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38. [LO 1] Lauren owns a condomium. In each of the following alternative situations, determine whether the
condominium should be treated as a residence or nonresidence for tax purposes?
a. Lauren lives in the condo for 19 days and rents it out for 22 days.
Residence: personal use (19 days) exceeds 14 days and 10% of rental days (2.2)
b. Lauren lives in the condo for 8 days and rents it out for 9 days
Nonresidence: Personal use does not exceed 14 days.
c. Lauren lives in the condo for 80 days and rents it out for 120 days
Residence: personal use (80 days) exceeds 14 days and 10% of rental days (12)
d. Lauren lives in the condo for 30 days and rents it out for 320 days.
Nonresidence: Personal use (30 days) exceeds 14 days but not 10% of rental days (32).
45. LO 3] Javier and Anita Sanchez purchased a home on January 1, year 1 for $500,000 by paying $200,000 down
and borrowing the remaining $300,000 with a 7 percent loan secured by the home. The loan requires interest-only
payments for the first five years. The Sanchezes would itemize deductions even if they did not have any deductible
interest. On January 1, the Sanchezes also borrowed money on a second loan secured by the home for $75,000.
The interest rate on the loan is 8 percent and the Sanchezes make interest-only payments in year 1 on the second
loan.
a. Assuming the Sanchezes use the second loan to landscape the yard to their home, what is the maximum
amount of interest expense (on both loans combined) they are allowed to deduct year 1?
b. Assume the original facts and that the Sanchezes use the $75,000 loan proceeds for an extended family
vacation. What is the maximum amount of interest expense (on both loans combined) they are allowed to
deduct in year 1?
c. Assume the original facts, except that the Sanchezes borrow $120,000 on the second loan and they use the
proceeds for an extended family vacation and other personal expenses. What is the maximum amount of
interest expense (on both loans combined) they are allowed to deduct in year 1?
a. $27,000 ($21,000 + $6,000), determined as follows:.
The first loan of $300,000 is classified as acquisition indebtedness. The second loan of $75,000 would
likely also be classified as acquisition indebtedness because it was used to substantially improve the home.
Because the Sanchezes’ acquisition indebtedness of $375,000 ($300,000 + $75,000) does not exceed the
$1,000,000 acquisition debt limit, they may deduct all of the $21,000 interest on the first loan ($300,000 ×
7%) and the entire $6,000 of interest on the second loan ($75,000 × 8%).
b. $27,000 ($21,000 + $6,000), determined as follows:
The Sanchezes can deduct the $21,000 interest on the first loan which is acquisition debt ($300,000 × 7%).
The second loan qualifies as a home-equity loan because it was not used to substantially improve the home.
The amount of home-equity indebtedness is limited to the lesser of
(1) the FMV of the qualified residence in excess of the acquisition debt related to that residence and
(2) $100,000 ($50,000 for married filing separately). The Sanchezes’ home is worth $500,000 ($200,000
down payment plus the $300,000 acquisition indebtedness). Hence the home-equity indebtedness is
limited to $75,000 which is the lesser of
(1) FMV of residence less acquisition debt ($500,000 - $300,000) = $200,000, or
(2) the amount of home-equity indebtedness or $100,000,
Thus the Sanchezes can deduct interest on up to $100,000 of home-equity indebtedness. Because their
second loan of $75,000 is below this limit, they can deduct the full $6,000 of interest paid on the second
loan ($75,000 × 8%).
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c. $29,143 under the average interest expense method, determined as follows:.
In this case, the Sanchezes have $420,000 of debt but only $400,000 of qualifying debt ($300,000
acquisition debt + $100,000 qualifying home equity debt). The second loan qualifies as a home-equity
loan because it was not used to substantially improve the home. The amount of home-equity
indebtedness is limited to the lesser of
(1) the FMV of the qualified residence in excess of the acquisition debt related to that residence and
(2) $100,000 ($50,000 for married filing separately). The Sanchezes’ home is worth $500,000 ($200,000
down payment plus the $300,000 acquisition indebtedness). Hence the home-equity indebtedness is
limited to $100,000 which is the lesser of
(1) FMV of residence less acquisition debt ($500,000 - $300,000) = $200,000 or
(2) the amount of qualifying home-equity indebtedness of $100,000
In total, the Sanchezes paid $30,600 of interest ($21,000 on the acquisition debt $300,000 × 7% + $9,600
on the second loan $120,000 × 8%). Because the total debt secured by the home exceeds the total
qualifying debt, the Sanchezes can use the average interest method or the chronological order method to
determine the total deductible interest.
Under the chronological method, they would deduct the $21,000 interest on the first mortgage and $8,000
on the second mortgage ($100,000 qualifying home equity debt × 8%) for a total of $29,000.
Under the average interest method the Sanchezes may deduct $29,143 of interest, computed as follows:
$30,600 total interest × $400,000/$420,000 = $29,143. Assuming the $21,000 interest on the acquisition
debt is deductible in full, $8,143 of the interest on the second loan is deductible.
In total, the Sanchezes would deduct more interest under the average interest method than under the
chronological method.
49. [LO 3] On January 1 of year 1, Arthur and Aretha Franklin purchased a home for $1.5 million by paying
$200,000 down and borrowing the remaining $1.3 million with a 7 percent loan secured by the home.
a. What is the amount of the interest expense the Franklins may deduct in year 1?
b. Assume that in year 2, the Franklins pay off the entire loan but at the beginning of year 3, they borrow
$300,000 secured by the home at a 7 percent rate. They make interest-only payments on the loan during
the year. What amount of interest expense may the Franklins deduct in year 3 on this loan? Does it
matter what they do with the loan proceeds? Explain.
c. Assume the same facts as in (b), except that the Franklins borrow $80,000 secured by their home. What
amount of interest expense may the Franklins deduct in year 3 on this loan? Does it matter what they do
with the loan proceeds? Explain.
a. $77,000.
Because the acquisition indebtedness limit ($1,000,000) and the home-equity indebtedness limit ($100,000)
are two separate limits, the maximum amount of debt on which a taxpayer may deduct qualified residence
interest is $1,100,000 as long as the value of the taxpayer’s residence (or residences) is at least
$1,100,000. Since the Franklin’s home is worth $1.5 million, they can deduct interest on up to $1.1
million. Thus, the amount of deductible interest on the loan is calculated as follows:
Total interest expense = total loan principal x interest rate
= $1.3 million × 7%
= $91,000
Deductible interest expense = Qualified debt/Total debt x total interest expense
= [$1.1 million/1.3 million] × $91,000
= $77,000
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b. $7,000 or $21,000 depending on what they do with the proceeds.
Once acquisition indebtedness is established, only payments on principal can reduce the indebtedness and
only additional indebtedness secured by the residence and incurred to substantially improve the residence
can increase it. In this case, the Franklins reduced their original acquisition indebtedness to zero.
Assuming the Franklins do not use the additional loan in year 3 to substantially improve their home, the
loan cannot be classified as acquisition indebtedness. Thus, the interest on the loan can only be deducted
to the extent that it qualifies as home-equity indebtedness. $100,000 of the loan qualifies as home-equity
indebtedness and the Franklins may deduct $7,000 of interest paid on the loan ($100,000 × 7%). On the
other hand, if the Franklins use the proceeds of the loan to substantially improve the home, they may
deduct the full $21,000 of interest paid on the loan ($300,000 × 7%).
c. $5,600
Similar to part b above, the new loan can only be classified as acquisition indebtedness to the extent that
the loan proceeds are used to substantially improve the residence. However, in this scenario, the Franklins
will be able to deduct the full $5,600 ($80,000 × 7%) paid in interest because even if the loan proceeds are
not used to substantially improve the residence, the full amount of interest is deductible because it qualifies
as home-equity indebtedness and the amount of the loan is less than $100,000. Thus, it does not matter
how the Franklins use the loan proceeds as long as the loan is less than $100,000.
52. LO 3] On January 1, year 1 Brandon and Alisa Roy purchased a home for $1.5 million by paying $500,000
down and borrowing the remaining $1 million with a 7 percent loan secured by the home. Later the same day, the
Roys took out a second loan, secured by the home, in the amount of $300,000.
a. Assuming the interest rate on the second loan is 8 percent. What is the maximum amount of the interest
expense the Roys may deduct on these two loans in year 1?
b. Assuming the interest rate on the second loan is 6 percent, what is the maximum amount of interest
expense the Roys may deduct on these two loans in year 1?
a. $79,538.
