Mortgage Interest
Posted on July 5, 2008
Filed Under Deductions, Federal Income Tax
Before the Tax Reform Act of 1986, interest was deductible regardless of the loan’s purpose. After the Tax Reform Act, with an important exception for home mortgage interest, only interest expenditures with a business purpose are deductible. In short, although home mortgage interest is a distinctly personal expense, Congress made an exception to the Tax Reform Act’s strict rule prohibiting deductions for personal interest expenses by maintaining in the Code an itemized deduction for interest on home acquisition or home equity loans secured by a qualified residence. A home is a qualified residence if it is (1) the taxpayer’s main home or (2) a second home used by the taxpayer or close relatives for more than the greater of 14 days or 10 percent of the number of days it is rented at fair market value, what I term as the “personal use vs. rental use test.” If the second residence is not used by taxpayer (or close relatives) or rented during the year, the personal use vs. rental use test does not apply and the second home is considered a qualified residence for tax purposes. Many prospective buyers worry that Congress may eliminate the second home mortgage interest deduction.
For mortgages taken out after October 13, 1987, acquisition indebtedness is defined as debt incurred to acquire, build, or substantially improve a qualified residence and secured by such residence. The mortgage interest deduction limit (pdf file) is interest paid on acquisition debt up to $1,000,000 ($500,000 for married filing separately). Moreover, for interest payments to qualify as a deductible expense, the indebtedness cannot exceed the lesser of the residence’s fair market value or the taxpayer’s adjusted basis in the residence; interest paid on borrowings against unrealized appreciation is not deductible. However, taxpayers with qualified residence debt over the $1,000,000 ceiling may consider converting a second home into a full-time rental property. Click on mortgage interest deduction rental property for more details.
Taxpayers with 2007 adjusted gross income over $156,400 ($78,200 for married filing separately) are subject to a mortgage interest deduction phase out. In addition, interest on home equity indebtedness is not allowed when figuring the alternative minimum tax unless the loan is used to buy, build, or substantially improve a qualified residence.
Home equity indebtedness is debt secured by a qualified residence that exceeds acquisition indebtedness. For interest to be deductible, home equity debt cannot exceed the lesser of (1) $100,000 ($50,000 for married filing separately) for qualified residences combined (i.e., main and second homes) or (2) the fair market value of the residence in question minus total acquisition debt outstanding on that home. Other than the general prohibition against using loans with deductible interest to purchase tax-free investments, home equity loans can be spent (or squandered) for any purpose.
A home refinancing loan to buy, build, or substantially improve a first or second residence is considered home acquisition debt with deductible interest payments provided it does not exceed the adjusted basis of the home (i.e., principal balance outstanding on the original acquisition debt immediately before refinancing plus any portion of the new loan used to improve the residence) or cause total acquisition debt to exceed $1 million. If a home refinancing loan is used for any other purpose, the excess of debt over the home’s adjusted basis is classified as home equity debt and deductible provided it doesn’t exceed the $100,000 maximum for all home equity indebtedness. And if the refinancing proceeds are used for mixed purposes, the combined $1,100,000 acquisition/equity limit applies. A summary and warning: once you pay off all or part of the original mortgage, you lose the corresponding interest deduction and cannot get it back by refinancing unless refinancing includes the cost of substantial improvements to the home (thus increasing the tax basis of the home) or is classified as home equity indebtedness subject to a $100,000 limit for all outstanding home equity debt.
Any home improvement loans that cause the total amount of acquisition indebtedness to exceed $1,000,000 are considered home equity loans and subject to a $100,000 limit and other restrictions for home equity indebtedness. Interest on indebtedness in excess of the combined $1,100,000 acquisition/equity limit is a nondeductible personal expense. The restrictions imposed by the Tax Reform Act of 1986 do not apply to mortgages taken out before October 14, 1987; that is, the rules for home mortgage indebtedness booked before this date are, in effect, grandfathered by the Revenue Act of 1987. Thus, pre-October 14, 1987 mortgages are treated as acquisition indebtedness (but such indebtedness reduces the $1 million limit on new, post-October 13, 1987 acquisition debt) and interest is fully deductible regardless of purpose (but not deductible if used to purchase tax-exempt investments). If pre-October 14, 1987 debt is refinanced after October 13, 1987, it is considered acquisition indebtedness if it doesn’t exceed the original balance outstanding immediately before refinancing and does not extend beyond the original term of the loan or, in the case of a loan without a fixed term, the term of the first refinancing (but not to exceed 30 years).
Generally speaking, points on home mortgages must be charged for the use of money in order to be deductible. Points charged for specific services (appraisal fees, notary fees, settlement fees, etc.) are not interest and therefore not deductible. Points paid on refinancing must be amortized over the life of the loan unless the refinancing is but a temporary step in obtaining permanent financing. However, points allocable to that portion of a refinancing loan used to substantially improve the main residence are deductible in the year paid. Points on a mortgage for a second home must be amortized over the loan term.
Additional information on the mortgage interest deduction is listed below:
- AMT mortgage interest deduction
- Home mortgage interest deduction calculator
- Itemized deductions mortgage interest
- Mortgage interest deduction divorce
- Home mortgage interest deduction
Many happy returns, Roger
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