Understanding the Rules for Deducting Home Mortgage Interest

  • Posted by Jordan Blakley
  • 04/15/2014
  • taxes
Understanding the Rules for Deducting Home Mortgage Interest

The IRS's home mortgage interest deduction is one of the most valuable tax write-offs for American families. While its effect can vary depending on your income, other deductions, and your mortgage, it's likely that it will reduce your annual tax costs by thousands of dollars. Claiming it is relatively simple for most people, as long as you follow the IRS's rules.

1) Itemize or Else

To claim the deduction, you have to itemize by filing a long-form 1040 tax return and attaching Schedule A. This means that you have to give up the standard deduction, which is $6,200 for a single person or $12,400 for a married couple as of the 2014 tax year.

However, when you itemize your deductions, you get to write off more than just your home mortgage interest. The IRS also lets you deduct your state income tax, property tax, charitable contributions and a bunch of other items. As long as they add up to more than your standard deduction, you come out ahead itemizing.

2) Which House? Which Loan?

The IRS doesn't let you write off interest on just any loan, though. First, the loan has to be a mortgage, which means that it needs to have your home as collateral. Putting a home improvement on a credit card doesn't make the interest deductible. It's the type of loan that matters.

Second, the mortgage has to be taken out against your first or second home. For the IRS's purposes, a house is anything that you own that has a sleeping area, a kitchen or a bathroom. We tend to think of houses and condos, but the definition could include boats and RVs, too. If you own more than two houses or other qualifying items, though, the mortgages against those additional pieces of property aren't deductible (unless they were used for business, investment, or some other deductible expense).

A second home isn't the same thing as a rental property, however. If you rent out your second home, you have to live in it at least 14 days during the year or 10% of the number of days you rented out the home.

3) Loan Limits

The IRS applies two different limits to the home mortgage interest deduction. Interestingly, they aren't tied to how much interest you pay, though. Instead, they're tied to how much you borrow.

You can deduct up the interest on up to $1 million of what the IRS calls home purchase debt. This category includes money that you borrow to buy a house. It also includes money that you borrow as a part of a refinance. A loan that pays for repairs to your house, renovations, or remodeling is also considered home purchase debt. Generally, if the money goes back into your house, it's purchase debt.

In addition to that write off, you can also deduct the interest on up to $100,000 of home equity debt. Home equity debt is money that you borrow against your house for any purpose other than to buy, build or repair it. Debt consolidation loans or cash that you take out in a refinance are examples of home equity debt. You can also use home equity debt as home purchase debt, giving you an extra $100,000 of cushion.

4) Elimination of the Deduction for Some

Two tax rules wipe out or reduce some taxpayers' home mortgage interest deductions:

The Alternative Minimum Tax eliminates most deductions and replaces them with special tax rates and a special large AMT exemption. It leaves your deduction for your mortgage interest, but eliminates the deduction for home equity debt interest. The "Pease Limitation" gradually reduces the value of most itemized deductions for high income taxpayers that aren't subject to the AMT. It reduces the value of all of your mortgage interest deductions -- home purchase and home equity debt. These limitations typically only apply to families with significant incomes. If you aren't making over $100,000 per year, it's relatively unlikely that the AMT will affect you, and the Pease Limitation only comes into play with incomes that are over $250,000.

There are many special situations that affect some homeowners' mortgage interest deduction. Late payment charges, prepayment penalties, home sales, divorce - even minister and military housing allowance can impact your deduction. Tax laws and regulations change all the time and how they impact you depends on your own financial situation. If you've got questions about how mortgage interest deductions affect you, consult your professional tax advisor.