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H&rblock online Publication 541 - Main Content Table of Contents Forming a PartnershipOrganizations Classified as Partnerships Family Partnership Partnership Agreement Terminating a PartnershipIRS e-file (Electronic Filing) Exclusion From Partnership Rules Partnership Return (Form 1065) Partnership DistributionsSubstantially appreciated inventory items. H&rblock online Partner's Gain or Loss Partner's Basis for Distributed Property Transactions Between Partnership and PartnersGuaranteed Payments Sale or Exchange of Property Contribution of Property Contribution of Services Basis of Partner's InterestAdjusted Basis Effect of Partnership Liabilities Disposition of Partner's InterestSale, Exchange, or Other Transfer Payments for Unrealized Receivables and Inventory Items Liquidation at Partner's Retirement or Death Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)Partnership Item. H&rblock online Small Partnerships and the Small Partnership Exception Small Partnership TEFRA Election Role of Tax Matters Partner (TMP) in TEFRA Proceedings Statute of Limitations and TEFRA Amended Returns and Administrative Adjustment Requests (AARs) How To Get Tax Help Forming a Partnership The following sections contain general information about partnerships. H&rblock online Organizations Classified as Partnerships An unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes if its members carry on a trade, business, financial operation, or venture and divide its profits. H&rblock online However, a joint undertaking merely to share expenses is not a partnership. H&rblock online For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants. H&rblock online The rules you must use to determine whether an organization is classified as a partnership changed for organizations formed after 1996. H&rblock online Organizations formed after 1996. H&rblock online   An organization formed after 1996 is classified as a partnership for federal tax purposes if it has two or more members and it is none of the following. H&rblock online An organization formed under a federal or state law that refers to it as incorporated or as a corporation, body corporate, or body politic. H&rblock online An organization formed under a state law that refers to it as a joint-stock company or joint-stock association. H&rblock online An insurance company. H&rblock online Certain banks. H&rblock online An organization wholly owned by a state, local, or foreign government. H&rblock online An organization specifically required to be taxed as a corporation by the Internal Revenue Code (for example, certain publicly traded partnerships). H&rblock online Certain foreign organizations identified in section 301. H&rblock online 7701-2(b)(8) of the regulations. H&rblock online A tax-exempt organization. H&rblock online A real estate investment trust. H&rblock online An organization classified as a trust under section 301. H&rblock online 7701-4 of the regulations or otherwise subject to special treatment under the Internal Revenue Code. H&rblock online Any other organization that elects to be classified as a corporation by filing Form 8832. H&rblock online For more information, see the instructions for Form 8832. H&rblock online Limited liability company. H&rblock online   A limited liability company (LLC) is an entity formed under state law by filing articles of organization as an LLC. H&rblock online Unlike a partnership, none of the members of an LLC are personally liable for its debts. H&rblock online An LLC may be classified for federal income tax purposes as either a partnership, a corporation, or an entity disregarded as an entity separate from its owner by applying the rules in Regulations section 301. H&rblock online 7701-3. H&rblock online See Form 8832 and section 301. H&rblock online 7701-3 of the regulations for more details. H&rblock online A domestic LLC with at least two members that does not file Form 8832 is classified as a partnership for federal income tax purposes. H&rblock online Organizations formed before 1997. H&rblock online   An organization formed before 1997 and classified as a partnership under the old rules will generally continue to be classified as a partnership as long as the organization has at least two members and does not elect to be classified as a corporation by filing Form 8832. H&rblock online Community property. H&rblock online    Spouses who own a qualified entity (defined later) can choose to classify the entity as a partnership for federal tax purposes by filing the appropriate partnership tax returns. H&rblock online They can choose to classify the entity as a sole proprietorship by filing a Schedule C (Form 1040) listing one spouse as the sole proprietor. H&rblock online A change in reporting position will be treated for federal tax purposes as a conversion of the entity. H&rblock online   A qualified entity is a business entity that meets all the following requirements. H&rblock online The business entity is wholly owned by spouses as community property under the laws of a state, a foreign country, or a possession of the United States. H&rblock online No person other than one or both spouses would be considered an owner for federal tax purposes. H&rblock online The business entity is not treated as a corporation. H&rblock online   For more information about community property, see Publication 555, Community Property. H&rblock online Publication 555 discusses the community property laws of Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. H&rblock online Family Partnership Members of a family can be partners. H&rblock online However, family members (or any other person) will be recognized as partners only if one of the following requirements is met. H&rblock online If capital is a material income-producing factor, they acquired their capital interest in a bona fide transaction (even if by gift or purchase from another family member), actually own the partnership interest, and actually control the interest. H&rblock online If capital is not a material income-producing factor, they joined together in good faith to conduct a business. H&rblock online They agreed that contributions of each entitle them to a share in the profits, and some capital or service has been (or is) provided by each partner. H&rblock online Capital is material. H&rblock online   Capital is a material income-producing factor if a substantial part of the gross income of the business comes from the use of capital. H&rblock online Capital is ordinarily an income-producing factor if the operation of the business requires substantial inventories or investments in plants, machinery, or equipment. H&rblock online Capital is not material. H&rblock online   In general, capital is not a material income-producing factor if the income of the business consists principally of fees, commissions, or other compensation for personal services performed by members or employees of the partnership. H&rblock online Capital interest. H&rblock online   A capital interest in a partnership is an interest in its assets that is distributable to the owner of the interest in either of the following situations. H&rblock online The owner withdraws from the partnership. H&rblock online The partnership liquidates. H&rblock online   The mere right to share in earnings and profits is not a capital interest in the partnership. H&rblock online Gift of capital interest. H&rblock online   If a family member (or any other person) receives a gift of a capital interest in a partnership in which capital is a material income-producing factor, the donee's distributive share of partnership income is subject to both of the following restrictions. H&rblock online It must be figured by reducing the partnership income by reasonable compensation for services the donor renders to the partnership. H&rblock online The donee's distributive share of partnership income attributable to donated capital must not be proportionately greater than the donor's distributive share attributable to the donor's capital. H&rblock online Purchase. H&rblock online   For purposes of determining a partner's distributive share, an interest purchased by one family member from another family member is considered a gift from the seller. H&rblock online The fair market value of the purchased interest is considered donated capital. H&rblock online For this purpose, members of a family include only spouses, ancestors, and lineal descendants (or a trust for the primary benefit of those persons). H&rblock online Example. H&rblock online A father sold 50% of his business to his son. H&rblock online The resulting partnership had a profit of $60,000. H&rblock online Capital is a material income-producing factor. H&rblock online The father performed services worth $24,000, which is reasonable compensation, and the son performed no services. H&rblock online The $24,000 must be allocated to the father as compensation. H&rblock online Of the remaining $36,000 of profit due to capital, at least 50%, or $18,000, must be allocated to the father since he owns a 50% capital interest. H&rblock online The son's share of partnership profit cannot be more than $18,000. H&rblock online Business owned and operated by spouses. H&rblock online   If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. H&rblock online If so, they should report income or loss from the business on Form 1065. H&rblock online They should not report the income on a Schedule C (Form 1040) in the name of one spouse as a sole proprietor. H&rblock online However, the spouses can elect not to treat the joint venture as a partnership by making a Qualified Joint Venture Election. H&rblock online Qualified Joint Venture Election. H&rblock online   A "qualified joint venture," whose only members are spouses filing a joint return, can elect not to be treated as a partnership for federal tax purposes. H&rblock online A qualified joint venture conducts a trade or business where: the only members of the joint venture are spouses filing jointly; both spouses elect not to be treated as a partnership; both spouses materially participate in the trade or business (see Passive Activity Limitations in the Instructions for Form 1065 for a definition of material participation); and the business is co-owned by both spouses and is not held in the name of a state law entity such as a partnership or LLC. H&rblock online   Under this election, a qualified joint venture conducted by spouses who file a joint return is not treated as a partnership for federal tax purposes and therefore does not have a Form 1065 filing requirement. H&rblock online All items of income, gain, deduction, loss, and credit are divided between the spouses based on their respective interests in the venture. H&rblock online Each spouse takes into account his or her respective share of these items as a sole proprietor. H&rblock online Each spouse would account for his or her respective share on the appropriate form, such as Schedule C (Form 1040). H&rblock online For purposes of determining net earnings from self-employment, each spouse's share of income or loss from a qualified joint venture is taken into account just as it is for federal income tax purposes (i. H&rblock online e. H&rblock online , based on their respective interests in the venture). H&rblock online   If the spouses do not make the election to treat their respective interests in the joint venture as sole proprietorships, each spouse should carry his or her share of the partnership income or loss from Schedule K-1 (Form 1065) to their joint or separate Form(s) 1040. H&rblock online Each spouse should include his or her respective share of self-employment income on a separate Schedule SE (Form 1040), Self-Employment Tax. H&rblock online   This generally does not increase the total tax on the return, but it does give each spouse credit for social security earnings on which retirement benefits are based. H&rblock online However, this may not be true if either spouse exceeds the social security tax limitation. H&rblock online   For more information on qualified joint ventures, go to IRS. H&rblock online gov, enter “Election for Qualified Joint Ventures” in the search box and select the link reading “Election for Husband and Wife Unincorporated Businesses. H&rblock online ” Partnership Agreement The partnership agreement includes the original agreement and any modifications. H&rblock online The modifications must be agreed to by all partners or adopted in any other manner provided by the partnership agreement. H&rblock online The agreement or modifications can be oral or written. H&rblock online Partners can modify the partnership agreement for a particular tax year after the close of the year but not later than the date for filing the partnership return for that year. H&rblock online This filing date does not include any extension of time. H&rblock online If the partnership agreement or any modification is silent on any matter, the provisions of local law are treated as part of the agreement. H&rblock online Terminating a Partnership A partnership terminates when one of the following events takes place. H&rblock online All its operations are discontinued and no part of any business, financial operation, or venture is continued by any of its partners in a partnership. H&rblock online At least 50% of the total interest in partnership capital and profits is sold or exchanged within a 12-month period, including a sale or exchange to another partner. H&rblock online Unlike other partnerships, an electing large partnership does not terminate on the sale or exchange of 50% or more of the partnership interests within a 12-month period. H&rblock online See section 1. H&rblock online 708-1(b) of the regulations for more information on the termination of a partnership. H&rblock online For special rules that apply to a merger, consolidation, or division of a partnership, see sections 1. H&rblock online 708-1(c) and 1. H&rblock online 708-1(d) of the regulations. H&rblock online Date of termination. H&rblock online   The partnership's tax year ends on the date of termination. H&rblock online For the event described in (1), above, the date of termination is the date the partnership completes the winding up of its affairs. H&rblock online For the event described in (2), above, the date of termination is the date of the sale or exchange of a partnership interest that, by itself or together with other sales or exchanges in the preceding 12 months, transfers an interest of 50% or more in both capital and profits. H&rblock online Short period return. H&rblock online   If a partnership is terminated before the end of what would otherwise be its tax year, Form 1065 must be filed for the short period, which is the period from the beginning of the tax year through the date of termination. H&rblock online The return is due the 15th day of the fourth month following the date of termination. H&rblock online See Partnership Return (Form 1065), later, for information about filing Form 1065. H&rblock online Conversion of partnership into limited liability company (LLC). H&rblock online   The conversion of a partnership into an LLC classified as a partnership for federal tax purposes does not terminate the partnership. H&rblock online The conversion is not a sale, exchange, or liquidation of any partnership interest; the partnership's tax year does not close; and the LLC can continue to use the partnership's taxpayer identification number. H&rblock online   However, the conversion may change some of the partners' bases in their partnership interests if the partnership has recourse liabilities that become nonrecourse liabilities. H&rblock online Because the partners share recourse and nonrecourse liabilities differently, their bases must be adjusted to reflect the new sharing ratios. H&rblock online If a decrease in a partner's share of liabilities exceeds the partner's basis, he or she must recognize gain on the excess. H&rblock online For more information, see Effect of Partnership Liabilities under Basis of Partner's Interest, later. H&rblock online   The same rules apply if an LLC classified as a partnership is converted into a partnership. H&rblock online IRS e-file (Electronic Filing) Please click here for the text description of the image. H&rblock online e-file Certain partnerships with more than 100 partners are required to file Form 1065, Schedules K-1, and related forms and schedules electronically (e-file). H&rblock online Other partnerships generally have the option to file electronically. H&rblock online For details about IRS e-file, see the Form 1065 instructions. H&rblock online Exclusion From Partnership Rules Certain partnerships that do not actively conduct a business can choose to be completely or partially excluded from being treated as partnerships for federal income tax purposes. H&rblock online All the partners must agree to make the choice, and the partners must be able to compute their own taxable income without computing the partnership's income. H&rblock online However, the partners are not exempt from the rule that limits a partner's distributive share of partnership loss to the adjusted basis of the partner's partnership interest. H&rblock online Nor are they exempt from the requirement of a business purpose for adopting a tax year for the partnership that differs from its required tax year. H&rblock online Investing partnership. H&rblock online   An investing partnership can be excluded if the participants in the joint purchase, retention, sale, or exchange of investment property meet all the following requirements. H&rblock online They own the property as co-owners. H&rblock online They reserve the right separately to take or dispose of their shares of any property acquired or retained. H&rblock online They do not actively conduct business or irrevocably authorize some person acting in a representative capacity to purchase, sell, or exchange the investment property. H&rblock online Each separate participant can delegate authority to purchase, sell, or exchange his or her share of the investment property for the time being for his or her account, but not for a period of more than a year. H&rblock online Operating agreement partnership. H&rblock online   An operating agreement partnership group can be excluded if the participants in the joint