The federal government understands that home mortgages are the largest financial burdens many Americans will ever assume in their lifetimes. In order to provide a break (and presumably to encourage people to participate in the real estate market), the Internal Revenue Service (IRS) allows taxpayers to take deductions on the interest paid on their mortgages.

But what if you get a second home mortgage? Does it matter what you use it for? Can you just deduct interest indefinitely? 

We'll take an in-depth look at the tax implications of taking on a second mortgage, showing you how to go about calculating your deduction on your taxes as well as highlighting various restrictions and pitfalls.

The Basics

First, you need to understand what constitutes a "qualified home" (the one on which a mortgage interest deduction applies), and how the IRS defines "mortgage interest" and "mortgage debt."

For starters, a "qualified home" refers to either your main home where you normally live, or a second home. Mobile homes, house trailers, apartments and boats all qualify, so long as they have "sleeping, cooking, and toilet facilities," as IRS Publication 936 puts it.

If you have three or more properties, you can only claim two of them as, respectively, your primary and second homes for a given year. If you happen to sell one of the homes you were claiming in the course of that year, you can then deem another property your primary or second home for the balance of that year. 

If you're claiming deductions on a home that doubles as something else, such as a rental property or an office, some nuanced rules and calculations come into play, relating to how much time you occupy the premises. You can refer to specifics here, but generally speaking, if you rent out a second home, you need to live there for at least 14 days or more than 10% of the amount of time it's rented out over a year (whichever is longer) to be able to deduct the mortgage interest on it. (If you don't live there at all, then you're a landlord, and a whole different set of rules comes into play: see Tax Deductions For Rental Property Owners).

Mortgage interest only applies to interest paid on loans that use your home(s) as collateral. This includes:

The IRS outlines three categories of mortgage debt. These vary depending on when you took out the debt and what the proceeds were used for:

  • Grandfathered debt refers to mortgages that were secured by your home on or before October 13, 1987 (after which current tax rules took effect).
  • Home acquisition debt refers to mortgages taken out after October 13, 1987 that were used to buy, build or improve your home (i.e.., renovations, repairs, etc.).
  • Home-equity debt or loan refers to mortgages taken out after October 13, 1987 that were used for other, non-residence-related purposes, such as to finance college tuition, a new car, a vacation or pretty much anything else not related to buying, building or improving a home.

The Deductions

That depends on what kind of debt you already have – and how much more you want to assume. If you are married and file jointly, you can only deduct interest on $1 million or less worth of home acquisition debt and $100,000 or less worth of home equity debt overall. If single, or married and filing separately, then your limits become $500,000 for home acquisition debt and $50,000 home equity debt, respectively.

In other words, if your mortgage or mortgages are used to buy, build or improve your primary and/or second home (making it home acquisition debt) and total $1 million, you can deduct all you've paid in interest. For example, if you have a 4% interest rate on each of two mortgages that together add up to $1 million, you can deduct all of your annual interest payments of $40,000.

However, if your home acquisition debt is, let's say, $2 million, then you'd only be able to deduct half of the total interest you paid on $2 million worth of mortgages in that year. If those same 4% interest rates applied, then you'd only be able to deduct $40,000 instead of the $80,000 you presumably paid in interest that year. (This is something to consider for anyone trying to finance a seven-figure property. See Jumbo Vs. Conventional Mortgages: How They Differ.)

Although this limit doesn't apply to grandfathered debt, you won't be able to take additional deductions on new mortgages if your grandfathered debt already exceeds $1 million. What if you only have $900,000 in grandfathered debt? Then you could only deduct interest for an additional $100,000 worth of home acquisition debt.

At least, this is the general rule. The IRS provides a worksheet to determine your actual deductible home mortgage interest.

The Paperwork

 As long as you've paid at least $600 worth of mortgage interest, you'll receive a notice from your mortgage holder or lender (it's usually Form 1098) a few months before tax-filing time. Along with the dollar amount of your annual payments, this Mortgage Interest Statement will also show your paid mortgage insurance premiums and deductible points paid (if you purchased a home that year). Once you have this document in hand, you'll use it to complete your tax return, on form 1040, Schedule A (Itemized Deductions).

With home acquisition debt and home equity debt combined, you can technically borrow $1.1 million against your home. However, if you happen to have additional debt that exceeds this threshold, you may be able to deduct the interest if those proceeds were used for a qualified expense, such as an investment (also reported on Schedule A) or a business (Schedule C or C-EZ).

Refinancing, Points and Premiums

If you refinance any mortgage, including your second one, then you can claim the new loan as home acquisition debt up to the principal of the previous loan. Anything above that will be treated as home equity debt.

In addition, if you pay points on the new mortgage, you can deduct them over the life of the loan. Assuming you refinance a new 30-year mortgage, you can deduct 1/30th of whatever you paid in points every year. If you haven't deducted all the points by the time you sell or refinance the house (again), then you can deduct any remaining all at once in that year. You'll file the deduction on Schedule A, form 1040, line 12.

As long as your adjusted gross income doesn't exceed $109,000 (or $54,500 if married and filing separately), you can deduct some or all of your mortgage insurance premiums as well. This would fall into your "home acquisition debt" category.

The Bottom Line

The tax rules are complicated, there's no denying that, but if you proceed properly, the provisions could save you thousands of dollars a year. Be sure to consult a qualified tax professional before you decide to take out a second mortgage.