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01/06/09: Deducting Mortgage Interest

Housing Counsel

By Benny L. Kass

(Second in a Series)

Income tax returns are the most imaginative fiction being written today.

Herman Wouk

Deducting the interest you pay on your home mortgage is one of the few tax benefits available to American homeowners. If you have a mortgage loan, by the end of this month you will get Form 1098 that reflects the amount of interest you paid the lender last year. Put that number on Line 10 of Schedule A of Form 1040. If you have a loan from a private person – say your family – make sure to determine how much interest you have paid, and that number will be put on Line 11.

There are three major limitations on the amount of interest you can deduct. First, you can only deduct the interest you pay on loans up to 1 million dollars. Over that amount, no deduction is allowed.

Second, you have to understand the concept of “acquisition indebtedness”. According to the Internal Revenue Service, “home acquisition debt is a mortgage you took out after October13, 1987, to buy, build or substantially improve a qualified home (your main or second home).” (Publication 936, entitled Home Mortgage Interest Deduction, December 9, 2008).

Let’s take this example. In 2000, you bought a condominium for $300,000 and obtained a $240,000 loan. Based on the rapid appreciation since then, your unit is now worth $500,000, and you still owe $230,000. You refinance, and get a new loan in the amount of $400,000. Your acquisition indebtedness is the amount of your old loan, and subject to the third limitation discussed below, you can only deduct the interest up to that amount.

The third limitation involves home equity loans – commonly referred to as HELOCs. Here, you can deduct interest on an additional $100,000 of mortgage indebtedness. But this additional amount is not linked exclusively to a HELOC; you are able to include it in the total amount you owe on your house.

So, in our example, your acquisition indebtedness becomes $330,000 ($230,000 + $100,000), and you can deduct for tax purposes the interest you have paid up to this amount. However, since you borrowed $400,000, the interest paid on the additional $70,000 is lost.

Cooperative Housing: A qualified home can include a recreational vehicle or a boat, so long as it contains a kitchen, sleeping quarters and a toilet (called a “head” on a boat). But what about housing cooperatives, of which there any many in the Washington metropolitan area.

According to the IRS, “a qualified home includes stock in a cooperative housing corporation owned by a tenant-stockholder. This applies only if the tenant-stockholder is entitled to live in the house or apartment because of owning stock in the cooperative.”

The IRS suggests that in order to qualify for the interest deduction, the cooperative must have only one class of stock outstanding. However, especially in the District of Columbia, there are a number of associations that do not have stock certificates, but only documents entitled “Proprietary Leases”. My informal discussions with IRS representatives leads me to believe that those coops will still be classified as “qualified home”. However, cooperative owners should consult with their own financial and legal advisors on their specific situations.

Generally, if you are a coop owner, you can deduct payments you make for your share of the interest paid by the cooperative, as well as any interest you pay for your individual share loan that you obtained when you purchased your unit.

Reverse Mortgages: More and more people are starting to obtain reverse mortgages – either from commercial lenders or from their own families. This loan – generally available only to persons over the age of 62 who have little or no current mortgage obligations – provides cash to the homeowner, either in monthly annuities, a line of credit, or as one lump sum. Interest accrues until the homeowner either sells the house or dies. This interest is not deductible until the loan is paid in full. It should be noted that the home acquisition indebtedness limitations discussed above also apply to reverse mortgages, and your tax accountant should be consulted to determine exactly how much of the interest will be tax deductible.

Points: This is money that the borrower pays up-front to the lender, usually for the purpose of reducing the mortgage interest rate. Generally, one point equals one percent of the loan. So if you borrow $400,000, one point will cost you $4,000. The rule of thumb is that for every point you pay, you can reduce your interest rate by 1/8 of a percent.

In recent years, points have fallen into disfavor by borrowers. Why pay $4,000 to a lender just to save a few dollars a month on mortgage payments, especially since the additional moneys paid are probably tax deductible anyway? We are too concerned about interest rates. If you do the numbers, you will see that the savings is not really that great. Let’s look at this example. A $400,000 loan, amortized over 30 years at 5 ½ percent will cost you $2271.16/month. That same loan at 5 3/8 carries a monthly mortgage of $2239.90 – a savings of $31.26 per month. While I do not belittle any savings, no matter how small, the fact is that is it nevertheless a small amount. And if you are in a 28% tax bracket, that reduces the savings down to $22.50.

However, points are deductible, again with limitations. If you buy a house, the points you pay for your loan are deductible in full when you file your next tax return. If you obtain a refinance loan, and pay points, you can only deduct them ratably – equally – over the life of the loan. In the example above, if your $400,000 loan is for 30 years, each year you can only deduct 1/30 of the $4000 you paid (i.e. $133.33). Of course, when you pay off that loan, any unused points are then fully deductible. There are several restrictions and limitations on deducting points, and your should discuss this with your tax advisor. Additionally, Publication 936 has extensive coverage of this area.

Mortgage Insurance Premiums: If you do not put down 20 percent when you buy a home, you most likely will be required to obtain a mortgage insurance policy. Additionally, FHA and the VA require such insurance, which the VA calls a “funding fee”.

Congress finally recognized what legal scholars have been saying for years: the payment for such insurance is no different from mortgage interest, and should also be deductible. If you obtained a home loan in 2008 which included mortgage insurance, you may be able to take a deduction, and list it on Line 13 of Schedule A. There is a limit on the amount you can deduct. If your adjusted gross income is more than $109,000 – or $54,500 if you file a separate tax return – you cannot deduct these premiums.

The IRS has provided a relatively simple worksheet to assist you in determining this deduction, which can be found on page A-7 of “2008 Instructions for Schedules A & B, Form 1040). This is also available from the IRS (,
(Next: The Home Sale Exclusion Rules)

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