production, extraction, or use of property meet all the following requirements. H&rblock online They own the property as co-owners, either in fee or under lease or other form of contract granting exclusive operating rights. H&rblock online They reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used. H&rblock online They do not jointly sell services or the property produced or extracted. H&rblock online Each separate participant can delegate authority to sell his or her share of the property produced or extracted for the time being for his or her account, but not for a period of time in excess of the minimum needs of the industry, and in no event for more than one year. H&rblock online However, this exclusion does not apply to an unincorporated organization one of whose principal purposes is cycling, manufacturing, or processing for persons who are not members of the organization. H&rblock online Electing the exclusion. H&rblock online   An eligible organization that wishes to be excluded from the partnership rules must make the election not later than the time for filing the partnership return for the first tax year for which exclusion is desired. H&rblock online This filing date includes any extension of time. H&rblock online See Regulations section 1. H&rblock online 761-2(b) for the procedures to follow. H&rblock online Partnership Return (Form 1065) Every partnership that engages in a trade or business or has gross income must file an information return on Form 1065 showing its income, deductions, and other required information. H&rblock online The partnership return must show the names and addresses of each partner and each partner's distributive share of taxable income. H&rblock online The return must be signed by a general partner. H&rblock online If a limited liability company is treated as a partnership, it must file Form 1065 and one of its members must sign the return. H&rblock online A partnership is not considered to engage in a trade or business, and is not required to file a Form 1065, for any tax year in which it neither receives income nor pays or incurs any expenses treated as deductions or credits for federal income tax purposes. H&rblock online See the Instructions for Form 1065 for more information about who must file Form 1065. H&rblock online Partnership Distributions Partnership distributions include the following. H&rblock online A withdrawal by a partner in anticipation of the current year's earnings. H&rblock online A distribution of the current year's or prior years' earnings not needed for working capital. H&rblock online A complete or partial liquidation of a partner's interest. H&rblock online A distribution to all partners in a complete liquidation of the partnership. H&rblock online A partnership distribution is not taken into account in determining the partner's distributive share of partnership income or loss. H&rblock online If any gain or loss from the distribution is recognized by the partner, it must be reported on his or her return for the tax year in which the distribution is received. H&rblock online Money or property withdrawn by a partner in anticipation of the current year's earnings is treated as a distribution received on the last day of the partnership's tax year. H&rblock online Effect on partner's basis. H&rblock online   A partner's adjusted basis in his or her partnership interest is decreased (but not below zero) by the money and adjusted basis of property distributed to the partner. H&rblock online See Adjusted Basis under Basis of Partner's Interest, later. H&rblock online Effect on partnership. H&rblock online   A partnership generally does not recognize any gain or loss because of distributions it makes to partners. H&rblock online The partnership may be able to elect to adjust the basis of its undistributed property. H&rblock online Certain distributions treated as a sale or exchange. H&rblock online   When a partnership distributes the following items, the distribution may be treated as a sale or exchange of property rather than a distribution. H&rblock online Unrealized receivables or substantially appreciated inventory items distributed in exchange for any part of the partner's interest in other partnership property, including money. H&rblock online Other property (including money) distributed in exchange for any part of a partner's interest in unrealized receivables or substantially appreciated inventory items. H&rblock online   See Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later. H&rblock online   This treatment does not apply to the following distributions. H&rblock online A distribution of property to the partner who contributed the property to the partnership. H&rblock online Payments made to a retiring partner or successor in interest of a deceased partner that are the partner's distributive share of partnership income or guaranteed payments. H&rblock online Substantially appreciated inventory items. H&rblock online   Inventory items of the partnership are considered to have appreciated substantially in value if, at the time of the distribution, their total fair market value is more than 120% of the partnership's adjusted basis for the property. H&rblock online However, if a principal purpose for acquiring inventory property is to avoid ordinary income treatment by reducing the appreciation to less than 120%, that property is excluded. H&rblock online Partner's Gain or Loss A partner generally recognizes gain on a partnership distribution only to the extent any money (and marketable securities treated as money) included in the distribution exceeds the adjusted basis of the partner's interest in the partnership. H&rblock online Any gain recognized is generally treated as capital gain from the sale of the partnership interest on the date of the distribution. H&rblock online If partnership property (other than marketable securities treated as money) is distributed to a partner, he or she generally does not recognize any gain until the sale or other disposition of the property. H&rblock online For exceptions to these rules, see Distribution of partner's debt and Net precontribution gain, later. H&rblock online Also, see Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later. H&rblock online Example. H&rblock online The adjusted basis of Jo's partnership interest is $14,000. H&rblock online She receives a distribution of $8,000 cash and land that has an adjusted basis of $2,000 and a fair market value of $3,000. H&rblock online Because the cash received does not exceed the basis of her partnership interest, Jo does not recognize any gain on the distribution. H&rblock online Any gain on the land will be recognized when she sells or otherwise disposes of it. H&rblock online The distribution decreases the adjusted basis of Jo's partnership interest to $4,000 [$14,000 − ($8,000 + $2,000)]. H&rblock online Marketable securities treated as money. H&rblock online   Generally, a marketable security distributed to a partner is treated as money in determining whether gain is recognized on the distribution. H&rblock online This treatment, however, does not generally apply if that partner contributed the security to the partnership or an investment partnership made the distribution to an eligible partner. H&rblock online   The amount treated as money is the security's fair market value when distributed, reduced (but not below zero) by the excess (if any) of: The partner's distributive share of the gain that would be recognized had the partnership sold all its marketable securities at their fair market value immediately before the transaction resulting in the distribution, over The partner's distributive share of the gain that would be recognized had the partnership sold all such securities it still held after the distribution at the fair market value in (1). H&rblock online   For more information, including the definition of marketable securities, see section 731(c) of the Internal Revenue Code. H&rblock online Loss on distribution. H&rblock online   A partner does not recognize loss on a partnership distribution unless all the following requirements are met. H&rblock online The adjusted basis of the partner's interest in the partnership exceeds the distribution. H&rblock online The partner's entire interest in the partnership is liquidated. H&rblock online The distribution is in money, unrealized receivables, or inventory items. H&rblock online   There are exceptions to these general rules. H&rblock online See the following discussions. H&rblock online Also, see Liquidation at Partner's Retirement or Death under Disposition of Partner's Interest, later. H&rblock online Distribution of partner's debt. H&rblock online   If a partnership acquires a partner's debt and extinguishes the debt by distributing it to the partner, the partner will recognize capital gain or loss to the extent the fair market value of the debt differs from the basis of the debt (determined under the rules discussed in Partner's Basis for Distributed Property, later). H&rblock online   The partner is treated as having satisfied the debt for its fair market value. H&rblock online If the issue price (adjusted for any premium or discount) of the debt exceeds its fair market value when distributed, the partner may have to include the excess amount in income as canceled debt. H&rblock online   Similarly, a deduction may be available to a corporate partner if the fair market value of the debt at the time of distribution exceeds its adjusted issue price. H&rblock online Net precontribution gain. H&rblock online   A partner generally must recognize gain on the distribution of property (other than money) if the partner contributed appreciated property to the partnership during the 7-year period before the distribution. H&rblock online   The gain recognized is the lesser of the following amounts. H&rblock online The excess of: The fair market value of the property received in the distribution, over The adjusted basis of the partner's interest in the partnership immediately before the distribution, reduced (but not below zero) by any money received in the distribution. H&rblock online The “net precontribution gain” of the partner. H&rblock online This is the net gain the partner would recognize if all the property contributed by the partner within 7 years of the distribution, and held by the partnership immediately before the distribution, were distributed to another partner, other than a partner who owns more than 50% of the partnership. H&rblock online For information about the distribution of contributed property to another partner, see Contribution of Property , under Transactions Between Partnership and Partners, later. H&rblock online   The character of the gain is determined by reference to the character of the net precontribution gain. H&rblock online This gain is in addition to any gain the partner must recognize if the money distributed is more than his or her basis in the partnership. H&rblock online For these rules, the term “money” includes marketable securities treated as money, as discussed earlier. H&rblock online Effect on basis. H&rblock online   The adjusted basis of the partner's interest in the partnership is increased by any net precontribution gain recognized by the partner. H&rblock online Other than for purposes of determining the gain, the increase is treated as occurring immediately before the distribution. H&rblock online See Basis of Partner's Interest , later. H&rblock online   The partnership must adjust its basis in any property the partner contributed within 7 years of the distribution to reflect any gain that partner recognizes under this rule. H&rblock online Exceptions. H&rblock online   Any part of a distribution that is property the partner previously contributed to the partnership is not taken into account in determining the amount of the excess distribution or the partner's net precontribution gain. H&rblock online For this purpose, the partner's previously contributed property does not include a contributed interest in an entity to the extent its value is due to property contributed to the entity after the interest was contributed to the partnership. H&rblock online   Recognition of gain under this rule also does not apply to a distribution of unrealized receivables or substantially appreciated inventory items if the distribution is treated as a sale or exchange, as discussed earlier. H&rblock online Partner's Basis for Distributed Property Unless there is a complete liquidation of a partner's interest, the basis of property (other than money) distributed to the partner by a partnership is its adjusted basis to the partnership immediately before the distribution. H&rblock online However, the basis of the property to the partner cannot be more than the adjusted basis of his or her interest in the partnership reduced by any money received in the same transaction. H&rblock online Example 1. H&rblock online The adjusted basis of Emily's partnership interest is $30,000. H&rblock online She receives a distribution of property that has an adjusted basis of $20,000 to the partnership and $4,000 in cash. H&rblock online Her basis for the property is $20,000. H&rblock online Example 2. H&rblock online The adjusted basis of Steve's partnership interest is $10,000. H&rblock online He receives a distribution of $4,000 cash and property that has an adjusted basis to the partnership of $8,000. H&rblock online His basis for the distributed property is limited to $6,000 ($10,000 − $4,000, the cash he receives). H&rblock online Complete liquidation of partner's interest. H&rblock online   The basis of property received in complete liquidation of a partner's interest is the adjusted basis of the partner's interest in the partnership reduced by any money distributed to the partner in the same transaction. H&rblock online Partner's holding period. H&rblock online   A partner's holding period for property distributed to the partner includes the period the property was held by the partnership. H&rblock online If the property was contributed to the partnership by a partner, then the period it was held by that partner is also included. H&rblock online Basis divided among properties. H&rblock online   If the basis of property received is the adjusted basis of the partner's interest in the partnership (reduced by money received in the same transaction), it must be divided among the properties distributed to the partner. H&rblock online For property distributed after August 5, 1997, allocate the basis using the following rules. H&rblock online Allocate the basis first to unrealized receivables and inventory items included in the distribution by assigning a basis to each item equal to the partnership's adjusted basis in the item immediately before the distribution. H&rblock online If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess. H&rblock online Allocate any remaining basis to properties other than unrealized receivables and inventory items by assigning a basis to each property equal to the partnership's adjusted basis in the property immediately before the distribution. H&rblock online If the allocable basis exceeds the total of these assigned bases, increase the assigned bases by the amount of the excess. H&rblock online If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess. H&rblock online Allocating a basis increase. H&rblock online   Allocate any basis increase required in rule (2), above, first to properties with unrealized appreciation to the extent of the unrealized appreciation. H&rblock online If the basis increase is less than the total unrealized appreciation, allocate it among those properties in proportion to their respective amounts of unrealized appreciation. H&rblock online Allocate any remaining basis increase among all the properties in proportion to their respective fair market values. H&rblock online Example. H&rblock online Eun's basis in her partnership interest is $55,000. H&rblock online In a distribution in liquidation of her entire interest, she receives properties A and B, neither of which is inventory or unrealized receivables. H&rblock online Property A has an adjusted basis to the partnership of $5,000 and a fair market value of $40,000. H&rblock online Property B has an adjusted basis to the partnership of $10,000 and a fair market value of $10,000. H&rblock online To figure her basis in each property, Eun first assigns bases of $5,000 to property A and $10,000 to property B (their adjusted bases to the partnership). H&rblock online This leaves a $40,000 basis increase (the $55,000 allocable basis minus the $15,000 total of the assigned bases). H&rblock online She first allocates $35,000 to property A (its unrealized appreciation). H&rblock online The remaining $5,000 is allocated between the properties based on their fair market values. H&rblock online $4,000 ($40,000/$50,000) is allocated to property A and $1,000 ($10,000/$50,000) is allocated to property B. H&rblock online Eun's basis in property A is $44,000 ($5,000 + $35,000 + $4,000) and her basis in property B is $11,000 ($10,000 + $1,000). H&rblock online Allocating a basis decrease. H&rblock online   Use the following rules to allocate any basis decrease required in rule (1) or rule (2), earlier. H&rblock online Allocate the basis decrease first to items with unrealized depreciation to the extent of the unrealized depreciation. H&rblock online If the basis decrease is less than the total unrealized depreciation, allocate it among those items in proportion to their respective amounts of unrealized depreciation. H&rblock online Allocate any remaining basis decrease among all the items in proportion to their respective assigned basis amounts (as decreased in (1)). H&rblock online Example. H&rblock online Armando's basis in his partnership interest is $20,000. H&rblock online In a distribution in liquidation of his entire interest, he receives properties C and D, neither of which is inventory or unrealized receivables. H&rblock online Property C has an adjusted basis to the partnership of $15,000 and a fair market value of $15,000. H&rblock online Property D has an adjusted basis to the partnership of $15,000 and a fair market value of $5,000. H&rblock online To figure his basis in each property, Armando first assigns bases of $15,000 to property C and $15,000 to property D (their adjusted bases to the