Editor's Note: This article is part of our 2014 Tax Tips series. Robert Flach is an expert with more than 40 years of experience as a tax professional and also blogs as The Wandering Tax Pro.
NEW YORK (MainStreet) You can deduct "qualified residence interest" on debt secured by a personal residence, aka mortgage interest, on Schedule A subject to certain limitations. The bank or mortgage company will report the interest paid for the year on Form 1098.
Unlike the deduction for real estate taxes, which is allowed on an unlimited number of properties, you can only deduct mortgage interest on two properties at a time. If your principal residence is in New Jersey and you have two personal-use vacation properties, one in Florida and one in the Pocono Mountains, and all three properties have a mortgage, you can only deduct the interest on two of the properties each year.
There are three kinds of deductible qualified residence interest -
1) Grandfathered debt debt acquired on or before October 13, 1987, that was secured by your main residence or a qualified second home. It does matter what the proceeds of the loan were used for, as long as the debt was secured by the property.
2) Acquisition debt - debt acquired after October 13, 1987, to buy, build, or substantially improve your main residence or a qualified second home. A substantial improvement is one that adds value to the home, prolongs the home's useful life, or adapts the home to new uses.
3) Home equity debt debt acquired after October 13, 1987, that is secured by a principal residence or second home that is not used to buy, build, or substantially improve the property. There is no restriction or limitation on what the money can be used for - you can use it to buy a car, pay for college, or pay down credit card debt.
There are special limits on the amount of principal on which interest can be deducted.
- Grandfathered debt is not limited. Interest on all grandfathered debt is deductible in full as mortgage interest.
- Acquisition debt is limited to $1 million ($500,000 if Married Filing Separately). Qualified acquisition debt cannot exceed the cost of the home and any substantial improvements. The $1 million (or $500,000) debt limit is reduced by any grandfathered debt.
- Home equity debt is limited to $100,000 ($50,000 if married filing separately). The $100,000 (or $50,000) debt limit is reduced by any grandfathered debt in excess of $1 million (or $500,000). If you have total home equity debt of $150,000 and the interest on this debt for the year is $9,000 you can only deduct $6,000 ($100,000 divided by $150,000 x $9,000).
When you refinance existing acquisition debt the new mortgage is treated as acquisition debt only up to the balance of the old mortgage principal just prior to the refinancing, plus any additional debt used to improve the residence substantially. Any excess principal, such as amounts used to cover closing costs, is considered home equity and must be applied to the $100,000 limitation.
You can elect not to treat certain debt secured by your residence as home equity debt so it is not included in the $100,000 limit. Home equity borrowings used to purchase investments can be claimed as investment interest, which has its own separate limitation. If you use a home equity line of credit to purchase assets or supplies for your sole-proprietorship or one-person LLC, you can deduct the appropriate interest on Schedule C.
If a refinanced mortgage contains both acquisition debt and home equity debt, the home equity debt is paid down first. You refinanced a mortgage to combine the original purchase mortgage balance of $200,000 and the balance in a home equity line of credit of $90,000. During the year you pay down $6,000 of the refinanced loan. The $284,000 remaining principal is considered to be $200,000 of acquisition debt and $84,000 of home equity debt.
You may also deduct as mortgage interest late payment fees and charges on a mortgage loan. Sometimes these charges are included in the mortgage interest reported on Form 1098, and sometimes they are not. You should check your annual loan amortization statement.
A property acquired under a "time-share" arrangement can be considered a second home, and interest paid on mortgages secured by the ownership-interest in the property can be deducted as mortgage interest.
The mortgage interest that accrues on a "reverse mortgage" is not currently deductible. This interest is added to the principal of the loan and can be deducted in the year that the loan is repaid.
The rules for equitable and beneficial ownership and a life estate I discussed in an earlier Tax Tip also apply to mortgage interest.
--Written by Robert D. Flach for MainStreet