Mortgage Tax Considerations
If you itemize deductions, you can generally deduct “qualified residence interest” you pay on certain home mortgages taken in connection with your primary residence and a second residence. (You cannot deduct mortgage interest with respect to a third residence.) This deduction generally applies only to interest on mortgages to buy, build, or improve your primary or secondary residence or to home equity loans used for any purpose.
The extent to which you may deduct the interest on your home loan depends on several factors, including the manner in which the loan proceeds are used, the amount of the loan(s), the type of loan, and whether your loan was taken prior to October 14, 1987.
What is qualified residence interest?
Qualified residence interest consists of any interest you pay in a given tax year for acquisition indebtedness or home equity indebtedness on your “qualified residence.”
A qualified residence is your principal residence and/or a second residence that meets certain requirements. A second residence you rent to others during the year can be considered a qualified residence for tax purposes only if you (or close relatives) use it for personal purposes for the greater of 14 days during the year or 10 percent of the number of days it is rented during the year.
Definition of home acquisition indebtedness
Acquisition indebtedness is a loan that meets certain dollar limitations and is incurred in buying, building, or substantially improving your qualified residence. In addition, the loan must be secured by a mortgage on that residence.
Example(s): Assume John buys his first home for $250,000, taking out a mortgage of $200,000. The $200,000 mortgage is considered acquisition indebtedness.
Tip: An improvement must add value to your home (and be added to your home’s basis for tax purposes). Proceeds used to pay for repairs do not qualify.
Amount of home acquisition debt
Home acquisition debt on your primary residence and a second residence totaling up to $1 million ($500,000 if you’re married and file separately) qualifies for interest deductibility. However, these dollar amounts are reduced by the total amount of any outstanding “pre-October 13, 1987” indebtedness that you may have. For IRS purposes, all loans taken on and secured by your primary residence and one second residence prior to October 14, 1987 (no matter how the proceeds are used) are considered “grand fathered” home acquisition debt. All interest paid on such grand fathered debt is deductible, even if the total debt exceeds $1 million (or $500,000 if you’re married and file separately).
Tip: Because the Internal Revenue Service has complex rules for tracing the use of borrowed funds, you should keep detailed records of loans taken to buy, build, or improve a residence so you can (if necessary) prove that the proceeds qualify as a home acquisition loan.
Definition of home equity indebtedness
Home equity indebtedness refers to debt secured by your main or second home that exceeds the acquisition indebtedness. Home equity debt is limited to the lesser of:
- The fair market value (FMV) of the home minus total acquisition indebtedness on that home, or
- $100,000 ($50,000 if married filing separately) for main and second homes combined
Interest on home equity loans that meet these limits and qualifications is deductible no matter what the loan proceeds are used for, except when the proceeds are used to purchase tax-exempt vehicles (investments or properties), such as tax-exempt bonds.
Example(s): Suppose you bought a home in 1980 for $180,000, taking out a mortgage of $130,000 to buy the home. The $130,000 is considered home acquisition debt. A few years later, when the fair market value of the home has increased to $195,000 and the principal balance on the original $130,000 acquisition loan has been paid down to $110,000, you take out a home equity loan of $90,000. You may deduct interest paid on $85,000 of the $90,000 home equity loan. Why? Interest cannot be deducted on the home equity debt that exceeds the difference between the fair market value of the residence ($195,000) and the principal owed on the acquisition debt on the residence ($110,000) at the time the home equity loan is taken.
Caution: Refinancing of an acquisition debt is considered acquisition debt to the extent it does not exceed the principal outstanding on the loan immediately before the refinancing.