partnership). H&rblock online This leaves a $10,000 basis decrease (the $30,000 total of the assigned bases minus the $20,000 allocable basis). H&rblock online He allocates the entire $10,000 to property D (its unrealized depreciation). H&rblock online Armando's basis in property C is $15,000 and his basis in property D is $5,000 ($15,000 − $10,000). H&rblock online Distributions before August 6, 1997. H&rblock online   For property distributed before August 6, 1997, allocate the basis using the following rules. H&rblock online Allocate the basis first to unrealized receivables and inventory items included in the distribution to the extent of the partnership's adjusted basis in those items. H&rblock online If the partnership's adjusted basis in those items exceeded the allocable basis, allocate the basis among the items in proportion to their adjusted bases to the partnership. H&rblock online Allocate any remaining basis to other distributed properties in proportion to their adjusted bases to the partnership. H&rblock online Partner's interest more than partnership basis. H&rblock online   If the basis of a partner's interest to be divided in a complete liquidation of the partner's interest is more than the partnership's adjusted basis for the unrealized receivables and inventory items distributed, and if no other property is distributed to which the partner can apply the remaining basis, the partner has a capital loss to the extent of the remaining basis of the partnership interest. H&rblock online Special adjustment to basis. H&rblock online   A partner who acquired any part of his or her partnership interest in a sale or exchange or upon the death of another partner may be able to choose a special basis adjustment for property distributed by the partnership. H&rblock online To choose the special adjustment, the partner must have received the distribution within 2 years after acquiring the partnership interest. H&rblock online Also, the partnership must not have chosen the optional adjustment to basis when the partner acquired the partnership interest. H&rblock online   If a partner chooses this special basis adjustment, the partner's basis for the property distributed is the same as it would have been if the partnership had chosen the optional adjustment to basis. H&rblock online However, this assigned basis is not reduced by any depletion or depreciation that would have been allowed or allowable if the partnership had previously chosen the optional adjustment. H&rblock online   The choice must be made with the partner's tax return for the year of the distribution if the distribution includes any property subject to depreciation, depletion, or amortization. H&rblock online If the choice does not have to be made for the distribution year, it must be made with the return for the first year in which the basis of the distributed property is pertinent in determining the partner's income tax. H&rblock online   A partner choosing this special basis adjustment must attach a statement to his or her tax return that the partner chooses under section 732(d) of the Internal Revenue Code to adjust the basis of property received in a distribution. H&rblock online The statement must show the computation of the special basis adjustment for the property distributed and list the properties to which the adjustment has been allocated. H&rblock online Example. H&rblock online Chin Ho purchased a 25% interest in X partnership for $17,000 cash. H&rblock online At the time of the purchase, the partnership owned inventory having a basis to the partnership of $14,000 and a fair market value of $16,000. H&rblock online Thus, $4,000 of the $17,000 he paid was attributable to his share of inventory with a basis to the partnership of $3,500. H&rblock online Within 2 years after acquiring his interest, Chin Ho withdrew from the partnership and for his entire interest received cash of $1,500, inventory with a basis to the partnership of $3,500, and other property with a basis of $6,000. H&rblock online The value of the inventory received was 25% of the value of all partnership inventory. H&rblock online (It is immaterial whether the inventory he received was on hand when he acquired his interest. H&rblock online ) Since the partnership from which Chin Ho withdrew did not make the optional adjustment to basis, he chose to adjust the basis of the inventory received. H&rblock online His share of the partnership's basis for the inventory is increased by $500 (25% of the $2,000 difference between the $16,000 fair market value of the inventory and its $14,000 basis to the partnership at the time he acquired his interest). H&rblock online The adjustment applies only for purposes of determining his new basis in the inventory, and not for purposes of partnership gain or loss on disposition. H&rblock online The total to be allocated among the properties Chin Ho received in the distribution is $15,500 ($17,000 basis of his interest − $1,500 cash received). H&rblock online His basis in the inventory items is $4,000 ($3,500 partnership basis + $500 special adjustment). H&rblock online The remaining $11,500 is allocated to his new basis for the other property he received. H&rblock online Mandatory adjustment. H&rblock online   A partner does not always have a choice of making this special adjustment to basis. H&rblock online The special adjustment to basis must be made for a distribution of property (whether or not within 2 years after the partnership interest was acquired) if all the following conditions existed when the partner received the partnership interest. H&rblock online The fair market value of all partnership property (other than money) was more than 110% of its adjusted basis to the partnership. H&rblock online If there had been a liquidation of the partner's interest immediately after it was acquired, an allocation of the basis of that interest under the general rules (discussed earlier under Basis divided among properties) would have decreased the basis of property that could not be depreciated, depleted, or amortized and increased the basis of property that could be. H&rblock online The optional basis adjustment, if it had been chosen by the partnership, would have changed the partner's basis for the property actually distributed. H&rblock online Required statement. H&rblock online   Generally, if a partner chooses a special basis adjustment and notifies the partnership, or if the partnership makes a distribution for which the special basis adjustment is mandatory, the partnership must provide a statement to the partner. H&rblock online The statement must provide information necessary for the partner to compute the special basis adjustment. H&rblock online Marketable securities. H&rblock online   A partner's basis in marketable securities received in a partnership distribution, as determined in the preceding discussions, is increased by any gain recognized by treating the securities as money. H&rblock online See Marketable securities treated as money under Partner's Gain or Loss, earlier. H&rblock online The basis increase is allocated among the securities in proportion to their respective amounts of unrealized appreciation before the basis increase. H&rblock online Transactions Between Partnership and Partners For certain transactions between a partner and his or her partnership, the partner is treated as not being a member of the partnership. H&rblock online These transactions include the following. H&rblock online Performing services for, or transferring property to, a partnership if: There is a related allocation and distribution to a partner, and The entire transaction, when viewed together, is properly characterized as occurring between the partnership and a partner not acting in the capacity of a partner. H&rblock online Transferring money or other property to a partnership if: There is a related transfer of money or other property by the partnership to the contributing partner or another partner, and The transfers together are properly characterized as a sale or exchange of property. H&rblock online Payments by accrual basis partnership to cash basis partner. H&rblock online   A partnership that uses an accrual method of accounting cannot deduct any business expense owed to a cash basis partner until the amount is paid. H&rblock online However, this rule does not apply to guaranteed payments made to a partner, which are generally deductible when accrued. H&rblock online Guaranteed Payments Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership's income. H&rblock online A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner. H&rblock online This treatment is for purposes of determining gross income and deductible business expenses only. H&rblock online For other tax purposes, guaranteed payments are treated as a partner's distributive share of ordinary income. H&rblock online Guaranteed payments are not subject to income tax withholding. H&rblock online The partnership generally deducts guaranteed payments on line 10 of Form 1065 as a business expense. H&rblock online They are also listed on Schedules K and K-1 of the partnership return. H&rblock online The individual partner reports guaranteed payments on Schedule E (Form 1040) as ordinary income, along with his or her distributive share of the partnership's other ordinary income. H&rblock online Guaranteed payments made to partners for organizing the partnership or syndicating interests in the partnership are capital expenses. H&rblock online Generally, organizational and syndication expenses are not deductible by the partnership. H&rblock online However, a partnership can elect to deduct a portion of its organizational expenses and amortize the remaining expenses (see Business start-up and organizational costs in the Instructions for Form 1065). H&rblock online Organizational expenses (if the election is not made) and syndication expenses paid to partners must be reported on the partners' Schedule K-1 as guaranteed payments. H&rblock online Minimum payment. H&rblock online   If a partner is to receive a minimum payment from the partnership, the guaranteed payment is the amount by which the minimum payment is more than the partner's distributive share of the partnership income before taking into account the guaranteed payment. H&rblock online Example. H&rblock online Under a partnership agreement, Divya is to receive 30% of the partnership income, but not less than $8,000. H&rblock online The partnership has net income of $20,000. H&rblock online Divya's share, without regard to the minimum guarantee, is $6,000 (30% × $20,000). H&rblock online The guaranteed payment that can be deducted by the partnership is $2,000 ($8,000 − $6,000). H&rblock online Divya's income from the partnership is $8,000, and the remaining $12,000 of partnership income will be reported by the other partners in proportion to their shares under the partnership agreement. H&rblock online If the partnership net income had been $30,000, there would have been no guaranteed payment since her share, without regard to the guarantee, would have been greater than the guarantee. H&rblock online Self-employed health insurance premiums. H&rblock online   Premiums for health insurance paid by a partnership on behalf of a partner, for services as a partner, are treated as guaranteed payments. H&rblock online The partnership can deduct the payments as a business expense, and the partner must include them in gross income. H&rblock online However, if the partnership accounts for insurance paid for a partner as a reduction in distributions to the partner, the partnership cannot deduct the premiums. H&rblock online   A partner who qualifies can deduct 100% of the health insurance premiums paid by the partnership on his or her behalf as an adjustment to income. H&rblock online The partner cannot deduct the premiums for any calendar month, or part of a month, in which the partner is eligible to participate in any subsidized health plan maintained by any employer of the partner, the partner's spouse, the partner's dependents, or any children under age 27 who are not dependents. H&rblock online For more information on the self-employed health insurance deduction, see chapter 6 in Publication 535. H&rblock online Including payments in partner's income. H&rblock online   Guaranteed payments are included in income in the partner's tax year in which the partnership's tax year ends. H&rblock online Example 1. H&rblock online Under the terms of a partnership agreement, Erica is entitled to a fixed annual payment of $10,000 without regard to the income of the partnership. H&rblock online Her distributive share of the partnership income is 10%. H&rblock online The partnership has $50,000 of ordinary income after deducting the guaranteed payment. H&rblock online She must include ordinary income of $15,000 ($10,000 guaranteed payment + $5,000 ($50,000 × 10%) distributive share) on her individual income tax return for her tax year in which the partnership's tax year ends. H&rblock online Example 2. H&rblock online Lamont is a calendar year taxpayer who is a partner in a partnership. H&rblock online The partnership uses a fiscal year that ended January 31, 2013. H&rblock online Lamont received guaranteed payments from the partnership from February 1, 2012, until December 31, 2012. H&rblock online He must include these guaranteed payments in income for 2013 and report them on his 2013 income tax return. H&rblock online Payments resulting in loss. H&rblock online   If guaranteed payments to a partner result in a partnership loss in which the partner shares, the partner must report the full amount of the guaranteed payments as ordinary income. H&rblock online The partner separately takes into account his or her distributive share of the partnership loss, to the extent of the adjusted basis of the partner's partnership interest. H&rblock online Sale or Exchange of Property Special rules apply to a sale or exchange of property between a partnership and certain persons. H&rblock online Losses. H&rblock online   Losses will not be allowed from a sale or exchange of property (other than an interest in the partnership) directly or indirectly between a partnership and a person whose direct or indirect interest in the capital or profits of the partnership is more than 50%. H&rblock online   If the sale or exchange is between two partnerships in which the same persons directly or indirectly own more than 50% of the capital or profits interests in each partnership, no deduction of a loss is allowed. H&rblock online   The basis of each partner's interest in the partnership is decreased (but not below zero) by the partner's share of the disallowed loss. H&rblock online   If the purchaser later sells the property, only the gain realized that is greater than the loss not allowed will be taxable. H&rblock online If any gain from the sale of the property is not recognized because of this rule, the basis of each partner's interest in the partnership is increased by the partner's share of that gain. H&rblock online Gains. H&rblock online   Gains are treated as ordinary income in a sale or exchange of property directly or indirectly between a person and a partnership, or between two partnerships, if both of the following tests are met. H&rblock online More than 50% of the capital or profits interest in the partnership(s) is directly or indirectly owned by the same person(s). H&rblock online The property in the hands of the transferee immediately after the transfer is not a capital asset. H&rblock online Property that is not a capital asset includes accounts receivable, inventory, stock-in-trade, and depreciable or real property used in a trade or business. H&rblock online More than 50% ownership. H&rblock online   To determine if there is more than 50% ownership in partnership capital or profits, the following rules apply. H&rblock online An interest directly or indirectly owned by, or for, a corporation, partnership, estate, or trust is considered to be owned proportionately by, or for, its shareholders, partners, or beneficiaries. H&rblock online An individual is considered to own the interest directly or indirectly owned by, or for, the individual's family. H&rblock online For this rule, “family” includes only brothers, sisters, half-brothers, half-sisters, spouses, ancestors, and lineal descendants. H&rblock online If a person is considered to own an interest using rule (1), that person (the “constructive owner”) is treated as if actually owning that interest when rules (1) and (2) are applied. H&rblock online However, if a person is considered to own an interest using rule (2), that person is not treated as actually owning that interest in reapplying rule (2) to make another person the constructive owner. H&rblock online Example. H&rblock online Individuals A and B and Trust T are equal partners in Partnership ABT. H&rblock online A's husband, AH, is the sole beneficiary of Trust T. H&rblock online Trust T's partnership interest will be attributed to AH only for the purpose of further attributing the interest to A. H&rblock online As a result, A is a more-than-50% partner. H&rblock online This means that any deduction for losses on transactions between her and ABT will not be allowed, and gain from property that in the hands of the transferee is not a capital asset is treated as ordinary, rather than capital, gain. H&rblock online More information. H&rblock online   For more information on these special rules, see Sales and Exchanges Between Related Persons in chapter 2 of Publication 544. H&rblock online Contribution of Property Usually, neither the partner nor the partnership recognizes a gain or loss when property is contributed to the partnership in exchange for a partnership interest. H&rblock online This applies whether a partnership is being formed or is already operating. H&rblock online The partnership's holding period for the property includes the partner's holding period. H&rblock online The contribution of limited partnership interests in one partnership for limited partnership interests in another partnership qualifies as a tax-free contribution of property to the second partnership if the transaction is made for business purposes. H&rblock online The exchange is not subject to the rules explained later under Disposition of Partner's Interest. H&rblock online Disguised