If you were one of the eager buyers during the housing boom who purchased with a “no income verification” mortgage, or if you tapped cash when lenders let you use your home as an ATM, you’re lucky if you have been able to stretch your budget to meet mortgage payments.

Now, if you plan to deduct mortgage interest that seems too large for your income, the IRS may come calling to find out just how you’ve pulled it off.

Last August, the Treasury Inspector General for Tax Administration, or TIGTA, released a study showing that Form 1098, which details the total amount of mortgage interest paid in a tax year and is supplied by mortgage lenders to their individual customers and the IRS, could uncover many individuals who were either not reporting their full income or not filing an income tax return at all.

Common sense dictates that anyone who pays a certain amount of mortgage interest should also be reporting an income that’s large enough to support that payment, as well as other living expenses.

If you’re cheating on taxes, the 1098 could out you — if not this year, soon. The IRS has responded to the TIGTA memorandum saying it has formed a task force to study how mortgage interest can be used more fully in its enforcement efforts.

When the IRS audits an individual, they typically dig back a few years into records, says Benson Goldstein, senior technical manager at the American Institute of Certified Public Accountants, or AICPA.

Given the exotic mortgages prevalent earlier in this decade, it’s feasible that many taxpayers could be honestly filing their taxes, but they’re claiming interest deductions that seem too large for their income, adds Tom Ochsenschlager, vice president, AICPA.

Keep records

In an audit, says Goldstein, the IRS is going to examine the source of the money that supports the mortgage interest.

Goldstein says that there could be legitimate reasons taxpayers are reporting mortgage interest that appears too large for their income. If, for instance, you received help from your family — say an $8,000 check annually from your parents, keep documentation of that gift.

Deduct correctly

You could be paying lots of mortgage interest not just from buying with an exotic mortgage, because you took on a big “cash-out” refinance or equity loan.

“Many people are under the mistaken impression that any interest from any loan on their home is deductible, but it is not,” says William Lazor, partner with the accounting firm Kronick Kalada Berdy, Kingston, Pa.

If the loan isn’t for “acquisition,” meaning for the purchase of the home, deductibility is limited to interest charges on loan amounts to $100,000 — but deductibility is allowed on interest charges on debt in excess of $100,000 when the funds are used for home improvements, says Greg Rosica, partner with Ernst & Young, Tampa, Fla.

Making it even more confusing, the fair market value, or FMV, of your home also comes into play when figuring out allowable deductions.

The IRS offers this example in Publication 936: You own one home that you bought in 2000. Its FMV now is $110,000, and the current balance on your original mortgage is $95,000. Bank M offers you a home mortgage loan of 125 percent of the FMV of the home, less any outstanding mortgages or other liens. To consolidate some of your other debts, you take out a $42,500 home mortgage loan (125 percent x $110,000 equals $137,500, minus $95,000 gives you $42,500). But the interest is deductible only on $15,000 of that, because deductibility is limited to whichever is smaller: the $100,000 maximum limit or the amount the current FMV ($110,000) exceeds the amount of your original mortgage ($95,000).

If you are using funds for home improvements, keep receipts and other applicable records, adds Rosica.

Compare yourself

The IRS won’t provide any specifics as to when and how it will pursue audits, with spokesmen only saying that the agency has identified corrective actions to more effectively pursue potential nonfilers and under-reporters through mortgage data.

In his many years as a CPA, Lazor says he’s never seen an audit triggered by the IRS looking for minor infractions of home equity deductibility. It’s much more likely that the IRS will focus on finding nonfilers or finding individuals who grossly underreport their likely income, based upon what the 1098 shows.

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