Mortgage Interest – Deductible or Not

Summer, 2008

Most taxpayers believe that all their mortgage interest is deductible on their tax returns, but they may have a surprise. In order to determine whether your mortgage interest is deductible or not, it is important to know the types of mortgage interest and the limitations.

1.      Acquisition indebtedness is debt incurred in acquiring, constructing, or substantially improving a qualified residence and is secured by such residence and is limited to $1,000,000.

2.      Refinanced debt will still be considered acquisition debt if it does not exceed the principal amount of acquisition debt immediately before refinancing.

3.      Home equity indebtedness is all nonacquisition debt that is secured by a qualified residence to the extent it does not exceed $100,000 and it does not exceed the fair market value of the residence reduced by acquisition debt. Interest on such debt is deductible even if the proceeds are used for personal expenditures.

4.      Qualified residence includes your primary residence and a second residence such as a vacation home. You must consider both properties as one when applying the debt limitations.

Acquisition debt is probably most misunderstood when refinancing a home. Many taxpayers have built equity in their homes and refinance to provide cash to do other things such as investing, pay off debt, purchase large ticket items while thinking that the mortgage interest is fully tax deductible. After all the mortgage company sends you a form labeled “Mortgage Interest Statement” showing you how much was paid during the year. Most taxpayers use this information to take a deduction on their tax return. However, unless the cash was used for home improvements, your mortgage interest deduction is limited to the acquisition debt.

Example, let’s assume that you borrow $150,000 to buy your home, years later your home has gone up in value and your current loan balance is $140,000 and you refinance for $300,000. Unless you use the difference between $300,000 and $140,000 or $160,000 for home improvement, interest on $60,000 is personal interest and not deductible because you are allowed to borrow $100,000 over acquisition debt as a home equity loan.

Furthermore, acquisition debt cannot exceed $1,000,000. Interest on acquisition debt over this amount is not deductible. Example, if you borrow $1,350,000 to acquire your home, interest on the $350,000 is not deductible. Exception, acquisition incurred on or before October 13, 1987 is grandfathered and not subject to the $1,000,000 limitation. Refinancing of this grandfathered debt also qualifies as long as the refinancing does not exceed the principal amount before refinancing.

Home equity indebtness is not only limited to $100,000 it is also limited to fair market value of your residence. Example, the fair market value of your residence is $120,000, the mortgage balance is $100,000. If you take out a home equity loan for $30,000, the interest deduction will be limited to $20,000, since $10,000 exceeds the FMV reduced by acquisition debt.

As you can see, the rules regarding mortgage interest are complicated. If you have any questions regarding this or other matters, please do not hesitate to call. We look forward to helping you with tax or other financial matters.