sales. H&rblock online   A contribution of money or other property to the partnership followed by a distribution of different property from the partnership to the partner is treated not as a contribution and distribution, but as a sale of property, if both of the following tests are met. H&rblock online The distribution would not have been made but for the contribution. H&rblock online The partner's right to the distribution does not depend on the success of partnership operations. H&rblock online   All facts and circumstances are considered in determining if the contribution and distribution are more properly characterized as a sale. H&rblock online However, if the contribution and distribution occur within 2 years of each other, the transfers are presumed to be a sale unless the facts clearly indicate that the transfers are not a sale. H&rblock online If the contribution and distribution occur more than 2 years apart, the transfers are presumed not to be a sale unless the facts clearly indicate that the transfers are a sale. H&rblock online Form 8275 required. H&rblock online   A partner must attach Form 8275, Disclosure Statement, (or other statement) to his or her return if the partner contributes property to a partnership and, within 2 years (before or after the contribution), the partnership transfers money or other consideration to the partner. H&rblock online For exceptions to this requirement, see section 1. H&rblock online 707-3(c)(2) of the regulations. H&rblock online   A partnership must attach Form 8275 (or other statement) to its return if it distributes property to a partner, and, within 2 years (before or after the distribution), the partner transfers money or other consideration to the partnership. H&rblock online   Form 8275 must include the following information. H&rblock online A caption identifying the statement as a disclosure under section 707 of the Internal Revenue Code. H&rblock online A description of the transferred property or money, including its value. H&rblock online A description of any relevant facts in determining if the transfers are properly viewed as a disguised sale. H&rblock online See section 1. H&rblock online 707-3(b)(2) of the regulations for a description of the facts and circumstances considered in determining if the transfers are a disguised sale. H&rblock online Contribution to partnership treated as investment company. H&rblock online   Gain is recognized when property is contributed (in exchange for an interest in the partnership) to a partnership that would be treated as an investment company if it were incorporated. H&rblock online   A partnership is generally treated as an investment company if over 80% of the value of its assets is held for investment and consists of certain readily marketable items. H&rblock online These items include money, stocks and other equity interests in a corporation, and interests in regulated investment companies and real estate investment trusts. H&rblock online For more information, see section 351(e)(1) of the Internal Revenue Code and the related regulations. H&rblock online Whether a partnership is treated as an investment company under this test is ordinarily determined immediately after the transfer of property. H&rblock online   This rule applies to limited partnerships and general partnerships, regardless of whether they are privately formed or publicly syndicated. H&rblock online Contribution to foreign partnership. H&rblock online   A domestic partnership that contributed property after August 5, 1997, to a foreign partnership in exchange for a partnership interest may have to file Form 8865 if either of the following apply. H&rblock online Immediately after the contribution, the partnership owned, directly or indirectly, at least a 10% interest in the foreign partnership. H&rblock online The fair market value of the property contributed to the foreign partnership, when added to other contributions of property made to the partnership during the preceding 12-month period, is greater than $100,000. H&rblock online   The partnership may also have to file Form 8865, even if no contributions are made during the tax year, if it owns a 10% or more interest in a foreign partnership at any time during the year. H&rblock online See the form instructions for more information. H&rblock online Basis of contributed property. H&rblock online   If a partner contributes property to a partnership, the partnership's basis for determining depreciation, depletion, gain, or loss for the property is the same as the partner's adjusted basis for the property when it was contributed, increased by any gain recognized by the partner at the time of contribution. H&rblock online Allocations to account for built-in gain or loss. H&rblock online   The fair market value of property at the time it is contributed may be different from the partner's adjusted basis. H&rblock online The partnership must allocate among the partners any income, deduction, gain, or loss on the property in a manner that will account for the difference. H&rblock online This rule also applies to contributions of accounts payable and other accrued but unpaid items of a cash basis partner. H&rblock online   The partnership can use different allocation methods for different items of contributed property. H&rblock online A single reasonable method must be consistently applied to each item, and the overall method or combination of methods must be reasonable. H&rblock online See section 1. H&rblock online 704-3 of the regulations for allocation methods generally considered reasonable. H&rblock online   If the partnership sells contributed property and recognizes gain or loss, built-in gain or loss is allocated to the contributing partner. H&rblock online If contributed property is subject to depreciation or other cost recovery, the allocation of deductions for these items takes into account built-in gain or loss on the property. H&rblock online However, the total depreciation, depletion, gain, or loss allocated to partners cannot be more than the depreciation or depletion allowable to the partnership or the gain or loss realized by the partnership. H&rblock online Example. H&rblock online Areta and Sofia formed an equal partnership. H&rblock online Areta contributed $10,000 in cash to the partnership and Sofia contributed depreciable property with a fair market value of $10,000 and an adjusted basis of $4,000. H&rblock online The partnership's basis for depreciation is limited to the adjusted basis of the property in Sofia's hands, $4,000. H&rblock online In effect, Areta purchased an undivided one-half interest in the depreciable property with her contribution of $10,000. H&rblock online Assuming that the depreciation rate is 10% a year under the General Depreciation System (GDS), she would have been entitled to a depreciation deduction of $500 per year, based on her interest in the partnership, if the adjusted basis of the property equaled its fair market value when contributed. H&rblock online To simplify this example, the depreciation deductions are determined without regard to any first-year depreciation conventions. H&rblock online However, since the partnership is allowed only $400 per year of depreciation (10% of $4,000), no more than $400 can be allocated between the partners. H&rblock online The entire $400 must be allocated to Areta. H&rblock online Distribution of contributed property to another partner. H&rblock online   If a partner contributes property to a partnership and the partnership distributes the property to another partner within 7 years of the contribution, the contributing partner must recognize gain or loss on the distribution. H&rblock online   The recognized gain or loss is the amount the contributing partner would have recognized if the property had been sold for its fair market value when it was distributed. H&rblock online This amount is the difference between the property's basis and its fair market value at the time of contribution. H&rblock online The character of the gain or loss will be the same as the character of the gain or loss that would have resulted if the partnership had sold the property to the distributee partner. H&rblock online Appropriate adjustments must be made to the adjusted basis of the contributing partner's partnership interest and to the adjusted basis of the property distributed to reflect the recognized gain or loss. H&rblock online Disposition of certain contributed property. H&rblock online   The following rules determine the character of the partnership's gain or loss on a disposition of certain types of contributed property. H&rblock online Unrealized receivables. H&rblock online If the property was an unrealized receivable in the hands of the contributing partner, any gain or loss on its disposition by the partnership is ordinary income or loss. H&rblock online Unrealized receivables are defined later under Payments for Unrealized Receivables and Inventory Items. H&rblock online When reading the definition, substitute “partner” for “partnership. H&rblock online ” Inventory items. H&rblock online If the property was an inventory item in the hands of the contributing partner, any gain or loss on its disposition by the partnership within 5 years after the contribution is ordinary income or loss. H&rblock online Inventory items are defined later in Payments for Unrealized Receivables and Inventory Items. H&rblock online Capital loss property. H&rblock online If the property was a capital asset in the contributing partner's hands, any loss on its disposition by the partnership within 5 years after the contribution is a capital loss. H&rblock online The capital loss is limited to the amount by which the partner's adjusted basis for the property exceeded the property's fair market value immediately before the contribution. H&rblock online Substituted basis property. H&rblock online If the disposition of any of the property listed in (1), (2), or (3) is a nonrecognition transaction, these rules apply when the recipient of the property disposes of any substituted basis property (other than certain corporate stock) resulting from the transaction. H&rblock online Contribution of Services A partner can acquire an interest in partnership capital or profits as compensation for services performed or to be performed. H&rblock online Capital interest. H&rblock online   A capital interest is an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds were distributed in a complete liquidation of the partnership. H&rblock online This determination generally is made at the time of receipt of the partnership interest. H&rblock online The fair market value of such an interest received by a partner as compensation for services must generally be included in the partner's gross income in the first tax year in which the partner can transfer the interest or the interest is not subject to a substantial risk of forfeiture. H&rblock online The capital interest transferred as compensation for services is subject to the rules for restricted property discussed in Publication 525 under Employee Compensation. H&rblock online   The fair market value of an interest in partnership capital transferred to a partner as payment for services to the partnership is a guaranteed payment, discussed earlier. H&rblock online Profits interest. H&rblock online   A profits interest is a partnership interest other than a capital interest. H&rblock online If a person receives a profits interest for providing services to, or for the benefit of, a partnership in a partner capacity or in anticipation of being a partner, the receipt of such an interest is not a taxable event for the partner or the partnership. H&rblock online However, this does not apply in the following situations. H&rblock online The profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease. H&rblock online Within 2 years of receipt, the partner disposes of the profits interest. H&rblock online The profits interest is a limited partnership interest in a publicly traded partnership. H&rblock online   A profits interest transferred as compensation for services is not subject to the rules for restricted property that apply to capital interests. H&rblock online Basis of Partner's Interest The basis of a partnership interest is the money plus the adjusted basis of any property the partner contributed. H&rblock online If the partner must recognize gain as a result of the contribution, this gain is included in the basis of his or her interest. H&rblock online Any increase in a partner's individual liabilities because of an assumption of partnership liabilities is considered a contribution of money to the partnership by the partner. H&rblock online Interest acquired by gift, etc. H&rblock online   If a partner acquires an interest in a partnership by gift, inheritance, or under any circumstance other than by a contribution of money or property to the partnership, the partner's basis must be determined using the basis rules described in Publication 551. H&rblock online Adjusted Basis There is a worksheet for adjusting the basis of a partner's interest in the partnership in the Partner's Instructions for Schedule K-1 (Form 1065). H&rblock online The basis of an interest in a partnership is increased or decreased by certain items. H&rblock online Increases. H&rblock online   A partner's basis is increased by the following items. H&rblock online The partner's additional contributions to the partnership, including an increased share of, or assumption of, partnership liabilities. H&rblock online The partner's distributive share of taxable and nontaxable partnership income. H&rblock online The partner's distributive share of the excess of the deductions for depletion over the basis of the depletable property, unless the property is oil or gas wells whose basis has been allocated to partners. H&rblock online Decreases. H&rblock online   The partner's basis is decreased (but never below zero) by the following items. H&rblock online The money (including a decreased share of partnership liabilities or an assumption of the partner's individual liabilities by the partnership) and adjusted basis of property distributed to the partner by the partnership. H&rblock online The partner's distributive share of the partnership losses (including capital losses). H&rblock online The partner's distributive share of nondeductible partnership expenses that are not capital expenditures. H&rblock online This includes the partner's share of any section 179 expenses, even if the partner cannot deduct the entire amount on his or her individual income tax return. H&rblock online The partner's deduction for depletion for any partnership oil and gas wells, up to the proportionate share of the adjusted basis of the wells allocated to the partner. H&rblock online Partner's liabilities assumed by partnership. H&rblock online   If contributed property is subject to a debt or if a partner's liabilities are assumed by the partnership, the basis of that partner's interest is reduced (but not below zero) by the liability assumed by the other partners. H&rblock online This partner must reduce his or her basis because the assumption of the liability is treated as a distribution of money to that partner. H&rblock online The other partners' assumption of the liability is treated as a contribution by them of money to the partnership. H&rblock online See Effect of Partnership Liabilities , later. H&rblock online Example 1. H&rblock online Ivan acquired a 20% interest in a partnership by contributing property that had an adjusted basis to him of $8,000 and a $4,000 mortgage. H&rblock online The partnership assumed payment of the mortgage. H&rblock online The basis of Ivan's interest is: Adjusted basis of contributed property $8,000 Minus: Part of mortgage assumed by other partners (80% × $4,000) 3,200 Basis of Ivan's partnership interest $4,800 Example 2. H&rblock online If, in Example 1, the contributed property had a $12,000 mortgage, the basis of Ivan's partnership interest would be zero. H&rblock online The $1,600 difference between the mortgage assumed by the other partners, $9,600 (80% × $12,000), and his basis of $8,000 would be treated as capital gain from the sale or exchange of a partnership interest. H&rblock online However, this gain would not increase the basis of his partnership interest. H&rblock online Book value of partner's interest. H&rblock online   The adjusted basis of a partner's interest is determined without considering any amount shown in the partnership books as a capital, equity, or similar account. H&rblock online Example. H&rblock online Enzo contributes to his partnership property that has an adjusted basis of $400 and a fair market value of $1,000. H&rblock online His partner contributes $1,000 cash. H&rblock online While each partner has increased his capital account by $1,000, which will be re
