Mortgage Interest – Deductible?
Mortgage rates are still at some of the lowest rates seen in years, and with some of the current programs like the HARP program, allowing a debt to value ratio of 125%, many people are taking advantage of them.
Unfortunately, not everyone understands what is deductible or non-deductible mortgage interest. And since it all is reported on a single form, the IRS is starting to take a much closer look at this on people’s individual returns.
To start with, you need to remember that there are two different types of mortgage debt – Acquisition debt and Home equity debt.
Acquisition Debt is loan proceeds used to originally buy, build, or improve your primary residence. You have to be careful when defining this – if you have paid down your loan and then refinanced taking additional money out, the additional funds are not acquisition debt unless you use them to make improvements, even if the refinanced amount is less than your original purchase. Interest on acquisition debt is only deductible for the first $1,000,000 financed.
Home Equity Debt is the funds borrowed against your primary residence in excess of the acquisition debt. For individual taxes, this is the lowest of the difference between your acquisition debt and the fair market value of your home, the difference between your acquisition debt and the $1,000,000 cap, or $100,000.
So, how does this all work?
Say you borrow $1.25 million to purchase your home 10 years ago. For that first year, you exceed the $1,000,000 cap by 20%, so 20% of your mortgage interest is not deductible.
A couple of years go by, and you’ve paid it down to $1.1 million – because it is all still original acquisition debt you get to deduct interest on up to $1,000,000 (about 90% of the interest) – even if you have refinanced it once or twice to get a better rate. And as a bonus, the IRS says the paydown is applied to the non-deductible portion first. This means as long as your loan has not fallen below the $1,000,000 mark you still get the full interest on the first $1,000,000 as acquisition debt.
A little more complicated – You pay your original loans down to $850,000 and then refinance, pulling out $150,000 to pay off credit cards and auto loans. As long as your home value is still over $950,000 you will get to deduct 95% of your interest ($850,000 in acquisition plus $100,000 in home equity out of $1,000,000 in mortgages.)
What if your home value crashed after refinancing and it was now worth $750,000? Then you only get to deduct interest on the $850,000 in acquisition debt (85%). The interest on the entire equity portion is non-deductible.
The big picture – make sure you and your tax preparer know the history of your mortgages. The IRS is looking for low-hanging fruit right now and the general public’s lack of knowledge in this area makes it an easy target for auditors.