When is mortgage interest NOT deductible? Friedman LLP’s Karl Neulinger focuses on this question, which many home owners don’t even know they should be asking. The following transcribes a recent conversation Karl had with a client concerning mortgage interest and how it can impact tax returns.
Q. I have a few questions regarding the deductibility of a mortgage. I own a home and am thinking of purchasing a second home.
A. Are you going to rent the second home or is this something solely for you and your family?
Q. This is something just for us and won’t be rented. We will take out a mortgage on the property and would like to know whether or not we can deduct the mortgage interest.
A. The answer is generally yes, but it depends on your circumstances. The Internal Revenue Code allows the deduction for mortgage interest, but it must be qualified residence interest. This is defined as interest that is paid or accrued on either acquisition indebtedness or home equity indebtedness with respect to any qualified residence of a taxpayer.
Q. What is acquisition indebtedness?
A. Acquisition indebtedness is essentially what it sounds like. It’s any indebtedness that you incur in acquiring, constructing, or improving any qualified residence and is secured by the residence. The loan, in this case, must be secured by the acquired property and not just any residence.
Both acquisition indebtedness and home equity indebtedness have maximum dollar limits. The limit on acquisition indebtedness is $1 million ($500K if married filing separately), and the home equity limitation is $100K ($50K if married filing separately).
Q. That’s fine. Our home had an original mortgage of $600K, and the property we are looking at will have a mortgage of $600K, so we’re all set.
A. Not necessarily. A qualified residence is actually not defined as one property alone. A qualified residence can be a taxpayer’s principal residence and one other residence. Therefore, the loans must be aggregated. If you have indebtedness of over $1 million, you will not be able to deduct the interest attributable to the excess of your loans over that $1 million mark.
One planning tool that you may take advantage of, is taking some of your excess acquisition indebtedness and using it as home equity indebtedness. By doing that, you can prorate your interest deduction over $1.1 million of indebtedness instead of $1 million.
Q. Are there any other kinds of limitations to the allowable interest deduction?
A. Sure there are. Again, it all depends on your individual facts and circumstances. An example would be interest attributable to the refinancing of a loan. The letter of the law states that when you refinance, acquisition indebtedness only applies to the refinanced portion. Therefore, assume that you have a house worth $800K, with a mortgage of $200K. One day you refinance the mortgage and take out a new loan in the amount of $250K, using the $50K to buy a new car for personal use. Even though the loan is secured by the property, the incremental increase of $50K to the loan will not be treated as acquisition indebtedness and the interest will be disallowed.
Q. Is there anything else I should know?
A. When it comes to tax planning, elements like mortgage interest can impact different cases in different ways. There can be instances where you can elect to deduct mortgage interest as something other than mortgage interest; and you may get more of a tax benefit if you are able to deduct it elsewhere on your tax return. That’s why it’s important to engage an advisor so they can provide advice on how these factors can impact you and what resources are available to get you the most return.