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H&rblock online Publication 936 - Main Content Table of Contents Part I. H&rblock online Home Mortgage InterestSecured Debt Qualified Home Special Situations Points Mortgage Insurance Premiums Form 1098, Mortgage Interest Statement How To Report Special Rule for Tenant-Stockholders in Cooperative Housing Corporations Part II. H&rblock online Limits on Home Mortgage Interest DeductionHome Acquisition Debt Home Equity Debt Grandfathered Debt Table 1 Instructions How To Get Tax HelpLow Income Taxpayer Clinics Part I. H&rblock online Home Mortgage Interest This part explains what you can deduct as home mortgage interest. H&rblock online It includes discussions on points, mortgage insurance premiums, and how to report deductible interest on your tax return. H&rblock online Generally, home mortgage interest is any interest you pay on a loan secured by your home (main home or a second home). H&rblock online The loan may be a mortgage to buy your home, a second mortgage, a line of credit, or a home equity loan. H&rblock online You can deduct home mortgage interest if all the following conditions are met. H&rblock online You file Form 1040 and itemize deductions on Schedule A (Form 1040). H&rblock online The mortgage is a secured debt on a qualified home in which you have an ownership interest. H&rblock online Secured Debt and Qualified Home are explained later. H&rblock online  Both you and the lender must intend that the loan be repaid. H&rblock online Fully deductible interest. H&rblock online   In most cases, you can deduct all of your home mortgage interest. H&rblock online How much you can deduct depends on the date of the mortgage, the amount of the mortgage, and how you use the mortgage proceeds. H&rblock online   If all of your mortgages fit into one or more of the following three categories at all times during the year, you can deduct all of the interest on those mortgages. H&rblock online (If any one mortgage fits into more than one category, add the debt that fits in each category to your other debt in the same category. H&rblock online ) If one or more of your mortgages does not fit into any of these categories, use Part II of this publication to figure the amount of interest you can deduct. H&rblock online   The three categories are as follows. H&rblock online Mortgages you took out on or before October 13, 1987 (called grandfathered debt). H&rblock online Mortgages you took out after October 13, 1987, to buy, build, or improve your home (called home acquisition debt), but only if throughout 2013 these mortgages plus any grandfathered debt totaled $1 million or less ($500,000 or less if married filing separately). H&rblock online Mortgages you took out after October 13, 1987, other than to buy, build, or improve your home (called home equity debt), but only if throughout 2013 these mortgages totaled $100,000 or less ($50,000 or less if married filing separately) and totaled no more than the fair market value of your home reduced by (1) and (2). H&rblock online The dollar limits for the second and third categories apply to the combined mortgages on your main home and second home. H&rblock online   See Part II for more detailed definitions of grandfathered, home acquisition, and home equity debt. H&rblock online    You can use Figure A to check whether your home mortgage interest is fully deductible. H&rblock online This image is too large to be displayed in the current screen. H&rblock online Please click the link to view the image. H&rblock online Figure A. H&rblock online Is My Home Mortgage Interest Fully Deductible? Secured Debt You can deduct your home mortgage interest only if your mortgage is a secured debt. H&rblock online A secured debt is one in which you sign an instrument (such as a mortgage, deed of trust, or land contract) that: Makes your ownership in a qualified home security for payment of the debt, Provides, in case of default, that your home could satisfy the debt, and Is recorded or is otherwise perfected under any state or local law that applies. H&rblock online In other words, your mortgage is a secured debt if you put your home up as collateral to protect the interests of the lender. H&rblock online If you cannot pay the debt, your home can then serve as payment to the lender to satisfy (pay) the debt. H&rblock online In this publication, mortgage will refer to secured debt. H&rblock online Debt not secured by home. H&rblock online   A debt is not secured by your home if it is secured solely because of a lien on your general assets or if it is a security interest that attaches to the property without your consent (such as a mechanic's lien or judgment lien). H&rblock online   A debt is not secured by your home if it once was, but is no longer secured by your home. H&rblock online Wraparound mortgage. H&rblock online   This is not a secured debt unless it is recorded or otherwise perfected under state law. H&rblock online Example. H&rblock online Beth owns a home subject to a mortgage of $40,000. H&rblock online She sells the home for $100,000 to John, who takes it subject to the $40,000 mortgage. H&rblock online Beth continues to make the payments on the $40,000 note. H&rblock online John pays $10,000 down and gives Beth a $90,000 note secured by a wraparound mortgage on the home. H&rblock online Beth does not record or otherwise perfect the $90,000 mortgage under the state law that applies. H&rblock online Therefore, the mortgage is not a secured debt and John cannot deduct any of the interest he pays on it as home mortgage interest. H&rblock online Choice to treat the debt as not secured by your home. H&rblock online   You can choose to treat any debt secured by your qualified home as not secured by the home. H&rblock online This treatment begins with the tax year for which you make the choice and continues for all later tax years. H&rblock online You can revoke your choice only with the consent of the Internal Revenue Service (IRS). H&rblock online   You may want to treat a debt as not secured by your home if the interest on that debt is fully deductible (for example, as a business expense) whether or not it qualifies as home mortgage interest. H&rblock online This may allow you, if the limits in Part II apply, more of a deduction for interest on other debts that are deductible only as home mortgage interest. H&rblock online Cooperative apartment owner. H&rblock online   If you own stock in a cooperative housing corporation, see the Special Rule for Tenant-Stockholders in Cooperative Housing Corporations , near the end of this Part I. H&rblock online Qualified Home For you to take a home mortgage interest deduction, your debt must be secured by a qualified home. H&rblock online This means your main home or your second home. H&rblock online A home includes a house, condominium, cooperative, mobile home, house trailer, boat, or similar property that has sleeping, cooking, and toilet facilities. H&rblock online The interest you pay on a mortgage on a home other than your main or second home may be deductible if the proceeds of the loan were used for business, investment, or other deductible purposes. H&rblock online Otherwise, it is considered personal interest and is not deductible. H&rblock online Main home. H&rblock online   You can have only one main home at any one time. H&rblock online This is the home where you ordinarily live most of the time. H&rblock online Second home. H&rblock online   A second home is a home that you choose to treat as your second home. H&rblock online Second home not rented out. H&rblock online   If you have a second home that you do not hold out for rent or resale to others at any time during the year, you can treat it as a qualified home. H&rblock online You do not have to use the home during the year. H&rblock online Second home rented out. H&rblock online   If you have a second home and rent it out part of the year, you also must use it as a home during the year for it to be a qualified home. H&rblock online You must use this home more than 14 days or more than 10% of the number of days during the year that the home is rented at a fair rental, whichever is longer. H&rblock online If you do not use the home long enough, it is considered rental property and not a second home. H&rblock online For information on residential rental property, see Publication 527. H&rblock online More than one second home. H&rblock online   If you have more than one second home, you can treat only one as the qualified second home during any year. H&rblock online However, you can change the home you treat as a second home during the year in the following situations. H&rblock online If you get a new home during the year, you can choose to treat the new home as your second home as of the day you buy it. H&rblock online If your main home no longer qualifies as your main home, you can choose to treat it as your second home as of the day you stop using it as your main home. H&rblock online If your second home is sold during the year or becomes your main home, you can choose a new second home as of the day you sell the old one or begin using it as your main home. H&rblock online Divided use of your home. H&rblock online   The only part of your home that is considered a qualified home is the part you use for residential living. H&rblock online If you use part of your home for other than residential living, such as a home office, you must allocate the use of your home. H&rblock online You must then divide both the cost and fair market value of your home between the part that is a qualified home and the part that is not. H&rblock online Dividing the cost may affect the amount of your home acquisition debt, which is limited to the cost of your home plus the cost of any improvements. H&rblock online (See Home Acquisition Debt in Part II. H&rblock online ) Dividing the fair market value may affect your home equity debt limit, also explained in Part II . H&rblock online Renting out part of home. H&rblock online   If you rent out part of a qualified home to another person (tenant), you can treat the rented part as being used by you for residential living only if all of the following conditions apply. H&rblock online The rented part of your home is used by the tenant primarily for residential living. H&rblock online The rented part of your home is not a self-contained residential unit having separate sleeping, cooking, and toilet facilities. H&rblock online You do not rent (directly or by sublease) the same or different parts of your home to more than two tenants at any time during the tax year. H&rblock online If two persons (and dependents of either) share the same sleeping quarters, they are treated as one tenant. H&rblock online Office in home. H&rblock online   If you have an office in your home that you use in your business, see Publication 587, Business Use of Your Home. H&rblock online It explains how to figure your deduction for the business use of your home, which includes the business part of your home mortgage interest. H&rblock online Home under construction. H&rblock online   You can treat a home under construction as a qualified home for a period of up to 24 months, but only if it becomes your qualified home at the time it is ready for occupancy. H&rblock online   The 24-month period can start any time on or after the day construction begins. H&rblock online Home destroyed. H&rblock online   You may be able to continue treating your home as a qualified home even after it is destroyed in a fire, storm, tornado, earthquake, or other casualty. H&rblock online This means you can continue to deduct the interest you pay on your home mortgage, subject to the limits described in this publication. H&rblock online   You can continue treating a destroyed home as a qualified home if, within a reasonable period of time after the home is destroyed, you: Rebuild the destroyed home and move into it, or Sell the land on which the home was located. H&rblock online   This rule applies to your main home and to a second home that you treat as a qualified home. H&rblock online Time-sharing arrangements. H&rblock online   You can treat a home you own under a time-sharing plan as a qualified home if it meets all the requirements. H&rblock online A time-sharing plan is an arrangement between two or more people that limits each person's interest in the home or right to use it to a certain part of the year. H&rblock online Rental of time-share. H&rblock online   If you rent out your time-share, it qualifies as a second home only if you also use it as a home during the year. H&rblock online See Second home rented out , earlier, for the use requirement. H&rblock online To know whether you meet that requirement, count your days of use and rental of the home only during the time you have a right to use it or to receive any benefits from the rental of it. H&rblock online Married taxpayers. H&rblock online   If you are married and file a joint return, your qualified home(s) can be owned either jointly or by only one spouse. H&rblock online Separate returns. H&rblock online   If you are married filing separately and you and your spouse own more than one home, you can each take into account only one home as a qualified home. H&rblock online However, if you both consent in writing, then one spouse can take both the main home and a second home into account. H&rblock online Special Situations This section describes certain items that can be included as home mortgage interest and others that cannot. H&rblock online It also describes certain special situations that may affect your deduction. H&rblock online Late payment charge on mortgage payment. H&rblock online   You can deduct as home mortgage interest a late payment charge if it was not for a specific service performed in connection with your mortgage loan. H&rblock online Mortgage prepayment penalty. H&rblock online   If you pay off your home mortgage early, you may have to pay a penalty. H&rblock online You can deduct that penalty as home mortgage interest provided the penalty is not for a specific service performed or cost incurred in connection with your mortgage loan. H&rblock online Sale of home. H&rblock online   If you sell your home, you can deduct your home mortgage interest (subject to any limits that apply) paid up to, but not including, the date of the sale. H&rblock online Example. H&rblock online John and Peggy Harris sold their home on May 7. H&rblock online Through April 30, they made home mortgage interest payments of $1,220. H&rblock online The settlement sheet for the sale of the home showed $50 interest for the 6-day period in May up to, but not including, the date of sale. H&rblock online Their mortgage interest deduction is $1,270 ($1,220 + $50). H&rblock online Prepaid interest. H&rblock online   If you pay interest in advance for a period that goes beyond the end of the tax year, you must spread this interest over the tax years to which it applies. H&rblock online You can deduct in each year only the interest that qualifies as home mortgage interest for that year. H&rblock online However, there is an exception that applies to points, discussed later. H&rblock online Mortgage interest credit. H&rblock online    You may be able to claim a mortgage interest credit if you were issued a mortgage credit certificate (MCC) by a state or local government. H&rblock online Figure the credit on Form 8396, Mortgage Interest Credit. H&rblock online If you take this credit, you must reduce your mortgage interest deduction by the amount of the credit. H&rblock online   See Form 8396 and Publication 530 for more information on the mortgage interest credit. H&rblock online Ministers' and military housing allowance. H&rblock online   If you are a minister or a member of the uniformed services and receive a housing allowance that is not taxable, you can still deduct your home mortgage interest. H&rblock online Hardest Hit Fund and Emergency Homeowners' Loan Programs. H&rblock online   You can use a special method to compute your deduction for mortgage interest and real estate taxes on your main home if you meet the following two conditions. H&rblock online You received assistance under: A State Housing Finance Agency (State HFA) Hardest Hit Fund program in which program payments could be used to pay mortgage interest, or An Emergency Homeowners' Loan Program administered by the Department of Housing and Urban Development (HUD) or a state. H&rblock online You meet the rules to deduct all of the mortgage interest on your loan and all of the real estate taxes on your main home. H&rblock online If you meet these tests, then you can deduct all of the payments you actually made during the year to your mortgage servicer, the State HFA, or HUD on the home mortgage (including the amount shown on box 3 of Form 1098–MA, Mortgage Assistance Payments), but not more than the sum of the amounts shown on Form 1098, Mortgage Interest Statement, in box 1 (mortgage interest received from payer(s) / borrower(s)), box 4 (mortgage insurance premiums), and box 5 (other information including real property taxes paid). H&rblock online However, you are not required to use this special method to compute your deduction for mortgage interest and real estate taxes on your main home. H&rblock online Mortgage assistance payments under section 235 of the National Housing Act. H&rblock online   If you qualify for mortgage assistance payments for lower-income families under section 235 of the National Housing Act, part or all of the interest on your mortgage may be paid for you. H&rblock online You cannot deduct the interest that is paid for you. H&rblock online No other effect on taxes. H&rblock online   Do not include these mortgage assistance payments in your income. H&rblock online Also, do not use these payments to reduce other deductions, such as real estate taxes. H&rblock online Divorced or separated individuals. H&rblock online   If a divorce or separation agreement requires you or your spouse or former spouse to pay home mortgage interest on a home owned by both of you, the payment of interest may be alimony. H&rblock online See the discussion of Payments for jointly-owned home under Alimony in Publication 504, Divorced or Separated Individuals. H&rblock online Redeemable ground rents. H&rblock online   In some states (such as Maryland), you can buy your home subject to a ground rent. H&rblock online A ground rent is an obligation you assume to pay a fixed amount per year on the property. H&rblock online Under this arrangement, you are leasing (rather than buying) the land on which your home is located. H&rblock online   If you make annual or periodic rental payments on a redeemable ground rent, you can deduct them as mortgage interest. H&rblock online   A ground rent is a redeemable ground rent if all of the following are true. H&rblock online Your lease, including renewal periods, is for more than 15 years. H&rblock online You can freely assign the lease. H&rblock online You have a present or future right (under state or local law) to end the lease and buy the lessor's entire interest in the land by paying a specific amount. H&rblock online The lessor's interest in the land is primarily a security interest to protect the rental payments to which he or she is entitled. H&rblock online   Payments made to end the lease and to buy the lessor's entire interest in the land are not deductible as mortgage interest. H&rblock online Nonredeemable ground rents. H&rblock online   Payments on a nonredeemable ground rent are not mortgage interest. H&rblock online You can deduct them as rent if they are a business expense or if they are for rental property. H&rblock online Reverse mortgages. H&rblock online   A reverse mortgage is a loan where the lender pays you (in a lump sum, a monthly advance, a line of credit, or a combination