IRS Agent Trying To Apportion Mortgage Interest?

If the land is adjacent to land owned that your home is on, it should all be considered as part of the home for tax purposes. For example my home is on a double lot with all of the improvements grouped onto one lot for property taxes. But it is all on one loan and that loan is deductible.

If it is all one piece of undivided land, there should be no question. Where does anything in tax regulations give a limit to how much land around a home is limited for interest deduction?

An indication that adjoining land is part of the home for income tax purposes is that if you do not use up the captial gains exclusion ($250,000 or $500,000 married jointly) when selling your main home, you can use the remaining exclusion for adjoining property sold within 2 years before or after sale of the home. See http://www.irs.gov/publications/p523/ar02.html#en_... in IRS Publication 523.

If the land is deemed separate and held for investment, then the interest is postponed via form 4952 unless/until you have enuogh income to deduct it.

The real problem I see if the land is deemed an investment is that when you sell, no part of the gain is eligible for the section 121 exclusion.

Sounds like your total property may be divided into two or more parcels with only one having the improvements. That would be a valid reason.

If it is your home and one property, or one lot, this is not common behavior.

If your mortgage is on the property as a whole, it is generally not apportioned. IF this is rental property, that's a different kettle of fish.