The IRS today ruled that indebtedness in excess of $1 million incurred to acquire, construct, or substantially improve a qualified residence may constitute home equity indebtedness within the meaning of § 163(h)(3)(C). Rev. Rul. 2010-25, 2010-44 I.R.B. ___ (Nov. 1, 2010). In the ruling, a taxpayer who purchased a $1.5 million home with $300,000 cash and a $1.2 million mortgage loan could deduct interest on $1.1 million of the loan – $1 million as acquisition indebtedness under § 163(h)(3)(B) and $100,000 as home equity indebtedness under § 163(h)(3)(C). The IRS stated that it would not follow Pau v. Commissioner, T.C. Memo. 1997-43; andCatalano v. Commissioner, T.C. Memo. 2000-82:

The holding in Pau was based on the incorrect assertion that taxpayers must demonstrate that debt treated as home equity indebtedness “was not incurred in acquiring, constructing or substantially improving their residence.” The definition of home equity indebtedness in § 163(h)(3)(C) contains no such restrictions, and accordingly the Service will determine home equity indebtedness consistent with the provisions of this revenue ruling, notwithstanding the decisions in Pau and Catalano