of all three) while you continue to live in your home. H&rblock online With a reverse mortgage, you retain title to your home. H&rblock online Depending on the plan, your reverse mortgage becomes due with interest when you move, sell your home, reach the end of a pre-selected loan period, or die. H&rblock online Because reverse mortgages are considered loan advances and not income, the amount you receive is not taxable. H&rblock online Any interest (including original issue discount) accrued on a reverse mortgage is not deductible until you actually pay it, which is usually when you pay off the loan in full. H&rblock online Your deduction may be limited because a reverse mortgage loan generally is subject to the limit on Home Equity Debt discussed in Part II. H&rblock online Rental payments. H&rblock online   If you live in a house before final settlement on the purchase, any payments you make for that period are rent and not interest. H&rblock online This is true even if the settlement papers call them interest. H&rblock online You cannot deduct these payments as home mortgage interest. H&rblock online Mortgage proceeds invested in tax-exempt securities. H&rblock online   You cannot deduct the home mortgage interest on grandfathered debt or home equity debt if you used the proceeds of the mortgage to buy securities or certificates that produce tax-free income. H&rblock online “Grandfathered debt” and “home equity debt” are defined in Part II of this publication. H&rblock online Refunds of interest. H&rblock online   If you receive a refund of interest in the same tax year you paid it, you must reduce your interest expense by the amount refunded to you. H&rblock online If you receive a refund of interest you deducted in an earlier year, you generally must include the refund in income in the year you receive it. H&rblock online However, you need to include it only up to the amount of the deduction that reduced your tax in the earlier year. H&rblock online This is true whether the interest overcharge was refunded to you or was used to reduce the outstanding principal on your mortgage. H&rblock online If you need to include the refund in income, report it on Form 1040, line 21. H&rblock online   If you received a refund of interest you overpaid in an earlier year, you generally will receive a Form 1098, Mortgage Interest Statement, showing the refund in box 3. H&rblock online For information about Form 1098, see Form 1098, Mortgage Interest Statement , later. H&rblock online   For more information on how to treat refunds of interest deducted in earlier years, see Recoveries in Publication 525, Taxable and Nontaxable Income. H&rblock online Cooperative apartment owner. H&rblock online   If you own a cooperative apartment, you must reduce your home mortgage interest deduction by your share of any cash portion of a patronage dividend that the cooperative receives. H&rblock online The patronage dividend is a partial refund to the cooperative housing corporation of mortgage interest it paid in a prior year. H&rblock online   If you receive a Form 1098 from the cooperative housing corporation, the form should show only the amount you can deduct. H&rblock online Points The term “points” is used to describe certain charges paid, or treated as paid, by a borrower to obtain a home mortgage. H&rblock online Points may also be called loan origination fees, maximum loan charges, loan discount, or discount points. H&rblock online This image is too large to be displayed in the current screen. H&rblock online Please click the link to view the image. H&rblock online Figure B. H&rblock online Are My Points Fully Deductible This Year? A borrower is treated as paying any points that a home seller pays for the borrower's mortgage. H&rblock online See Points paid by the seller , later. H&rblock online General Rule You generally cannot deduct the full amount of points in the year paid. H&rblock online Because they are prepaid interest, you generally deduct them ratably over the life (term) of the mortgage. H&rblock online See Deduction Allowed Ratably , next. H&rblock online For exceptions to the general rule, see Deduction Allowed in Year Paid , later. H&rblock online Deduction Allowed Ratably If you do not meet the tests listed under Deduction Allowed in Year Paid , later, the loan is not a home improvement loan, or you choose not to deduct your points in full in the year paid, you can deduct the points ratably (equally) over the life of the loan if you meet all the following tests. H&rblock online You use the cash method of accounting. H&rblock online This means you report income in the year you receive it and deduct expenses in the year you pay them. H&rblock online Most individuals use this method. H&rblock online Your loan is secured by a home. H&rblock online (The home does not need to be your main home. H&rblock online ) Your loan period is not more than 30 years. H&rblock online If your loan period is more than 10 years, the terms of your loan are the same as other loans offered in your area for the same or longer period. H&rblock online Either your loan amount is $250,000 or less, or the number of points is not more than: 4, if your loan period is 15 years or less, or 6, if your loan period is more than 15 years. H&rblock online Example. H&rblock online You use the cash method of accounting. H&rblock online In 2013, you took out a $100,000 loan payable over 20 years. H&rblock online The terms of the loan are the same as for other 20-year loans offered in your area. H&rblock online You paid $4,800 in points. H&rblock online You made 3 monthly payments on the loan in 2013. H&rblock online You can deduct $60 [($4,800 ÷ 240 months) x 3 payments] in 2013. H&rblock online In 2014, if you make all twelve payments, you will be able to deduct $240 ($20 x 12). H&rblock online Deduction Allowed in Year Paid You can fully deduct points in the year paid if you meet all the following tests. H&rblock online (You can use Figure B as a quick guide to see whether your points are fully deductible in the year paid. H&rblock online ) Your loan is secured by your main home. H&rblock online (Your main home is the one you ordinarily live in most of the time. H&rblock online ) Paying points is an established business practice in the area where the loan was made. H&rblock online The points paid were not more than the points generally charged in that area. H&rblock online You use the cash method of accounting. H&rblock online This means you report income in the year you receive it and deduct expenses in the year you pay them. H&rblock online Most individuals use this method. H&rblock online The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes. H&rblock online The funds you provided at or before closing, plus any points the seller paid, were at least as much as the points charged. H&rblock online The funds you provided are not required to have been applied to the points. H&rblock online They can include a down payment, an escrow deposit, earnest money, and other funds you paid at or before closing for any purpose. H&rblock online You cannot have borrowed these funds from your lender or mortgage broker. H&rblock online You use your loan to buy or build your main home. H&rblock online The points were computed as a percentage of the principal amount of the mortgage. H&rblock online The amount is clearly shown on the settlement statement (such as the Settlement Statement, Form HUD-1) as points charged for the mortgage. H&rblock online The points may be shown as paid from either your funds or the seller's. H&rblock online Note. H&rblock online If you meet all of these tests, you can choose to either fully deduct the points in the year paid, or deduct them over the life of the loan. H&rblock online Home improvement loan. H&rblock online   You can also fully deduct in the year paid points paid on a loan to improve your main home, if tests (1) through (6) are met. H&rblock online Second home. H&rblock online You cannot fully deduct in the year paid points you pay on loans secured by your second home. H&rblock online You can deduct these points only over the life of the loan. H&rblock online Refinancing. H&rblock online   Generally, points you pay to refinance a mortgage are not deductible in full in the year you pay them. H&rblock online This is true even if the new mortgage is secured by your main home. H&rblock online   However, if you use part of the refinanced mortgage proceeds to improve your main home and you meet the first 6 tests listed under Deduction Allowed in Year Paid , you can fully deduct the part of the points related to the improvement in the year you paid them with your own funds. H&rblock online You can deduct the rest of the points over the life of the loan. H&rblock online Example 1. H&rblock online In 1998, Bill Fields got a mortgage to buy a home. H&rblock online In 2013, Bill refinanced that mortgage with a 15-year $100,000 mortgage loan. H&rblock online The mortgage is secured by his home. H&rblock online To get the new loan, he had to pay three points ($3,000). H&rblock online Two points ($2,000) were for prepaid interest, and one point ($1,000) was charged for services, in place of amounts that ordinarily are stated separately on the settlement statement. H&rblock online Bill paid the points out of his private funds, rather than out of the proceeds of the new loan. H&rblock online The payment of points is an established practice in the area, and the points charged are not more than the amount generally charged there. H&rblock online Bill's first payment on the new loan was due July 1. H&rblock online He made six payments on the loan in 2013 and is a cash basis taxpayer. H&rblock online Bill used the funds from the new mortgage to repay his existing mortgage. H&rblock online Although the new mortgage loan was for Bill's continued ownership of his main home, it was not for the purchase or improvement of that home. H&rblock online He cannot deduct all of the points in 2013. H&rblock online He can deduct two points ($2,000) ratably over the life of the loan. H&rblock online He deducts $67 [($2,000 ÷ 180 months) × 6 payments] of the points in 2013. H&rblock online The other point ($1,000) was a fee for services and is not deductible. H&rblock online Example 2. H&rblock online The facts are the same as in Example 1, except that Bill used $25,000 of the loan proceeds to improve his home and $75,000 to repay his existing mortgage. H&rblock online Bill deducts 25% ($25,000 ÷ $100,000) of the points ($2,000) in 2013. H&rblock online His deduction is $500 ($2,000 × 25%). H&rblock online Bill also deducts the ratable part of the remaining $1,500 ($2,000 − $500) that must be spread over the life of the loan. H&rblock online This is $50 [($1,500 ÷ 180 months) × 6 payments] in 2013. H&rblock online The total amount Bill deducts in 2013 is $550 ($500 + $50). H&rblock online Special Situations This section describes certain special situations that may affect your deduction of points. H&rblock online Original issue discount. H&rblock online   If you do not qualify to either deduct the points in the year paid or deduct them ratably over the life of the loan, or if you choose not to use either of these methods, the points reduce the issue price of the loan. H&rblock online This reduction results in original issue discount, which is discussed in chapter 4 of Publication 535. H&rblock online Amounts charged for services. H&rblock online    Amounts charged by the lender for specific services connected to the loan are not interest. H&rblock online Examples of these charges are: Appraisal fees, Notary fees, and Preparation costs for the mortgage note or deed of trust. H&rblock online  You cannot deduct these amounts as points either in the year paid or over the life of the mortgage. H&rblock online Points paid by the seller. H&rblock online   The term “points” includes loan placement fees that the seller pays to the lender to arrange financing for the buyer. H&rblock online Treatment by seller. H&rblock online   The seller cannot deduct these fees as interest. H&rblock online But they are a selling expense that reduces the amount realized by the seller. H&rblock online See Publication 523 for information on selling your home. H&rblock online Treatment by buyer. H&rblock online   The buyer reduces the basis of the home by the amount of the seller-paid points and treats the points as if he or she had paid them. H&rblock online If all the tests under Deduction Allowed in Year Paid , earlier, are met, the buyer can deduct the points in the year paid. H&rblock online If any of those tests are not met, the buyer deducts the points over the life of the loan. H&rblock online   If you need information about the basis of your home, see Publication 523 or Publication 530. H&rblock online Funds provided are less than points. H&rblock online   If you meet all the tests in Deduction Allowed in Year Paid , earlier, except that the funds you provided were less than the points charged to you (test (6)), you can deduct the points in the year paid, up to the amount of funds you provided. H&rblock online In addition, you can deduct any points paid by the seller. H&rblock online Example 1. H&rblock online When you took out a $100,000 mortgage loan to buy your home in December, you were charged one point ($1,000). H&rblock online You meet all the tests for deducting points in the year paid, except the only funds you provided were a $750 down payment. H&rblock online Of the $1,000 charged for points, you can deduct $750 in the year paid. H&rblock online You spread the remaining $250 over the life of the mortgage. H&rblock online Example 2. H&rblock online The facts are the same as in Example 1, except that the person who sold you your home also paid one point ($1,000) to help you get your mortgage. H&rblock online In the year paid, you can deduct $1,750 ($750 of the amount you were charged plus the $1,000 paid by the seller). H&rblock online You spread the remaining $250 over the life of the mortgage. H&rblock online You must reduce the basis of your home by the $1,000 paid by the seller. H&rblock online Excess points. H&rblock online   If you meet all the tests in Deduction Allowed in Year Paid , earlier, except that the points paid were more than generally paid in your area (test (3)), you deduct in the year paid only the points that are generally charged. H&rblock online You must spread any additional points over the life of the mortgage. H&rblock online Mortgage ending early. H&rblock online   If you spread your deduction for points over the life of the mortgage, you can deduct any remaining balance in the year the mortgage ends. H&rblock online However, if you refinance the mortgage with the same lender, you cannot deduct any remaining balance of spread points. H&rblock online Instead, deduct the remaining balance over the term of the new loan. H&rblock online   A mortgage may end early due to a prepayment, refinancing, foreclosure, or similar event. H&rblock online Example. H&rblock online Dan paid $3,000 in points in 2002 that he had to spread out over the 15-year life of the mortgage. H&rblock online He deducts $200 points per year. H&rblock online Through 2012, Dan has deducted $2,200 of the points. H&rblock online Dan prepaid his mortgage in full in 2013. H&rblock online He can deduct the remaining $800 of points in 2013. H&rblock online Limits on deduction. H&rblock online   You cannot fully deduct points paid on a mortgage that exceeds the limits discussed in Part II . H&rblock online See the Table 1 Instructions for line 10. H&rblock online Form 1098. H&rblock online    The mortgage interest statement you receive should show not only the total interest paid during the year, but also your deductible points paid during the year. H&rblock online See Form 1098, Mortgage Interest Statement , later. H&rblock online Mortgage Insurance Premiums You can treat amounts you paid during 2013 for qualified mortgage insurance as home mortgage interest. H&rblock online The insurance must be in connection with home acquisition debt, and the insurance contract must have been issued after 2006. H&rblock online Qualified mortgage insurance. H&rblock online   Qualified mortgage insurance is mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing Administration, or the Rural Housing Service, and private mortgage insurance (as defined in section 2 of the Homeowners Protection Act of 1998 as in effect on December 20, 2006). H&rblock online   Mortgage insurance provided by the Department of Veterans Affairs is commonly known as a funding fee. H&rblock online If provided by the Rural Housing Service, it is commonly known as a guarantee fee. H&rblock online The funding fee and guarantee fee can either be included in the amount of the loan or paid in full at the time of closing. H&rblock online These fees can be deducted fully in 2013 if the mortgage insurance contract was issued in 2013. H&rblock online Contact the mortgage insurance issuer to determine the deductible amount if it is not reported in box 4 of Form 1098. H&rblock online Special rules for prepaid mortgage insurance. H&rblock online   Generally, if you paid premiums for qualified mortgage insurance that are properly allocable to periods after the close of the tax year, such premiums are treated as paid in the period to which they are allocated. H&rblock online You must allocate the premiums over the shorter of the stated term of the mortgage or 84 months, beginning with the month the insurance was obtained. H&rblock online No deduction is allowed for the unamortized balance if the mortgage is satisfied before its term. H&rblock online This paragraph does not apply to qualified mortgage insurance provided by the Department of Veterans Affairs or the Rural Housing Service. H&rblock online Example. H&rblock online Ryan purchased a home in May of 2012 and financed the home with a 15-year mortgage. H&rblock online Ryan also prepaid all of the $9,240 in private mortgage insurance required at the time of closing in May. H&rblock online Since the $9,240 in private mortgage insurance is allocable to periods after 2012, Ryan must allocate the $9,240 over the shorter of the life of the mortgage or 84 months. H&rblock online Ryan's adjusted gross income (AGI) for 2012 is $76,000. H&rblock online Ryan can deduct $880 ($9,240 ÷ 84 x 8 months) for qualified mortgage