In Revenue Ruling 2010-25, the IRS issued a taxpayer friendly interpretation of the rules permitting an income tax deduction for certain home mortgage interest. The Internal Revenue Code permits a deduction for interest on two kinds of debt incurred in connection with a home. First, interest can be deducted on up to $1,000,000 of debt incurred to acquire, construct or substantially improve the taxpayer’s principal residence and one other residence. Second, the Code also permits a taxpayer to deduct interest on up to $100,000 of home equity indebtedness. This is any debt other than acquisition indebtedness that is secured by the residence.

Previously, in Pau v. Commissioner, the Tax Court had held that if a taxpayer incurred debt of $1,100,000 (or more) to purchase his home, he could only deduct interest on $1,000,000. The extra $100,000 did not qualify as home equity indebtedness because it was incurred to acquire the home and thereby excluded from the definition of home equity indebtedness.

The IRS has now decided that the Tax Court’s interpretation was too restrictive. It has stated that no debt in excess of the permitted $1,000,000 is treated as “acquisition indebtedness.” This means that the first $100,000 of additional debt can be home equity indebtedness, even if incurred to purchase the home. The bottom line of Revenue Ruling 2010-25 is that you can deduct interest on the first $1,100,000 of debt you incur to purchase a home.