Because the acquisition indebtedness limit ($1,000,000) and the home-equity indebtedness limit ($100,000)
are two separate limits, the maximum amount of debt on which a taxpayer may deduct qualified residence
interest is $1,100,000 as long as the value of the taxpayer’s residence (or residences) is at least
$1,100,000. Since the Roy’s home is worth $1.5 million, they can deduct interest on up to $1.1 million.
The Roys have two options for determining the amount of deductible interest. First, they could deduct a
pro-rata portion of the interest expense from each loan. Under this option, their deductible interest
expense would be calculated as follows:
Option 1: Total interest expense = [acquisition debt × interest rate] + [home equity debt × interest rate]
=[$1 million × 7%] + [$300,000 × 8%]
= $94,000
Deductible interest expense= Qualified debt/Total debt x total interest expense
= [$1.1 million/1.3 million] x $94,000
= $79,538
Alternatively, the Roys could deduct the interest based on the order in which the loans were taken out.
Under this option, the Roy’s deductible interest expense would be as follows:
Option 2: Deductible interest expense
$1 million × 7% = $70,000
$100,000 × 8% = $8,000
Deductible interest expense = $78,000
The Roys would maximize their interest expense deductions by using option 1 (the average interest expense
method). This option generates $1,538 more in interest deductions than option 2.
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b. $76,000.
Because the acquisition indebtedness limit ($1,000,000) and the home-equity indebtedness limit ($100,000)
are two separate limits, the maximum amount of debt on which a taxpayer may deduct qualified residence
interest is $1,100,000 as long as the value of the taxpayer’s residence (or residences) is at least
$1,100,000. Since the Roy’s home is worth $1.5 million, they can deduct interest on up to $1.1 million.
The Roys have two options for determining the amount of deductible interest. First, they could deduct a
pro-rata portion of the interest expense from each loan. Under this option, their deductible interest
expense would be calculated as follows:
Option 1: Total interest expense = [acquisition debt x interest rate] + [home equity debt × interest rate]
=[$1 million × 7%] + [$300,000 × 6%]
= $88,000
Deductible interest expense= Qualified debt/Total debt × total interest expense
= [$1.1 million/1.3 million] × $88,000
= $74,462
Alternatively, the Roys could deduct the interest based on the order in which the loans were taken out.
Under this option, the Roy’s deductible interest expense would be as follows:
Option 2: Deductible interest expense
$1 million × 7% = $70,000
$100,000 × 6% = $6,000
Deductible interest expense = $76,000
The Roys would maximize their interest expense deductions by using option 2 (the chronological order
method). This option generates $1,538 more in interest deductions than option 1.
63. [LO 5] Dillon rented his personal residence at Lake Tahoe for 14 days while he was vacationing in Ireland. He
resided in the home for the remainder of the year. Rental income from the property was $6,500. Expenses
associated with use of the home for the entire year were as follows:
Real property taxes
$3,100
Mortgage interest
12,000
Repairs
1,500
Insurance
1,500
Utilities
3,900
Depreciation
13,000
a. What effect does the rental have on Dillon’s AGI?
b. What effect does the rental have on Dillon’s itemized deductions?
a. Since Dillon resided in his home for at least 15 days during the year and rented the home for fewer than 15
days, he excludes the rental income from taxable income and does not deduct the associated rental expenses. So,
the rental has no effect on Dillon’s AGI.
b. He will be allowed to deduct the real property taxes of $3,100 and mortgage interest of $12,000 as itemized
deductions.
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Use the following facts to answer problems 64 and 65.
Natalie owns a condominium near Cocoa Beach in Florida. This year, she incurs the following expenses in
connection with her condo:
Insurance
$1,000
Advertising expense
500
Mortgage interest
3,500
Property taxes
900
Repairs & maintenance
650
Utilities
950
Depreciation
8,500
During the year, Natalie rented out the condo for 75 days, receiving $10,000 of gross income. She personally
used the condo for 35 days during her vacation.