insurance premiums in 2012. H&rblock online For 2013, Ryan can deduct $1,320 ($9,240 ÷ 84 x 12 months) if his AGI is $100,000 or less. H&rblock online In this example, the mortgage insurance premiums are allocated over 84 months, which is shorter than the life of the mortgage of 15 years (180 months). H&rblock online Limit on deduction. H&rblock online   If your adjusted gross income on Form 1040, line 38, is more than $100,000 ($50,000 if your filing status is married filing separately), the amount of your mortgage insurance premiums that are otherwise deductible is reduced and may be eliminated. H&rblock online See Line 13 in the instructions for Schedule A (Form 1040) and complete the Mortgage Insurance Premiums Deduction Worksheet to figure the amount you can deduct. H&rblock online If your adjusted gross income is more than $109,000 ($54,500 if married filing separately), you cannot deduct your mortgage insurance premiums. H&rblock online Form 1098. H&rblock online   The mortgage interest statement you receive should show not only the total interest paid during the year, but also your mortgage insurance premiums paid during the year, which may qualify to be treated as deductible mortgage interest. H&rblock online See Form 1098, Mortgage Interest Statement, next. H&rblock online Form 1098, Mortgage Interest Statement If you paid $600 or more of mortgage interest (including certain points and mortgage insurance premiums) during the year on any one mortgage, you generally will receive a Form 1098 or a similar statement from the mortgage holder. H&rblock online You will receive the statement if you pay interest to a person (including a financial institution or cooperative housing corporation) in the course of that person's trade or business. H&rblock online A governmental unit is a person for purposes of furnishing the statement. H&rblock online The statement for each year should be sent to you by January 31 of the following year. H&rblock online A copy of this form will also be sent to the IRS. H&rblock online The statement will show the total interest you paid during the year, any mortgage insurance premiums you paid, and if you purchased a main home during the year, it also will show the deductible points paid during the year, including seller-paid points. H&rblock online However, it should not show any interest that was paid for you by a government agency. H&rblock online As a general rule, Form 1098 will include only points that you can fully deduct in the year paid. H&rblock online However, certain points not included on Form 1098 also may be deductible, either in the year paid or over the life of the loan. H&rblock online See the earlier discussion of Points to determine whether you can deduct points not shown on Form 1098. H&rblock online Prepaid interest on Form 1098. H&rblock online   If you prepaid interest in 2013 that accrued in full by January 15, 2014, this prepaid interest may be included in box 1 of Form 1098. H&rblock online However, you cannot deduct the prepaid amount for January 2014 in 2013. H&rblock online (See Prepaid interest , earlier. H&rblock online ) You will have to figure the interest that accrued for 2014 and subtract it from the amount in box 1. H&rblock online You will include the interest for January 2014 with other interest you pay for 2014. H&rblock online Refunded interest. H&rblock online   If you received a refund of mortgage interest you overpaid in an earlier year, you generally will receive a Form 1098 showing the refund in box 3. H&rblock online See Refunds of interest , earlier. H&rblock online Mortgage insurance premiums. H&rblock online   The amount of mortgage insurance premiums you paid during 2013 may be shown in Box 4 of Form 1098. H&rblock online See Mortgage Insurance Premiums , earlier. H&rblock online How To Report Deduct the home mortgage interest and points reported to you on Form 1098 on Schedule A (Form 1040), line 10. H&rblock online If you paid more deductible interest to the financial institution than the amount shown on Form 1098, show the larger deductible amount on line 10. H&rblock online Attach a statement explaining the difference and print “See attached” next to line 10. H&rblock online Deduct home mortgage interest that was not reported to you on Form 1098 on Schedule A (Form 1040), line 11. H&rblock online If you paid home mortgage interest to the person from whom you bought your home, show that person's name, address, and taxpayer identification number (TIN) on the dotted lines next to line 11. H&rblock online The seller must give you this number and you must give the seller your TIN. H&rblock online A Form W-9, Request for Taxpayer Identification Number and Certification, can be used for this purpose. H&rblock online Failure to meet any of these requirements may result in a $50 penalty for each failure. H&rblock online The TIN can be either a social security number, an individual taxpayer identification number (issued by the Internal Revenue Service), or an employer identification number. H&rblock online If you can take a deduction for points that were not reported to you on Form 1098, deduct those points on Schedule A (Form 1040), line 12. H&rblock online Deduct mortgage insurance premiums on Schedule A (Form 1040), line 13. H&rblock online More than one borrower. H&rblock online   If you and at least one other person (other than your spouse if you file a joint return) were liable for and paid interest on a mortgage that was for your home, and the other person received a Form 1098 showing the interest that was paid during the year, attach a statement to your return explaining this. H&rblock online Show how much of the interest each of you paid, and give the name and address of the person who received the form. H&rblock online Deduct your share of the interest on Schedule A (Form 1040), line 11, and print “See attached” next to the line. H&rblock online Also, deduct your share of any qualified mortgage insurance premiums on Schedule A (Form 1040), line 13. H&rblock online   Similarly, if you are the payer of record on a mortgage on which there are other borrowers entitled to a deduction for the interest shown on the Form 1098 you received, deduct only your share of the interest on Schedule A (Form 1040), line 10. H&rblock online Let each of the other borrowers know what his or her share is. H&rblock online Mortgage proceeds used for business or investment. H&rblock online   If your home mortgage interest deduction is limited under the rules explained in Part II , but all or part of the mortgage proceeds were used for business, investment, or other deductible activities, see Table 2 near the end of this publication. H&rblock online It shows where to deduct the part of your excess interest that is for those activities. H&rblock online The Table 1 Instructions for line 13 in Part II explain how to divide the excess interest among the activities for which the mortgage proceeds were used. H&rblock online Special Rule for Tenant-Stockholders in Cooperative Housing Corporations A qualified home includes stock in a cooperative housing corporation owned by a tenant-stockholder. H&rblock online This applies only if the tenant-stockholder is entitled to live in the house or apartment because of owning stock in the cooperative. H&rblock online Cooperative housing corporation. H&rblock online   This is a corporation that meets all of the following conditions. H&rblock online Has only one class of stock outstanding, Has no stockholders other than those who own the stock that can live in a house, apartment, or house trailer owned or leased by the corporation, Has no stockholders who can receive any distribution out of capital other than on a liquidation of the corporation, and Meets at least one of the following requirements. H&rblock online Receives at least 80% of its gross income for the year in which the mortgage interest is paid or incurred from tenant-stockholders. H&rblock online For this purpose, gross income is all income received during the entire year, including amounts received before the corporation changed to cooperative ownership. H&rblock online At all times during the year, at least 80% of the total square footage of the corporation's property is used or available for use by the tenant-stockholders for residential or residential-related use. H&rblock online At least 90% of the corporation's expenditures paid or incurred during the year are for the acquisition, construction, management, maintenance, or care of corporate property for the benefit of the tenant-stockholders. H&rblock online Stock used to secure debt. H&rblock online   In some cases, you cannot use your cooperative housing stock to secure a debt because of either: Restrictions under local or state law, or Restrictions in the cooperative agreement (other than restrictions in which the main purpose is to permit the tenant- stockholder to treat unsecured debt as secured debt). H&rblock online However, you can treat a debt as secured by the stock to the extent that the proceeds are used to buy the stock under the allocation of interest rules. H&rblock online See chapter 4 of Publication 535 for details on these rules. H&rblock online Figuring deductible home mortgage interest. H&rblock online   Generally, if you are a tenant-stockholder, you can deduct payments you make for your share of the interest paid or incurred by the cooperative. H&rblock online The interest must be on a debt to buy, build, change, improve, or maintain the cooperative's housing, or on a debt to buy the land. H&rblock online   Figure your share of this interest by multiplying the total by the following fraction. H&rblock online      Your shares of stock in the cooperative   The total shares of stock in the cooperative Limits on deduction. H&rblock online   To figure how the limits discussed in Part II apply to you, treat your share of the cooperative's debt as debt incurred by you. H&rblock online The cooperative should determine your share of its grandfathered debt, its home acquisition debt, and its home equity debt. H&rblock online (Your share of each of these types of debt is equal to the average balance of each debt multiplied by the fraction just given. H&rblock online ) After your share of the average balance of each type of debt is determined, you include it with the average balance of that type of debt secured by your stock. H&rblock online Form 1098. H&rblock online    The cooperative should give you a Form 1098 showing your share of the interest. H&rblock online Use the rules in this publication to determine your deductible mortgage interest. H&rblock online Part II. H&rblock online Limits on Home Mortgage Interest Deduction This part of the publication discusses the limits on deductible home mortgage interest. H&rblock online These limits apply to your home mortgage interest expense if you have a home mortgage that does not fit into any of the three categories listed at the beginning of Part I under Fully deductible interest . H&rblock online Your home mortgage interest deduction is limited to the interest on the part of your home mortgage debt that is not more than your qualified loan limit. H&rblock online This is the part of your home mortgage debt that is grandfathered debt or that is not more than the limits for home acquisition debt and home equity debt. H&rblock online Table 1 can help you figure your qualified loan limit and your deductible home mortgage interest. H&rblock online Home Acquisition Debt Home acquisition debt is a mortgage you took out after October 13, 1987, to buy, build, or substantially improve a qualified home (your main or second home). H&rblock online It also must be secured by that home. H&rblock online If the amount of your mortgage is more than the cost of the home plus the cost of any substantial improvements, only the debt that is not more than the cost of the home plus improvements qualifies as home acquisition debt. H&rblock online The additional debt may qualify as home equity debt (discussed later). H&rblock online Home acquisition debt limit. H&rblock online   The total amount you can treat as home acquisition debt at any time on your main home and second home cannot be more than $1 million ($500,000 if married filing separately). H&rblock online This limit is reduced (but not below zero) by the amount of your grandfathered debt (discussed later). H&rblock online Debt over this limit may qualify as home equity debt (also discussed later). H&rblock online Refinanced home acquisition debt. H&rblock online   Any secured debt you use to refinance home acquisition debt is treated as home acquisition debt. H&rblock online However, the new debt will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing. H&rblock online Any additional debt not used to buy, build, or substantially improve a qualified home is not home acquisition debt, but may qualify as home equity debt (discussed later). H&rblock online Mortgage that qualifies later. H&rblock online   A mortgage that does not qualify as home acquisition debt because it does not meet all the requirements may qualify at a later time. H&rblock online For example, a debt that you use to buy your home may not qualify as home acquisition debt because it is not secured by the home. H&rblock online However, if the debt is later secured by the home, it may qualify as home acquisition debt after that time. H&rblock online Similarly, a debt that you use to buy property may not qualify because the property is not a qualified home. H&rblock online However, if the property later becomes a qualified home, the debt may qualify after that time. H&rblock online Mortgage treated as used to buy, build, or improve home. H&rblock online   A mortgage secured by a qualified home may be treated as home acquisition debt, even if you do not actually use the proceeds to buy, build, or substantially improve the home. H&rblock online This applies in the following situations. H&rblock online You buy your home within 90 days before or after the date you take out the mortgage. H&rblock online The home acquisition debt is limited to the home's cost, plus the cost of any substantial improvements within the limit described below in (2) or (3). H&rblock online (See Example 1 later. H&rblock online ) You build or improve your home and take out the mortgage before the work is completed. H&rblock online The home acquisition debt is limited to the amount of the expenses incurred within 24 months before the date of the mortgage. H&rblock online You build or improve your home and take out the mortgage within 90 days after the work is completed. H&rblock online The home acquisition debt is limited to the amount of the expenses incurred within the period beginning 24 months before the work is completed and ending on the date of the mortgage. H&rblock online (See Example 2 later. H&rblock online ) Example 1. H&rblock online You bought your main home on June 3 for $175,000. H&rblock online You paid for the home with cash you got from the sale of your old home. H&rblock online On July 15, you took out a mortgage of $150,000 secured by your main home. H&rblock online You used the $150,000 to invest in stocks. H&rblock online You can treat the mortgage as taken out to buy your home because you bought the home within 90 days before you took out the mortgage. H&rblock online The entire mortgage qualifies as home acquisition debt because it was not more than the home's cost. H&rblock online Example 2. H&rblock online On January 31, John began building a home on the lot that he owned. H&rblock online He used $45,000 of his personal funds to build the home. H&rblock online The home was completed on October 31. H&rblock online On November 21, John took out a $36,000 mortgage that was secured by the home. H&rblock online The mortgage can be treated as used to build the home because it was taken out within 90 days after the home was completed. H&rblock online The entire mortgage qualifies as home acquisition debt because it was not more than the expenses incurred within the period beginning 24 months before the home was completed. H&rblock online This is illustrated by Figure C. H&rblock online   Please click here for the text description of the image. H&rblock online Figure C. H&rblock online John's example Date of the mortgage. H&rblock online   The date you take out your mortgage is the day the loan proceeds are disbursed. H&rblock online This is generally the closing date. H&rblock online You can treat the day you apply in writing for your mortgage as the date you take it out. H&rblock online However, this applies only if you receive the loan proceeds within a reasonable time (such as within 30 days) after your application is approved. H&rblock online If a timely application you make is rejected, a reasonable additional time will be allowed to make a new application. H&rblock online Cost of home or improvements. H&rblock online   To determine your cost, include amounts paid to acquire any interest in a qualified home or to substantially improve the home. H&rblock online   The cost of building or substantially improving a qualified home includes the costs to acquire real property and building materials, fees for architects and design plans, and required building permits. H&rblock online Substantial improvement. H&rblock online   An improvement is substantial if it: Adds to the value of your home, Prolongs your home's useful life, or Adapts your home to new uses. H&rblock online    Repairs that maintain your home in good condition, such as repainting your home, are not substantial improvements. H&rblock online However, if you paint your home as part of a renovation that substantially improves your qualified home, you can include the painting costs in the cost of the improvements. H&rblock online Acquiring an interest in a home because of a divorce. H&rblock online   If you incur debt to acquire the interest of a spouse or former spouse in a home, because of a divorce or legal separation, you can treat that debt as home acquisition debt. H&rblock online Part of home not a qualified home. H&rblock online    To figure your home acquisition debt, you must divide the cost of your home and improvements between the part of your home that is a qualified home and any part that is not a qualified home. H&rblock online See Divided use of your home under Qualified Home in Part I. H&rblock online Home Equity