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1/20/11: Deducting Your Mortgage Interest Payments


Housing Counsel

By: Benny L. Kass

If you buy a really expensive house or a condo (or even a cooperative), the IRS has some good news for you. Despite the statutory limitation that prohibits you from deducting mortgage interest on any amount over 1 million dollars, there is a loophole. You can also deduct interest on up to another $100,000.

But what about the rest of us? Mortgage interest and real estate taxes are the only real tax benefits available to American homeowners, although that may change in the coming years. A recent tax commission report has renewed discussion among politicians and economists that these deduction should be limited – if not eliminated entirely.

In the meantime, let’s take advantage of these deductions.

Taxpayers have the right to deduct the interest they pay on their mortgage, and there are two categories. First is a complex concept called “acquisition indebtedness”; the other is home equity indebtedness.

Let’s look at each category:

Acquisition indebtedness is defined in the tax code as debt incurred in acquiring, constructing or substantially improving your principal residence. If you refinance your existing mortgage, the amount of that older loan immediately before refinancing is the amount of the acquisition indebtedness. Example: your original loan was $300,000, but now has been paid down to $250,000. You obtain a new loan in the amount of $350,000. In this first category, you can only deduct interest on the $250,000, unless you use the refinance proceeds to substantially improve your home. According to IRS Publication 936, entitled “Home Mortgage Interest Deduction”, “an improvement is substantial if it adds to the value of your home, prolongs your home’s useful life, or adapts your home to new uses.”

So, for example, if you used $50,000 of the refinance proceeds to add a new room to your house, that amount would be added to the acquisition indebtedness so that you can deduct the interest you pay on $300,000 of your new loan.

But now we have to look at the second category. Home equity debt involves money you borrowed that you do not use to buy, build or substantially improve your home. The money can be obtained in two ways: either as a separate Home Equity Loan (referred to as HELOCs), or the additional money as described in the example above that does not qualify as acquisition indebtedness.

Both categories have dollar limitations. Acquisition indebteness cannot exceed $1 million dollars (or $500,000 if you are married but file a separate tax return). Home equity debt cannot exceed $100,000.

Let us look at another example: Several years ago, you purchased your house for $150,000 and obtained a mortgage (or deed of trust) in the amount of $100,000. Last year, your mortgage indebtedness had been reduced to $95,000, but your house was worth $300,000.

Because rates were very low last year, you refinanced and were able to get a new mortgage of $175,000. You did not use any of the refinance proceeds to improve your house. Your acquisition indebtedness is $95,000. The additional $80,000 that you took out of your equity does not qualify as acquisition indebtedness, but since it is under $100,000, it qualifies as a home equity loan.

Several years ago, the Internal Revenue Service ruled that one does not have to take out a separate home equity loan to qualify for this aspect of the tax deduction. However, if you would have borrowed $200,000, you would only be able to deduct interest on $195,000 of your loan — the $95,000 acquisition indebtedness, plus the $100,000 home equity.

The remaining interest is treated as personal interest, and is not deductible.

You should also note that for all practical purposes, there are no restrictions on the use of the money obtained from a home equity loan.

However, in order to deduct any mortgage interest, the loan must be secured by a deed of trust recorded among the land records in the jurisdiction where your property is recorded. If, for example, parents lend money to a child to assist in buying a home, and that loan is not secured (i.e. not recorded) the daughter cannot deduct the interest she pays to her parents.

There may be situations where you chose not to treat the loan as secured. For example, if the loan can qualify as a business expense, you may be able to deduct more than the dollar limitations described above. According to Publication 936, “this treatment begins with the tax year for which you make the choice and continues for all later tax years. You may revoke your choice only with the consent of the Internal Revenue Service”.

In recent years, homeowners over the age of 62 are starting to consider reverse mortgages. Under this arrangement, based on the equity in your home, you can either get one lump sum payment or periodic payments from the lender. However, the interest will not become due until you move, sell your house or die. At that time, since your loan will be paid in full (and will include the accrued interest), you are eligible to claim the deduction. But beware: according to the IRS, a reverse mortgage is generally subject to the limits on Home Equity Debt, namely not to exceed $100,000.

Getting back to those million dollar loans, the IRS recently ruled that the amount over the acquisition debt is considered home equity debt. Accordingly, the IRS will now allow homeowners to deduct mortgage interest on loans up to $1,100,000.

By the end of this month, homeowners who paid more than $600 last year in mortgage interest, will be receiving IRS Form 1098 from their lender. That will show the total amount of interest paid in 2010. Review the amount carefully; computers can – and do- make mistakes, and if the amount is lower than you actually paid, you will not be able to deduct the full amount that you paid.

Take advantage of those deductions. They may not last forever.