64. [LO 5] Assume Natalie uses the IRS method of allocating expenses to rental use of the property.
a. What is the total amount of for AGI (rental) deductions Natalie may deduct in the current year related to the
condo?
b. What is the total amount of itemized deductions Natalie may deduct in the current year related to the condo?
c. If Natalie’s basis in the condo at the beginning of the year was $150,000, what is her basis in the condo at the
end of the year?
d. Assume that gross rental revenue was $1,000 (rather than $10,000), what amount of for AGI deductions may
Natalie deduct in the current year related to the condo?
Note that the home falls into the residence with significant rental use category.
a. $10,000, calculated as follows:
Gross rental income
Tier 1 expenses:
Advertising expense = $500
Mortgage interest = (75/110) × $3,500=$2,386
Property taxes= (75/110) × $900=$614
Less: total Tier 1 expenses
Balance
Tier 2 expenses:
Insurance = (75/110) × $1,000=$682
Repairs & Maintenance = (75/110) × $650=$443
Utilities= (75/110) × $950=$648
Less: total Tier 2 expenses
Balance
Tier 3 expenses:
Depreciation (75/110) × $8,500= $5,795, but the deduction
is limited to the remaining income
Balance
Total “For AGI” deductions ($3,500 + $1,773 + $4,727)
$10,000
(3,500)
$6,500
(1,773)
$4,727
(4,727)
$0
$10,000
b. Natalie may deduct the personal-use portion of the mortgage interest and property taxes since they are
deductible without regard to rental income. Her deductions for these items are computed as follows:
Mortgage interest [(35/110) × $3,500]
$1,114
Real property taxes [(35/110) × $900]
286
Total “from AGI” deductions
$1,400
c. $145,273, calculated as follows:
Beginning basis
Less: depreciation actually deducted
Adjusted basis
$150,000
(4,727)
$145,273
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d. $3,500. Even though it creates a loss ($1,000 - $3,500), Natalie is allowed to deduct all of the advertising
expense and the portion of the mortgage interest expense and real property taxes allocated to the rental
use of the home as for AGI deductions (these deductions are not limited to rental revenue). The loss is
not subject to the passive loss rule limitations.
65. [LO 5] Assume Natalie uses the Tax Court method of allocating expenses to rental use of the property.
a. What is the total amount of for AGI (rental) deductions Natalie may deduct in the current year related to the
condo?
b. What is the total amount of itemized deductions Natalie may deduct in the current year related to the condo?
c. If Natalie’s basis in the condo at the beginning of the year was $150,000, what is her basis in the condo at the
end of the year?
d. Assume that gross rental revenue was $2,000 (rather than $10,000), what amount of for AGI deductions may
Natalie deduct in the current year related to the condo?
Note that the home falls into the residence with significant rental use category.
a. $8,972, calculated as follows:
Gross rental income
Tier 1 expenses:
Advertising expense = $500
Mortgage interest = (75/365) × $3,500=$719
Property taxes= (75/365) × $900=$185
Less: total Tier 1 expenses
Balance
Tier 2 expenses:
Insurance = (75/110) × $1,000=$682
Repairs & Maintenance = (75/110) × $650=$443
Utilities= (75/110) × $950=$648
Less: total Tier 2 expenses
Balance
Tier 3 expenses:
Depreciation (75/110) × $8,500= $5,795
Balance—net income from rental of condo
Total “For AGI” deductions ($1,404 + $1,773 + $5,795)
$10,000
(1,404)
$8,596
(1,773)
$6,823
(5,795)
$1,028
$8,972
b. Natalie may deduct the personal-use portion of the mortgage interest and property taxes since they are
deductible without regard to rental income. Her deductions for these items are computed as follows:
Mortgage interest [(290/365) × $3,500]
$2,781
Real property taxes [(290/365) × $900]
$715
Total "from AGI" deductions
$3,496
c. $144,205, calculated as follows:
Beginning basis
Less: depreciation actually deducted
Adjusted basis
$150,000
(5,795)
$144,205
d. $1,404. Even though it creates a loss ($1,000 - $1,404), Natalie is allowed to deduct all of the advertising
expense and the portion of the mortgage interest expense and real property taxes allocated to the rental use of the
home as for AGI deductions (these deductions are not limited to rental revenue). The loss is not subject to the
passive loss rule limitations.
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