Debt If you took out a loan for reasons other than to buy, build, or substantially improve your home, it may qualify as home equity debt. H&rblock online In addition, debt you incurred to buy, build, or substantially improve your home, to the extent it is more than the home acquisition debt limit (discussed earlier), may qualify as home equity debt. H&rblock online Home equity debt is a mortgage you took out after October 13, 1987, that: Does not qualify as home acquisition debt or as grandfathered debt, and Is secured by your qualified home. H&rblock online Example. H&rblock online You bought your home for cash 10 years ago. H&rblock online You did not have a mortgage on your home until last year, when you took out a $50,000 loan, secured by your home, to pay for your daughter's college tuition and your father's medical bills. H&rblock online This loan is home equity debt. H&rblock online Home equity debt limit. H&rblock online   There is a limit on the amount of debt that can be treated as home equity debt. H&rblock online The total home equity debt on your main home and second home is limited to the smaller of: $100,000 ($50,000 if married filing separately), or The total of each home's fair market value (FMV) reduced (but not below zero) by the amount of its home acquisition debt and grandfathered debt. H&rblock online Determine the FMV and the outstanding home acquisition and grandfathered debt for each home on the date that the last debt was secured by the home. H&rblock online Example. H&rblock online You own one home that you bought in 2000. H&rblock online Its FMV now is $110,000, and the current balance on your original mortgage (home acquisition debt) is $95,000. H&rblock online Bank M offers you a home mortgage loan of 125% of the FMV of the home less any outstanding mortgages or other liens. H&rblock online To consolidate some of your other debts, you take out a $42,500 home mortgage loan [(125% × $110,000) − $95,000] with Bank M. H&rblock online Your home equity debt is limited to $15,000. H&rblock online This is the smaller of: $100,000, the maximum limit, or $15,000, the amount that the FMV of $110,000 exceeds the amount of home acquisition debt of $95,000. H&rblock online Debt higher than limit. H&rblock online   Interest on amounts over the home equity debt limit (such as the interest on $27,500 [$42,500 − $15,000] in the preceding example) generally is treated as personal interest and is not deductible. H&rblock online But if the proceeds of the loan were used for investment, business, or other deductible purposes, the interest may be deductible. H&rblock online If it is, see the Table 1 Instructions for line 13 for an explanation of how to allocate the excess interest. H&rblock online Part of home not a qualified home. H&rblock online   To figure the limit on your home equity debt, you must divide the FMV of your home between the part that is a qualified home and any part that is not a qualified home. H&rblock online See Divided use of your home under Qualified Home in Part I. H&rblock online Fair market value (FMV). H&rblock online    This is the price at which the home would change hands between you and a buyer, neither having to sell or buy, and both having reasonable knowledge of all relevant facts. H&rblock online Sales of similar homes in your area, on about the same date your last debt was secured by the home, may be helpful in figuring the FMV. H&rblock online Grandfathered Debt If you took out a mortgage on your home before October 14, 1987, or you refinanced such a mortgage, it may qualify as grandfathered debt. H&rblock online To qualify, it must have been secured by your qualified home on October 13, 1987, and at all times after that date. H&rblock online How you used the proceeds does not matter. H&rblock online Grandfathered debt is not limited. H&rblock online All of the interest you paid on grandfathered debt is fully deductible home mortgage interest. H&rblock online However, the amount of your grandfathered debt reduces the $1 million limit for home acquisition debt and the limit based on your home's fair market value for home equity debt. H&rblock online Refinanced grandfathered debt. H&rblock online   If you refinanced grandfathered debt after October 13, 1987, for an amount that was not more than the mortgage principal left on the debt, then you still treat it as grandfathered debt. H&rblock online To the extent the new debt is more than that mortgage principal, it is treated as home acquisition or home equity debt, and the mortgage is a mixed-use mortgage (discussed later under Average Mortgage Balance in the Table 1 instructions). H&rblock online The debt must be secured by the qualified home. H&rblock online   You treat grandfathered debt that was refinanced after October 13, 1987, as grandfathered debt only for the term left on the debt that was refinanced. H&rblock online After that, you treat it as home acquisition debt or home equity debt, depending on how you used the proceeds. H&rblock online Exception. H&rblock online   If the debt before refinancing was like a balloon note (the principal on the debt was not amortized over the term of the debt), then you treat the refinanced debt as grandfathered debt for the term of the first refinancing. H&rblock online This term cannot be more than 30 years. H&rblock online Example. H&rblock online Chester took out a $200,000 first mortgage on his home in 1986. H&rblock online The mortgage was a five-year balloon note and the entire balance on the note was due in 1991. H&rblock online Chester refinanced the debt in 1991 with a new 20-year mortgage. H&rblock online The refinanced debt is treated as grandfathered debt for its entire term (20 years). H&rblock online Line-of-credit mortgage. H&rblock online    If you had a line-of-credit mortgage on October 13, 1987, and borrowed additional amounts against it after that date, then the additional amounts are either home acquisition debt or home equity debt depending on how you used the proceeds. H&rblock online The balance on the mortgage before you borrowed the additional amounts is grandfathered debt. H&rblock online The newly borrowed amounts are not grandfathered debt because the funds were borrowed after October 13, 1987. H&rblock online See Average Mortgage Balance in the Table 1 Instructions that follow. H&rblock online Table 1 Instructions Unless you are subject to the overall limit on itemized deductions, you can deduct all of the interest you paid during the year on mortgages secured by your main home or second home in either of the following two situations. H&rblock online All the mortgages are grandfathered debt. H&rblock online The total of the mortgage balances for the entire year is within the limits discussed earlier under Home Acquisition Debt and Home Equity Debt . H&rblock online In either of those cases, you do not need Table 1. H&rblock online Otherwise, you can use Table 1 to determine your qualified loan limit and deductible home mortgage interest. H&rblock online Fill out only one Table 1 for both your main and second home regardless of how many mortgages you have. H&rblock online Table 1. H&rblock online Worksheet To Figure Your Qualified Loan Limit and Deductible Home Mortgage Interest For the Current Year See the Table 1 Instructions. H&rblock online Part I Qualified Loan Limit 1. H&rblock online Enter the average balance of all your grandfathered debt. H&rblock online See line 1 instructions 1. H&rblock online   2. H&rblock online Enter the average balance of all your home acquisition debt. H&rblock online See line 2 instructions 2. H&rblock online   3. H&rblock online Enter $1,000,000 ($500,000 if married filing separately) 3. H&rblock online   4. H&rblock online Enter the larger of the amount on line 1 or the amount on line 3 4. H&rblock online   5. H&rblock online Add the amounts on lines 1 and 2. H&rblock online Enter the total here 5. H&rblock online   6. H&rblock online Enter the smaller of the amount on line 4 or the amount on line 5 6. H&rblock online   7. H&rblock online If you have home equity debt, enter the smaller of $100,000 ($50,000 if married filing separately) or your limited amount. H&rblock online See the line 7 instructions for the limit which may apply to you. H&rblock online 7. H&rblock online   8. H&rblock online Add the amounts on lines 6 and 7. H&rblock online Enter the total. H&rblock online This is your qualified loan limit. H&rblock online 8. H&rblock online   Part II Deductible Home Mortgage Interest 9. H&rblock online Enter the total of the average balances of all mortgages on all qualified homes. H&rblock online  See line 9 instructions 9. H&rblock online     If line 8 is less than line 9, go on to line 10. H&rblock online If line 8 is equal to or more than line 9, stop here. H&rblock online All of your interest on all the mortgages included on line 9 is deductible as home mortgage interest on Schedule A (Form 1040). H&rblock online     10. H&rblock online Enter the total amount of interest that you paid. H&rblock online See line 10 instructions 10. H&rblock online   11. H&rblock online Divide the amount on line 8 by the amount on line 9. H&rblock online Enter the result as a decimal amount (rounded to three places) 11. H&rblock online × . H&rblock online 12. H&rblock online Multiply the amount on line 10 by the decimal amount on line 11. H&rblock online Enter the result. H&rblock online This is your deductible home mortgage interest. H&rblock online Enter this amount on Schedule A (Form 1040) 12. H&rblock online   13. H&rblock online Subtract the amount on line 12 from the amount on line 10. H&rblock online Enter the result. H&rblock online This is not home mortgage interest. H&rblock online See line 13 instructions 13. H&rblock online   Home equity debt only. H&rblock online   If all of your mortgages are home equity debt, do not fill in lines 1 through 5. H&rblock online Enter zero on line 6 and complete the rest of Table 1. H&rblock online Average Mortgage Balance You have to figure the average balance of each mortgage to determine your qualified loan limit. H&rblock online You need these amounts to complete lines 1, 2, and 9 of Table 1. H&rblock online You can use the highest mortgage balances during the year, but you may benefit most by using the average balances. H&rblock online The following are methods you can use to figure your average mortgage balances. H&rblock online However, if a mortgage has more than one category of debt, see Mixed-use mortgages , later, in this section. H&rblock online Average of first and last balance method. H&rblock online   You can use this method if all the following apply. H&rblock online You did not borrow any new amounts on the mortgage during the year. H&rblock online (This does not include borrowing the original mortgage amount. H&rblock online ) You did not prepay more than one month's principal during the year. H&rblock online (This includes prepayment by refinancing your home or by applying proceeds from its sale. H&rblock online ) You had to make level payments at fixed equal intervals on at least a semi-annual basis. H&rblock online You treat your payments as level even if they were adjusted from time to time because of changes in the interest rate. H&rblock online    To figure your average balance, complete the following worksheet. H&rblock online    1. H&rblock online Enter the balance as of the first day of the year that the mortgage was secured by your qualified home during the year (generally January 1)   2. H&rblock online Enter the balance as of the last day of the year that the mortgage was secured by your qualified home during the year (generally December 31)   3. H&rblock online Add amounts on lines 1 and 2   4. H&rblock online Divide the amount on line 3 by 2. H&rblock online Enter the result   Interest paid divided by interest rate method. H&rblock online   You can use this method if at all times in 2013 the mortgage was secured by your qualified home and the interest was paid at least monthly. H&rblock online    Complete the following worksheet to figure your average balance. H&rblock online    1. H&rblock online Enter the interest paid in 2013. H&rblock online Do not include points, mortgage insurance premiums, or any interest paid in 2013 that is for a year after 2013. H&rblock online However, do include interest that is for 2013 but was paid in an earlier year   2. H&rblock online Enter the annual interest rate on the mortgage. H&rblock online If the interest rate varied in 2013, use the lowest rate for the year   3. H&rblock online Divide the amount on line 1 by the amount on line 2. H&rblock online Enter the result   Example. H&rblock online Mr. H&rblock online Blue had a line of credit secured by his main home all year. H&rblock online He paid interest of $2,500 on this loan. H&rblock online The interest rate on the loan was 9% (. H&rblock online 09) all year. H&rblock online His average balance using this method is $27,778, figured as follows. H&rblock online 1. H&rblock online Enter the interest paid in 2013. H&rblock online Do not include points, mortgage insurance premiums, or any interest paid in 2013 that is for a year after 2013. H&rblock online However, do include interest that is for 2013 but was paid in an earlier year $2,500 2. H&rblock online Enter the annual interest rate on the mortgage. H&rblock online If the interest rate varied in 2013, use the lowest rate for the year . H&rblock online 09 3. H&rblock online Divide the amount on line 1 by the amount on line 2. H&rblock online Enter the result $27,778 Statements provided by your lender. H&rblock online   If you receive monthly statements showing the closing balance or the average balance for the month, you can use either to figure your average balance for the year. H&rblock online You can treat the balance as zero for any month the mortgage was not secured by your qualified home. H&rblock online   For each mortgage, figure your average balance by adding your monthly closing or average balances and dividing that total by the number of months the home secured by that mortgage was a qualified home during the year. H&rblock online   If your lender can give you your average balance for the year, you can use that amount. H&rblock online Example. H&rblock online Ms. H&rblock online Brown had a home equity loan secured by her main home all year. H&rblock online She received monthly statements showing her average balance for each month. H&rblock online She can figure her average balance for the year by adding her monthly average balances and dividing the total by 12. H&rblock online Mixed-use mortgages. H&rblock online   A mixed-use mortgage is a loan that consists of more than one of the three categories of debt (grandfathered debt, home acquisition debt, and home equity debt). H&rblock online For example, a mortgage you took out during the year is a mixed-use mortgage if you used its proceeds partly to refinance a mortgage that you took out in an earlier year to buy your home (home acquisition debt) and partly to buy a car (home equity debt). H&rblock online   Complete lines 1 and 2 of Table 1 by including the separate average balances of any grandfathered debt and home acquisition debt in your mixed-use mortgage. H&rblock online Do not use the methods described earlier in this section to figure the average balance of either category. H&rblock online Instead, for each category, use the following method. H&rblock online Figure the balance of that category of debt for each month. H&rblock online This is the amount of the loan proceeds allocated to that category, reduced by your principal payments on the mortgage previously applied to that category. H&rblock online Principal payments on a mixed-use mortgage are applied in full to each category of debt, until its balance is zero, in the following order: First, any home equity debt, Next, any grandfathered debt, and Finally, any home acquisition debt. H&rblock online Add together the monthly balances figured in (1). H&rblock online Divide the result in (2) by 12. H&rblock online   Complete line 9 of Table 1 by including the average balance of the entire mixed-use mortgage, figured under one of the methods described earlier in this section. H&rblock online Example 1. H&rblock online In 1986, Sharon took out a $1,400,000 mortgage to buy her main home (grandfathered debt). H&rblock online On March 2, 2013, when the home had a fair market value of $1,700,000 and she owed $1,100,000 on the mortgage, Sharon took out a second mortgage for $200,000. H&rblock online She used $180,000 of the proceeds to make substantial improvements to her home (home acquisition debt) and the remaining $20,000 to buy a car (home equity debt). H&rblock online Under the loan agreement, Sharon must make principal payments of $1,000 at the end of each month. H&rblock online During 2013, her principal payments on the second mortgage totaled $10,000. H&rblock online To complete Table 1, line 2, Sharon must figure a separate average balance for the part of her second mortgage that is home acquisition debt. H&rblock online The January and February balances were zero. H&rblock online The March through December balances were all $180,000, because none of her principal payments are applied to the home acquisition debt. H&rblock online (They are all applied to the home equity debt, reducing it to $10,000 [$20,000 − $10,000]. H&rblock online ) The monthly balances of the home acquisition debt total $1,800,000 ($180,000 × 10). H&rblock online Therefore, the average balance of the home acquisition debt for 2013 was $150,000 ($1,800,000 ÷ 12). H&rblock online Example 2. H&rblock online The facts are the same as in Example 1. H&rblock online In 2014, Sharon's January through October principal payments on her second mortgage are applied to the home equity debt, reducing it to zero. H&rblock online The balance of the home acquisition debt remains $180,000 for each of those months. H&rblock online Because her November and December principal payments are applied to the home acquisition debt, the November balance is $179,000 ($180,000 − $1,000) and the December balance is $178,000 ($180,000 − $2,000). H&rblock online The monthly balances total $2,157,000 [($180,000 × 10) + $179,000 + $178,000]. H&rblock online Therefore, the average balance of the home acquisition debt for 2014 is $179,750 ($2,157,000 ÷ 12). H&rblock online L