The Mortgage Interest Deduction
The qualified residence interest expense deduction (or mortgage interest deduction) is a significant provision in the U.S. tax code that allows taxpayers to reduce their taxable income by the amount of interest paid on mortgages for buying, building, or substantially improving their homes.
Eligible Properties
- Primary Residence: The home where the taxpayer ordinarily lives most of the year.
- Second Home: Can also qualify if it is used for personal use for more than 14 days or more than 10% of the days it is rented out, whichever is greater. It can include a house, condominium, cooperative, mobile home, house trailer, or boat, as long as it has sleeping, cooking, and toilet facilities.
Deduction Limits
- For mortgages taken out after December 15, 2017, the interest deduction is limited to the interest on up to $750,000 of indebtedness.
- For mortgages taken out on or before December 15, 2017, the limit is $1 million of indebtedness.
- The limits apply to the combined amount of debt on both the primary residence and second home.
Qualifying for the Deduction
- Acquisition Indebtedness: The mortgage must be secured by the qualified residence and used to buy, build, or substantially improve the residence. The interest on up to the applicable limit of acquisition indebtedness is deductible.
- Home Equity Loan Interest: Interest on home equity loans (or lines of credit) is deductible if the loan was used to buy, build, or substantially improve the taxpayer’s home that secures the loan, subject to the overall debt limits.
Non-deductible Interest
- Interest on the portion of the mortgage debt that exceeds the applicable limit is not deductible.
- Interest on home equity debt used for purposes other than to buy, build, or substantially improve a qualified residence (e.g., to pay off credit card debt or for personal expenses) is not deductible.
Other Considerations
- Refinanced Mortgages: Interest on refinanced debt is deductible under the same rules as the original debt, as long as the new loan does not exceed the amount of the refinanced mortgage debt.
- Multiple Homes: Taxpayers with more than two homes can only claim the deduction for their primary residence and one other selected home used for personal purposes.
- Itemized Deductions: To benefit from the mortgage interest deduction, taxpayers must itemize deductions on Schedule A of their federal income tax return, which might not be beneficial if the standard deduction is higher.
Reporting and Documentation
- Taxpayers must use Form 1098 (Mortgage Interest Statement) provided by their lender to report the amount of deductible mortgage interest on their tax return.
Example:
- In the current year, the Johnson family took out a mortgage of $700,000 to purchase a new primary residence. The annual interest paid on this mortgage for the year is $28,000.
- They also have a vacation home with a mortgage of $200,000, on which they paid $8,000 in interest in the same year.
- In addition, they took out a home equity line of credit (HELOC) of $50,000 on their primary residence to upgrade their kitchen, paying $2,000 in interest over the year.
- All mortgages were secured and taken out after December 15, 2017.
Calculation:
- Combined Mortgage Balance: $700,000 (primary) + $200,000 (vacation) = $900,000 total.
- The combined balance exceeds the $750,000 limit for mortgages taken out after December 15, 2017.
- Interest Paid: $28,000 (primary) + $8,000 (vacation) + $2,000 (HELOC) = $38,000 total.
- Deductible Interest Calculation: Because the total mortgage balance exceeds the $750,000 limit, the Johnson family can only deduct interest on the first $750,000 of their indebtedness.
- If we assume an equal interest rate across all loans for simplicity, they can deduct a proportional amount of the interest they paid, based on the $750,000 limit.
- The deductible portion of their mortgage interest is calculated as $750,000 / $900,000 (or 83.33%) * $38,000 = approximately $31,667.
Conclusion:
- The Johnson family can claim $31,667 as an itemized deduction for qualified residence interest expense on their tax return for the year.
- The interest deduction is limited due to the aggregate mortgage balance exceeding the $750,000 cap, but they are still able to significantly reduce their taxable income through the mortgage interest they paid on their primary and vacation homes, as well as the HELOC used for substantial improvement.
