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As advisors, many of our clients are homeowners. For these taxpayers, the mortgage interest expense on their homes indebtedness results in signicant tax savings along with other common itemized deduc- tions such as real estate taxes, state and local income taxes, and contributions to charitable organizations. This issues column offers a general discussion on the rules for deducting home mortgage interest.
The Internal Revenue Code allows individual taxpayers to deduct qualied residence interest as an itemized deduction.1 The term encompasses interest paid on the principal amounts of two loans: acquisi- tion indebtedness and home-equity indebtedness. The law also requires that in order to secure a qualied residence interest deduction: (1) only two homes may qualify for the annual deduction as qualied residence, and (2) the loan must be secured by the residence(s). The qualied residence rules allow taxpayers to have one main residence at any one time. This would be the home where a taxpayer lives most of the time. The second residence can be any home that the tax- payer chooses to treat as the second home.2 You do not have to use the home during the year for it to qualify as a second residence. If the second home was rented during part of the year, the home may still be considered a qualied residence.3 If you are married and le a joint return, your qualied residence(s) can be owned either jointly or only by one spouse.4 Acquisition indebtedness is dened as any secured
indebtedness which is incurred in acquiring, construct- ing, or substantially improving the qualied residence(s) and is subject to a $1,000,000 limitation ($500,000 for married individuals ling separate returns). Home-equity indebtedness is any debt other than acquisition indebtedness secured by a qualied residence. Unlike acquisition indebtedness, use of the loan proceeds is not restricted. A deduction for interest on home-equity indebtedness is limited to the lesser of: (1) the fair market value of the qualied residence reduced by the amount of acquisition in- debtedness, or (2) $100,000 ($50,000 for each spouse ling separately).5
Only the individual(s) who are legally obligated to pay the debt, and actually make the payments, are able to claim a tax deduction for mortgage interest. If parents pay their sons or daughters mortgage, they are not able to deduct the interest unless the parents have also cosigned on the loan.
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Determining the allowable deduction for mort- gage interest expense can be as easy as reporting the amount on Form 1098, Mortgage Interest State- ment, issued by the mortgage holder.6 On the other hand, the law contains several limitations that could result in surprises and unsuspecting outcomes on the amount of deductible mortgage interest. Three categories can be relied upon to initially determine whether interest paid during the year is limited.
- Mortgages taken out on or before October 13, 1987 (grandfathered indebtedness).7
- Mortgages taken out after October 13, 1987, to purchase, build, or improve your residence (ac- quisition indebtedness). However, these mort- gages plus any grandfathered debt must total $1 million or less ($500,000 or less if married ling separately).
- Mortgages taken out after October 13, 1987, other than to purchase, build, or improve your residence (home-equity indebtedness), but only if these mortgages total $100,000 or less ($50,000 or less if married ling separately) and total no more than the fair market value of the residence
reduced by grandfathered indebtedness and ac- quisition indebtedness.8
If all of your mortgages fall into one or more of the above three categories at all times during the tax year, you can deduct all of the interest on those mortgages. (If any one mortgage falls into more than one category, add the debt that falls into each cat- egory to your other debt in the same category.) If one or more of your mortgages does not fall into any of these categories, your home mortgage interest de- duction will be limited.