Introduced along with the income tax in 1913, the mortgage interest tax deduction has since become the favorite tax deduction for millions of U.S. homeowners. Here we look at the existing rules behind this deduction, as well as new changes resulting from the tax legislation of December 2017.
Getting Deductions: Who Qualifies
In most cases, all mortgage interest up to a certain level of loan can be deducted from U.S. federal taxes, provided the homeowner meets the following requirements:
- He or she files Form 1040 and itemizes deductions on Schedule A.
- He or she is legally liable for the loan – you cannot deduct interest if you make a payment on someone else's loan.
- He or she made the payment on a qualified home.
Acquisition Debt vs. Equity Debt: Big Tax Difference
Of course, because the deductions are regulated by the government, the rules are never quite as simple as they seem at first glance. There are two types of debt that generate tax-deductible interest. The first is debt that was taken out in order to buy, build or improve your home. This type of debt is known as "acquisition debt." The second type is debt that was taken out for other purposes and is known as "equity debt" because it draws on the equity of your property. This distinction has become particularly important since the passage of the new tax legislation in December 2017 (see How the GOP Tax Bill Affects You).
The bill includes significant changes in the amount of interest borrowers can deduct on mortgage loans and home-equity debt, making interest deductible only for loans of $750,000 or less. In addition, the rules have changed for home-equity loan money that is not used as acquisition debt – for example, to pay medical or college expenses rather than renovate a home. Here are some details.
- Post-Oct. 13, 1987, until Dec. 16, 2017, Debt: Interest on a mortgage taken out to buy, build or improve your home after October 13, 1987, may be fully deducted only if the total debt from all mortgages, including any grandfathered debt, amounts to $1 million or less for married couples and $500,000 or less for singles or married couples filing separately.
- Post-Dec. 16, 2017, until Dec. 31, 2025, Debt: Interest on a new mortgage taken out to buy, build or improve your home is fully deductible only if the total debt from all mortgages amounts to $750,000 or less for married couples and $500,000 or less for singles or married couples filing separately. (Also covered: loans under a binding contract that was in effect before 12/16/17, as long as the home purchase closed before 4/1/18). Interest on older loans – and new refinancing of such older loans – remains deductible at $1 million.
- Home Equity Debt Post-Oct. 13, 1987, until Dec. 16, 2017: Interest on second mortgages (or home-equity lines of credit) taken out for reasons other than to buy, build or improve your home must total $100,000 or less for married couples and $50,000 or less for singles or married couples filing separately. They must also total less than the fair market value of your house minus the value of all grandfathered debt and all post-October 13, 1987, mortgage debt.
- Home Equity Debt Post-Oct. 13, 1987, until Dec. 16, 2017: Interest on second mortgages (or home-equity lines of credit) taken out for reasons other than to buy, build or improve your home is not deductible at all. This is true. even if the original loan was taken out before Dec. 16, 2017, and will last until Dec. 31, 2025. Then, theoretically, loan rules would revert to the post 1987 rules..
If you managed to follow that logic without getting confused, you are in good shape so far – but don't start your deductions yet. There are additional stipulations. Even if you qualify for the deduction based on the criteria outlined above, you cannot take the deduction unless your mortgage is classified as secured debt, which means that your home must serve as collateral for the debt. If it is unsecured debt, it is considered a personal loan, and the interest on it is not deductible.
The Definition of 'Home'
The next hurdle that you need to cross is ensuring that your property is a "qualified home." In order to meet this definition, the property must have sleeping, cooking and toilet facilities. Items that fit this definition can include your primary residence, a second home, a condominium, a mobile home, a house trailer or a boat.
If your home is a second home, you can deduct the interest from only one second home. You must use that property at least 14 days during the year. If your second home is a rental property, you must use it more than 10% of the time that the property is rented out. If your rental property does not meet these criteria, the interest cannot be listed on Schedule A and must instead be listed on Schedule E.
In recent years, falling interest rates have encouraged homeowners to refinance their mortgages. Refinancing provides an opportunity to reduce monthly mortgage payments, reduce the term of the loan, or both. When refinancing is done without taking on additional debt, all interest generated by the mortgage remains tax deductible. When homeowners use their homes as a piggy bank and refinance in order to take out equity to generate spending money – that is, for reasons other than to buy, build or improve their homes – the Home Equity Debt Post-October 13, 1987, rules apply: You can only deduct interest on $100,000 or less, etc., depending on your tax status. (For more on this, read When (and When Not) to Refinance Your Mortgage.)
Proving It to the IRS
In the event of an audit by the Internal Revenue Service, you will need to have a copy of Form 1098, Mortgage Interest Statement, which should be provided each year by the firm that holds your mortgage. If you pay your mortgage payment to an individual, you will need to supply the name, Social Security number and address of the mortgage holder, in addition to the amount of interest paid. (For further reading, see Surviving the IRS Audit.)
The Bottom Line
The home mortgage interest tax deduction is cherished by homeowners and despised by proponents of income tax reform. Flat-tax advocates favor the demise of this deduction and, for many years, U.S. lawmakers on both sides of the aisle had been discussing a variety of tax reform schemes that generally involved the abolition of the mortgage interest tax deduction. It did survive, in diminished form, in the 2017 tax bill. What happens next remains to be seen
To learn more, check out Understanding the Mortgage Payment Structure.