For many, one of the most significant income tax deductions is their home mortgage interest. But this important deduction comes with a number of traps, as well as several opportunities. Here’s a refresher on that topic.

Home Acquisition Debt

The tax law actually permits the deduction of interest associated with two home mortgages: your principal residence and one other secondary residence. The debt proceeds must have been used to acquire, construct or substantially improve the residence, and the debt must be secured to that residence. This latter requirement of having the debt secured to the property can be a problem with family financing.

Example.  Phil, a 28-year-old, is acquiring his first home and borrows part of the acquisition funds from his parents on a private note. The funds borrowed from his parents allow Phil to have a sufficient down payment to secure a better interest rate on the first mortgage from his bank. Both the bank mortgage and Phil’s note to his parents are acquisition debt, as the proceeds trace to the purchase of his home. But Phil’s interest expense on the note to his parents is nondeductible unless his parents secure that note by recording it at the county courthouse.

The Two Residence Limit

The home acquisition interest deduction is limited to the taxpayer’s principal residence and one other residence selected by the taxpayer that is used personally, such as a seasonal vacation home. The general test of personal use is 14 days within a year, or 10% of the number of days that the property is rented, whichever is greater. Personal use includes days of use by family members.

For those with multiple homes, the key is to identify the secondary residence with the greatest interest expense. Interestingly, this residence can be a mobile home, boat or house trailer, as long as the property contains sleeping space, toilet and bath facilities, and cooking or kitchen equipment. As a result, that expensive recreational boat, with the proper facilities, can qualify for deductible interest as a second home.

The $1 Million Limit

Home acquisition interest, whether for one or two residences, is subject to an overall $1million debt limit. If the combined debt on the principal and second residence exceeds that amount, only the allocable portion of the interest expense attributable to the first $1million of debt is tax deductible.

Home Equity Debt

In addition to deducting the interest attributable to residential acquisition debt, a taxpayer is permitted to deduct interest on up to $100,000 of home equity debt. Home equity debt is defined as any debt secured by a qualified residence that is not acquisition debt. The home equity debt privilege is valuable, as it allows a taxpayer to achieve deductibility of interest on debt used for personal items (otherwise nondeductible), such as vacations, gifts to family members, retirement of credit card debt, etc.

It is possible for a single loan to represent both acquisition debt and home equity debt. But the home equity portion of the proceeds must be used for purposes other than residential acquisition, construction or substantial improvement.

Example.  Sue has a home that has appreciated substantially. She decides to refinance her mortgage to secure more favorable terms, and also to use the equity in her home to obtain additional funds for a new vehicle and to assist with her children’s education. Sue’s residence presently has a $300,000 secured acquisition debt. Sue refinances that debt with a new mortgage for $380,000. She uses the extra $80,000 of proceeds for vehicle and education purposes. $300,000 of this mortgage is acquisition debt, and $80,000 is qualified home equity debt. Accordingly, Sue may deduct all of the interest expense on this debt.

Example.  Ed purchases a new principal residence and incurs $1.4million of acquisition debt. Ed is limited to using $1million of this mortgage for tax deductible interest purposes. He cannot consider $100,000 of this $1.4million loan as home equity debt, because all of the proceeds trace to acquisition of the property. Home equity debt cannot be acquisition debt.

Deductible Points

For most taxpayers, points and fees associated with new debt must be amortized over the term of the loan. However, a special rule allows points on a principal residence acquisition or improvement debt to be deducted when paid. Points represent a charge of the lender, and are often listed on the closing statement as a loan origination fee or loan discount. The taxpayer needs to pay these points from cash at closing; they cannot be borrowed from the lender.But points on debt associated with a second residence (i.e., a vacation home) are not an immediate deduction. They must be amortized ratably over the term of the mortgage. Similarly, points on a refinanced home mortgage, including a principal residence mortgage, must be amortized over the term of the debt. 

Leon Dutkiewicz, CPA, CRSP, is a member of Margolis & Company’s Tax Advisory Services Group. For more information, please call Leon at (610) 667-6250, ext. #136 or contact him at ldutkiewicz@marg.com.