Home, Sweet Tax Break

Here's the lowdown on sorting out the tax implications of refis, points, renting, owning and more.
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If you own your home, you're privy to some of the biggest tax breaks written into the code -- and there's more to it than just being able to write off the interest paid on your mortgage. The following is an overview of some of the most important tax considerations in owning your home, as well as a few limitations and caveats.

Second (and third) homes.

You're able to deduct the interest on a loan used to purchase or construct a second home as well. And the tax code's definition of a "second residence" is pretty generous -- essentially any establishment with a toilet, sleeping and kitchen facilities will qualify. That means houseboats and Winnebagos as well as a second house or condominium.

If you rent out your second home, there are a few things to keep in mind. If you rent the home for more than 14 days, you lose the ability to deduct the mortgage interest. The definition of "rent," in this case, is pretty strict -- when counting rental days, you must include days that the home was held out for rental or listed for resale.

The interest on a loan used to purchase a third residence isn't deductible as an acquisition loan, but it could be deductible if the loan goes to purchasing investment or business property.

Limits on loan size.

Loans that are used to buy, construct or improve a first or second home are called home acquisition loans. Homeowners are allowed to deduct the interest on such loans as an itemized deduction on Schedule A. There is a limitation, though, for loans taken out after Oct. 13, 1987: Only the interest on up to $1 million of such debt qualifies for mortgage interest deduction. Loans obtained prior to Oct. 14, 1987, are exempt from the $1 million limit.

Debts acquired for any purpose other than to buy, construct or improve a home are called "home equity loans." Up to $100,000 of such debt qualifies for an interest deduction.

Limits on deductions.

Mortgage interest and the interest on home equity and investment loans are itemized deductions. (For more on itemized deductions, see

Tax Time -- What You Can and Can't Deduct.) Itemized deductions, though, are generally limited once taxpayers reach $137,300 in adjusted gross income, or AGI. Your itemized deductions will be reduced by 3% of the excess AGI over $137,300.

In other words, let's say your AGI is $177,300 and you have deductions for mortgage interest, charitable contributions and state and local taxes amounting to $20,000. The AGI excess over $137,300 is $40,000, so your itemized deductions will be reduced by $1,200 (3% of $40,000). You'll be allowed to deduct just $18,800 instead of the full $20,000.

The catch here, though, is that while the deductibility of mortgage interest is reduced when a taxpayer's AGI exceeds $137,300, the deductibility of investment interest is not. (Those of you with third homes or rental property, take note.) Deductions for medical expenses, casualty and theft losses, gambling losses and investment interest expenses won't be reduced.

Refinancing issues.

If you refinance your mortgage (on a first or second home) for the same amount as the remaining principal on the old loan, there's no change in the tax treatment of interest. (Yes, that means if it was deductible before, it's still deductible.)

But if you've refinanced in an effort to take cash out of your home (taking out a new loan for

more

than the principal you owed on your last loan), the deductibility of the interest on the excess amount depends on how you used the funds you withdrew and the total amount of the refinancing.

Once again, if you deploy the cash you pull from your home into buying, building or improving your first or second home, it's considered home acquisition debt, and the interest on the additional debt is deductible, subject to the $1 million loan limit.

If the excess is used for anything other than refurbishing your home -- such as paying off your credit cards or financing your children's education -- then the excess is considered a home equity loan. If the excess plus all other home equity loans does not exceed $100,000, then the interest is fully deductible. If the excess is used for investment or business purposes, though, then that part of the loan is classified as such.

Points.

Points, an upfront fee charged by many lenders, are generally deductible. (One point equals 1% of the loan amount.) Points that are considered a form of prepaid interest are deductible; points that are for specific lender services are not.

Points are generally deductible over the term of the loan, with one important exception -- points paid on an acquisition loan for your principal residence are deductible in the year they are paid. The points must be specifically labeled on the loan closing statement as "points," "loan origination fees" or "loan discount," and can't exceed the points generally charged in the geographic area.