Many tax advisors say that one of the most common errors on tax returns is claiming more home mortgage interest deduction than is actually available. Many homeowners believe that all interest paid on a home mortgage is deductible, but there are limits based on which property secures the debt and how you used the money.
The home mortgage interest deduction is limited to interest on debts that are secured by your principal residence and one second home. The deduction is also limited in amount, depending on the purpose for borrowing the money. You can deduct interest paid on the first $1 million of debt used for acquiring, constructing or substantially improving your residence (this is called “acquisition debt”). In addition, you can deduct up to $100,000 of home equity debt, no matter how you used the money. There are other details to consider. For example, you cannot take advantage of this deduction unless you itemize your deductions, and there are different rules for mortgages in place before October 14, 1987. These details and more are explained in IRS Publication 936.
One of the biggest areas of confusion arises when homes are refinanced to take more money out than the original balance of the loan. According to the IRS, refinanced acquisition debt is treated like the original acquisition debt, but only up to the balance of the debt immediately before the refinancing. The rest of the refinanced debt is eligible for the interest deduction only to the extent it doesn’t exceed the $100,000 limit on home equity debt.
For example, John and Mary Smith acquire a home in 1990 for $500,000 with a $400,000 loan and $100,000 in cash. The $400,000 debt is acquisition debt and all of the interest on that debt can be deducted because the debt doesn’t exceed $1 million. In 2003, the property is worth $700,000 and the mortgage balance is $300,000. The Smiths refinance the debt with a new loan equal to $550,000. What can they deduct? The Smiths should be able to deduct the interest on $400,000 of the debt ($300,000 as refinanced acquisition debt and $100,000 as home equity debt). The interest on the $150,000 of debt in excess of that amount is considered personal interest and will not be deductible.
Deducting interest that is paid on a home mortgage is one of the most popular tax breaks around. Although there has been some discussion lately about whether to continue this tax deduction, it is currently used by millions of Americans who itemize deductions and own a home. It is important to understand the details of the rule, however, so check with your tax advisor to make sure that your deduction is accurate.
If you own investment property (rather than property you live in or use as a second home), there are other rules about deducting interest on debt secured by that property. In addition, before you sell investment property, contact First American Exchange to discuss doing a 1031 exchange to defer paying capital gains taxes, which is another valuable tax benefit available to property owners.