Spruce Up Your Finances

Financial tips to keep more of your hard-earned money

The Home Mortgage Interest Deduction

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One big advantage of owning a home is if you carry out a mortgage when you first purchase it, the mortgage interest that you paid may be tax deductible. This may include the loans you used to purchased your home, the second mortgage, or home equity loans. To be deductible, the mortgage loans must meet all of the following tests:

  • Mortgage is a secured debt on a qualified home in which you have an ownership interest. Normally, the mortgage is a secured debt if  the home is put up as collateral to protect the interest of the lender.
  • You are legally liable for the loan.
  • There is a true debtor-creditor relationship between you and the lender

In addition, you can only claim these interest  deductions if you are itemizing your deductions (using Schedule A). Nowadays, the mortgage loans acquired for purchasing a home have been really high and most interests themselves have exceeded the standard deduction.

How Much You Can Deduct

Generally, you can deduct all of the home mortgage interest but how much you can deduct depends on the date of the mortgage, the amount of the mortgage, and how the mortgage proceeds are used. If all of the mortgages fit into one or more of the following three categories at all times during the year, you can deduct all of the interest on those mortgages.

  1. Mortgages taken out on or befor October 13, 1987 (called grandfathered debt) – all mortgage debt acquired on or before October 13, 1987 are deductible regardless of the amount.
  2. Mortgages taken out after October 13, 1987, to buy, build, or improve a home (also referred to as acquisition debt by the IRS) but only if throughout 2010 the mortgages plus any grandfathered debt totaled to $1,000,000 or less (amount is reduced to $500,ooo or less if taxpayer is married filing separate). These limitations only apply to mortgages incurred to purchase, build, or improve a home.
  3. Mortgages taken out after October 13, 1987, other than to buy, build, or improve a home (also referred to as home equity loans), but only if throughout 2010, these loans totaled $100,000 or less ($50,000 or less if married filing separate) and totaled no more than the FMV (fair market value) of the home reduced by (1) and (2).

You can deduct the mortgage interest for your main and second home for as long as the combined mortgages does not exceed the dollar limits for the second and third categories stated above.

Deducting Home Equity Loans

As you may already know, home equity is the difference between the fair market value of your home and your mortgage balance. Many homeowners have tapped into their equity to pay-off high interest loans such as credit cards, auto loans, and other personal loans. The advantage of doing so is that home equity loans interest are tax-deductible while personal loan interests are not. Another advantage of using the home equity loans is that the interest is much lower than the other consumer debt interest. For example, the current interest for home equity loans is around 5-8% while credit card interest may be around 10-20%.

For home equity loans, you can only deduct interest for up to $100,000 of home equity loans ($50,000 if married filing separate) for federal tax purposes if the loans are used other than to buy, build, or improve a home.

  • Example 1 – assuming that you took out a $110,000 home equity loan (and the overall mortgage loan has not exceeded the $1,000,000 limitations for all taxpayers – $500,000 for married filing separate) to consolidate your credit cards, auto loans and personal loan, you can only deduct interest for the $100,000.  So if the interest rate is 5%, and you paid $5,500 interest in total on the $110,000 loan, the maximum interest that you can deduct for the home equity loan is only $5,000.
  • Example 2 – assuming that you took out a $110,000 (and the overall mortgage loan has not exceeded the $1,000,000 limitations for all taxpayers – $500,000 for married filing separate) where you used $60,000 to pay-off credit card debts and auto loans and you used $50,000 to remodel your kitchen and bathrooms (home improvements). You can deduct all the interest payments. Only $60,000 is considered on the $100,000 limitations since the $50,000 is used to improve the home.

Deducting Points

In real estate, “points” are certain charges paid in order to reduce the interest rate on a mortgage. It may also be referred to as loan discounts, loan origination fees, maximum loan charges or discount points. In general, points are considered pre-paid interest so you cannot deduct them all at once on your tax return. Instead, they must be deducted ratably over the life of the loan. These rule applies to points paid on refinancing the loan, points paid on the second home mortgage. Please see the exception to the rule below.

Exception Rule: You may deduct  the points fully in the year that you paid them if you meet all of the following tests:

  • The loan is used to buy or build your main home and is secured by your main home, which is the one you ordinarily live in most of the time.  The points paid on the second home does not qualify.
  • Paying points is an established business practice in that area where loan is made. and that the points paid were not more than the points charged in that area.
  • The points were computed as a percentage of the principal amount of the mortgage and the points were not paid in place of amounts that ordinarily are stated separately on the settlement statement such as appraisal fees, inspection fees, title fees, attorney fees and property taxes.
  • You use the cash basis accounting and the funds you provided at or before closing, plus any points the seller paid, were at least as much as the points charged.

Deducting Mortgage Insurance Premiums

The amount paid for mortgage insurance premiums is treated as home mortgage interest and is deductible in your tax return.  The insurance must be in connection with your home purchase debt and the insurance contract must have been issued after 2006. Qualified mortgage insurance is mortgage insurance provided by the FHA (Federal Housing Administration), VA Loans or Veterans Administration loans, the Rural Housing Service and the private mortgage insurance (as defined in section 2 of the Homeowners Protection Act of 1998 that takes effect on December 2006.)