will be disallowed." Second, you'll be subject to interest on the disallowed amounts, and possibly be hit with penalties.

Any penalties will depend on whether the "facts and circumstances" surrounding you and your loan suggest that you did know -- or reasonably should have known -- that you were taking improper mortgage interest deductions.

The bottom line here: Just because the loan is packaged as a "home mortgage" doesn't automatically mean the interest is tax-deductible.

Pub Date: 12/14/97

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