According to research by the Tax Policy Center, more than 3 million taxpayers will be affected by AMT in 2005, and nearly 15 million may be affected in 2006 when certain AMT temporary provisions expire. With the combination of rapidly increasing AMT exposure for all taxpayers, and mortgage refinancing due to years of record-low interest rates, the impact of AMT on certain types of otherwise-deductible mortgage interest could be substantial. On March 17^th, the IRS released Revenue Ruling 2005-11, which clarifies the limited deductibility of mortgage interest for taxpayers who are subject to the Alternative Minimum Tax (AMT).

As defined in the Internal Revenue Code under Section 163, there are actually two different kinds of mortgage for tax purposes. The first, called acquisition indebtedness, is a loan used to acquire, build, or substantially improve a residence. Interest on acquisition indebtedness is up to $1,000,000 deductible for for taxpayers who itemize their deductions.

The second kind of mortgage interest is called home equity indebtedness. For tax purposes, this is any kind of borrowing against your residence that is not used to acquire, build, or substantially improve that particular residence. Home equity indebtedness includes the typical "home equity line of credit," as well as the cash-out portion of a cash-out refinance, to the extent that the additional borrowing is not used to substantially improve the home. Interest on up to $100,000 of home equity indebtedness is deductible. When a taxpayer becomes subject to the AMT, however, home equity indebtedness deductions must be added back to income. They are not deductible at all for AMT taxpayers.

Regardless of what your client's bank calls a particular loan, debt is classified as acquisition or home equity indebtedness based only on what the funds are used for – to acquire, build, or substantially improve the home, or for anything else.  In response to the high volumes of mortgage refinancing and additional equity borrowing in recent years, new Revenue Ruling 2005-11 clarifies how these rules are applied, and what is considered acquisition versus home equity indebtedness, in the event that a mortgage is refinanced—or even re-refinanced.

If a mortgage was originally considered to be entirely acquisition indebtedness, then any refinance of that mortgage will continue to be considered acquisition indebtedness, but only to the extent of the original mortgage. Any additional indebtedness, if not specifically used to substantially improve the residence, will be considered home equity indebtedness, subject to the $100,000-of-debt-principal restriction for regular tax purposes, and non-deductibility for AMT purposes.

Let's look at a real-life example of how these rules work. Say that in 2000 a taxpayer took out an initial mortgage of $150,000 to buy a house. The full amount of the mortgage interest would be considered acquisition indebtedness. In 2003, the taxpayer refinanced the initial mortgage, which had a reduced balance of $140,000, and took out a new mortgage for the same $140,000 at a lower interest rate. Since the entire refinanced amount was attributable to the remaining acquisition indebtedness, the refinanced mortgage interest is eligible to be treated under the more favorable acquisition indebtedness rules.

Now let's assume that the taxpayer refinances once again in 2004. The remaining balance on the mortgage has been reduced to $135,000, but the taxpayer takes out a mortgage for $140,000. In this case, the mortgage interest on the first $135,000 of debt principal will be still considered acquisition indebtedness, but the interest on the additional $5,000 will be subject to the home equity indebtedness rules. This will apply whether the additional $5,000 of debt went to pay off other expenses (e.g., a credit card balance or the down payment on a car), or even just to wrap the refinancing costs into the new loan balance. Unless the funds are use specifically to substantially improve the residence, the loan is considered home equity indebtedness, with the concomitant restrictions.

With the high volume of refinancing in recent years, many individuals now carry a mix of acquisition and home equity indebtedness, even if only due to the common decision to wrap refinance costs into a new loan balance. As the number of taxpayers subject to the AMT continues to climb, many may find, to their dismay, that a portion of mortgage interest that was deductible under the regular tax system will be deductible no longer.

Michael E. Kitces, MSFS, CFP®, CLU, ChFC, RHU, REBC, CASL, is Director of Financial Planning for Pinnacle Advisory Group, a private wealth management firm located in Columbia, Maryland. Michael welcomes your questions and comments at michael@kitces.com.