On January 1 of year 1, Arthur and Aretha Franklin purchased a home for $1.5 million by paying $200,000 down and borrowing the remaining $1.3 million with a 7 percent loan secured by the home.

a. What is the amount of the interest expense the Franklins may deduct in year 1?
b. Assume that in year 2, the Franklins pay off the entire loan but at the beginning of year 3, they borrow $300,000 secured by the home at a 7 percent rate. They make interest-only payments on the loan during the year. What amount of
interest expense may the Franklins deduct in year 3 on this loan (the Franklins do not use the loan proceeds to improve the home)?

c. Assume the same facts as in (b), except that the Franklins borrow $80,000 secured by their home. What amount of interest expense may the Franklins deduct in year 3 on this loan (the Franklins do not use the loan proceeds to improve the home)?

this will depend on the total interest paid during the year, since we are not told how long their mortgage is, we cannot know exactly how much interest expense they will pay. Generally mortgages require monthly payments, so I prepared a simulated amortization schedule for the first year assuming that the mortgage lasts 30 years and a monthly payment of $8,648.93.

year beg. scheduled principal interest ending

balance payment balance

1 1300000 8649 1066 7583 1298934

2 1298934 8649 1072 7577 1297863

3 1297863 8649 1078 7571 1296785

4 1296785 8649 1084 7565 1295700

5 1295700 8649 1091 7558 1294609

6 1294609 8649 1097 7552 1293512

7 1293512 8649 1103 7545 1292409

8 1292409 8649 1110 7539 1291299

9 1291299 8649 1116 7533 1290183

10 1290183 8649 1123 7526 1289060

11 1289060 8649 1129 7520 1287931

12 1287931 8649 1136 7513 1286795

total interest $90,582

The total interest that can be deducted in this case would be $90,582 during year 1.

b. Assume that in year 2, the Franklins pay off the entire loan but at the beginning of year 3, they borrow $300,000 secured by the home at a 7 percent rate. They make interest-only payments on the loan during the year. What amount of interest expense may the Franklins deduct in year 3 on this loan (the Franklins do not use the loan proceeds to improve the home)?

$0, interests from home equity loans used for personal expenses are not deductible.

c. Assume the same facts as in (b), except that the Franklins borrow $80,000 secured by their home. What amount of interest expense may the Franklins deduct in year 3 on this loan (the Franklins do not use the loan proceeds to improve the home)?

$0, interests from home equity loans used for personal expenses are not deductible.

Explanation: