If you own your primary residence or possibly a second home, you already know that you may be able to take advantage of federal tax deductions. First things first: you must itemize your deductions on a Schedule A for these homeowners' deductions to apply. If you take the standard deduction, you can't take a deduction on mortgage interest.
Here's the Internal Revenue Service (IRS) rule: For primary residences and vacation homes, you can deduct interest paid on up to $1 million of acquisition debt--mortgages taken to buy, build or improve your home or homes. You can deduct up to half of that if you are single or married and filing separately.
That means the interest paid on acquisition debt, up to a combined total of $1 million for your primary residence and vacation home, if you have one, is deductible. (Note that you can only deduct interest on one vacation property.) Interest on mortgage debt exceeding that total is not deductible. In addition, you can deduct interest on up to $100,000 of home equity debt, or up to half that if you are single or married and filing separately.
If any part of your mortgage debt was taken out before October 13, 1987, that balance is considered "grandfathered," and these interest deduction constraints don't apply. You can deduct all of your mortgage interest related to that grandfathered debt.
Types of properties that qualify for a mortgage interest deduction
Your mortgage debt must be secured by a qualifying property. According to the IRS, a qualifying home can be a house, condominium, cooperative, mobile home, house trailer or even a boat (yes, a boat) or similar property that has sleeping, cooking and toilet facilities.
You can even treat a home that's under construction as a qualifying home for up to 24 months as long as it becomes your main or vacation home when it's fit to occupy.
Calculating your home mortgage interest deduction
In the case of most homeowners, everything paid in home mortgage interest or home equity interest will be deductible. But if you own financed property in expensive areas, your mortgage interest expense may run up against the IRS limits.
Example of mortgage interest deduction calculation
Matt, a single filer, owns his main home and has a $450,000 mortgage on it. He also owns a vacation home, on which he owes $200,000. He took out a $40,000 home equity line of credit to pay his daughter's college tuition. He paid $22,000 in mortgage interest on both homes in 2010.
Here's how he determines his Schedule A deduction given the limits:
- A: Total up all acquisition mortgage balances--$450,000 plus $200,000 equals $650,000.
- B: Add the smaller of either the home equity debt or the $50,000 home equity debt limit to Matt's acquisition debt limit of $500,000 as a single filer; $500,000 plus $40,000 equals $540,000.
- C: Total up all mortgage and home equity debt--$450,000 plus $200,000 plus $40,000 equals $690,000.
- D: Divide the total of B by the total of C. In Matt's case, $540,000 divided by $690,000 equals 78.3 percent. This percentage is used to adjust the total mortgage interest paid to come up with the allowed amount for the deduction.
- Multiply the percentage in D by the amount of mortgage interest paid--or $22,000 times 78.3 percent. Matt can deduct up to $17,217.39 of his mortgage interest for the 2010 tax year.
Refinanced mortgage debt
Refinanced debt can be tricky. If you refinance acquisition debt, the amount used to pay off your mortgage is still considered acquisition debt. Additional amounts, however, are not. They are reclassified as home equity debt and subject to the $100,000/$50,000 limits rather than the $1,000,000/$500,000 limits.
You can write off mortgage insurance if your mortgage was taken out after 2006 and your adjusted gross income does not exceed $109,000 for a married couple (half that for singles and those married filing separately).
Points paid to lower mortgage rates are also deductible, but they must be pro-rated using a straight-line amortization schedule.
Example of points amortization calculation with mortgage refinance
Let's say you paid $6,000 in points in order to lower your mortgage rate on a 30-year loan. You get to deduct $200 a year for each of the 30 years. If you refinance before then, you can deduct any remaining points in that year. So if you refinance that 30-year loan after five years, you will have deducted only $1,000 of your points paid. You get to write off the remaining $5,000 in the year that you refinance.
Your Schedule A is also where you write off the property taxes you pay on your home. Unlike in prior years, you must itemize your 2010 return to take advantage of this deduction.
What about loopholes?
Interest that is disallowed on your Schedule A might be allowed on other parts of your tax return. For example, if you use part of your home for business, you could deduct part of your mortgage interest on a Schedule C (business income) or a Form 2106 (home office deduction). If you used a home equity loan to finance investments, you could deduct it as investment interest, thereby reducing your taxable investment income.
Home mortgage interest deductions can be complicated. When it comes to taxes, "the truth," as Oscar Wilde claims, "is rarely pure and never simple."