TD 8168 12 22 1987 Personal Interest and Home Mortgage Interest Expense Regulations 1 163 9T and 1 163 10T AGENCY Revenue Code for personal interest paid or accrued during the taxable year Section 163 h 2 defines personal interest as any interest otherwise allowable as a deduction under Chapter 1 of the Internal Revenue Code other than a interest paid or accrued on indebtedness properly allocable to the conduct of a trade or business other than the trade or business of performing services as an employee b investment interest c interest taken into account under section 469 in computing income or loss from a passive activity d qualified residence interest or e interest payable under section 6601 on any unpaid portion of the tax imposed by section 2001 for the period during which an extension of time for payment of such tax is in effect under section 6163 6166 or 6166A as in effect before its repeal by the Economic Recovery Tax Act of 1981 Internal Revenue Service Treasury ACTION Temporary regulations SUMMARY This document contains temporary regulations relating to the treatment of personal interest and the treatment and determination of qualified residence interest The text of the temporary regulations set forth in this document also serves as the text of the proposed regulations for the notice of proposed rulemaking on this subject in the Proposed Rules section of this issue of the Federal Register Changes to the applicable tax law were made by the Tax Reform Act of 1986 The regulations affect taxpayers other than corporations who have paid or accrued personal interest during a taxable year and taxpayers who have paid or accrued interest on debt secured by a principal or second residence Section 163 h 3 defines qualified residence interest as interest paid or accrued on debt that is secured by a qualified residence at the time such interest is paid or accrued Under section 163 h 3 B however interest expense constitutes qualified residence interest only to the extent that the underlying debt when added to the principal balance of all other debt previously secured by the qualified residence does not exceed the lesser of a the fair market value of the qualified residence or b the sum of the taxpayer s basis in the qualified residence adjusted only by the cost of any improvements plus the amount of qualified indebtedness secured medical and educational debt Section 163 h 3 C provides that for purposes of this limitation the taxpayer s basis in the qualified residence shall not be less than the principal balance of debt incurred prior to August 16 1986 and secured by the qualified residence on August 16 1986 Section 163 h 3 D provides that except as provided in regulations any determination with respect to the limitation on the amount of qualified residence interest shall be made at the time the debt is incurred DATES The regulations are effective for taxable years beginning after December 31 1986 FOR FURTHER INFORMATION CONTACT Sharon L Hall of the Legislation and Regulations Division Office of Chief Counsel Internal Revenue Service 1111 Constitution Avenue NW Washington DC 20224 Attention CC LR T 202 566 3288 not a toll free call SUPPLEMENTARY INFORMATION Background This document amends the Income Tax Regulations 26 CFR Part 1 and the Table of OMB Control Numbers 26 CFR Part 602 to provide rules under section 163 h of the Internal Revenue Code of 1986 Section 163 h was added to the Code by section 511 b of the Tax Reform Act of 1986 Pub L 99 514 100 Stat 2246 Qualified indebtedness is defined in section 163 h 4 as debt secured by a qualified residence which is incurred after August 16 1986 to pay for certain medical and educational Explanation of Statutory Provisions Section 163 h 1 provides that in the case of a taxpayer other than a corporation no deduction shall be allowed under Chapter 1 of the Internal 1 expenses which are paid or incurred within a reasonable period of time before or after such debt is incurred Limiting the fair market value determination to the date a debt is incurred will minimize controversy between taxpayers and the Service because the residence s fair market value with respect to any particular debt will be determined only once and because an independent appraisal ordinarily is conducted in connection with arm s length lending transactions Section 163 h 5 defines qualified residence as the principal residence of the taxpayer and one other residence designated by the taxpayer Explanation of Regulatory Provisions The regulations adopt an annual test to determine whether a taxpayer s debt secured by a qualified residence secured debt exceeds the section 163 h 3 B limitation on qualified residence interest An annual approach was chosen rather than a test applied only at the time a debt is incurred because an annual approach takes account of reductions in the principal balance of secured debt and therefore removes the incentive to refinance a secured debt in order to redetermine the limitation Moreover an annual test accounts more appropriately for lines of credit the balance of which may fluctuate from year to year In the case of a qualified residence that is real property the regulations provide an irrebuttable presumption that the fair market value is no less than the adjusted purchase price of the residence as of the end of the current taxable year This presumption further reduces controversy between taxpayers and the Service over fair market value It is believed that in a broad range of circumstances fair market value will in fact be at least as great as the adjusted purchase price These simplifications permit a taxpayer to determine whether all interest expense on secured debt is qualified residence interest by comparing the sum of the average balances for the taxable year of all secured debt to the adjusted purchase price determined as of the end of the year If this sum is less than the adjusted purchase price all of the interest paid or accrued on the secured debt is qualified residence interest If the combined average balance exceeds the adjusted purchase price the taxpayer must determine the amount of qualified residence interest using either the simplified method or the exact method A taxpayer may use a different method for each qualified residence in each taxable year The regulations apply the annual test by comparing the section 163 h 3 B limitation with the average principal balance of the debt during the taxable year The average balance was