Home Mortgage Interest Deductibility
By Richard Greenfield, CPA, Reminick, Aarons and Company, LLP
Home mortgage interest expense is deductible if certain requirements are met. In general, mortgage interest expense is deductible only if the home is collateral for the debt (secured debt). If the borrower cannot pay the debt, the lender can use the home to satisfy the loan. Interest expense paid on home acquisition debt, home equity debt, and grandfathered debt is generally considered deductible.
Home Acquisition Debt
A mortgage taken out after October 13, 1987, to acquire, build, or substantially improve a qualified residence is classified as home acquisition debt. Qualifying debt is limited to $1 million ($500,000 each for married filing separately). The $1 million limitation is reduced (but not below zero) by any grandfathered debt. If home acquisition debt is refinanced, the new debt will qualify as home acquisition debt only up to the balance of the old mortgage prior to refinancing. The interest attributable to the additional debt will be nondeductible personal interest unless it qualifies as home equity debt.
A qualifying substantial improvement is one that adds value to the home, prolongs the home’s useful life, or adapts the home to new uses.
There are three cases where a mortgage secured by a qualified residence will qualify as acquisition indebtedness even if the mortgage proceeds are not used to purchase, build, or substantially improve a residence. If the home is purchased 90 days before or after the date that the mortgage is taken out, the debt, limited to the cost of the home plus any substantial improvements, can still qualify as home acquisition indebtedness. If a home is built or improved, a mortgage taken out before the work is completed can also qualify, but it is limited to the costs incurred within 24 months prior to the date of the mortgage. Finally, if a home is built or improved and a mortgage is taken out within 90 days after the work is completed, the home acquisition debt is limited to the costs incurred within the period beginning 24 months before the work is completed and ending on the date of the mortgage.
Home Equity Debt
Home equity debt is considered to be any mortgage taken out after October 13, 1987, that is not considered home acquisition debt or grandfathered debt. It is often taken out for reasons other than to acquire, build, or substantially improve a home. In addition, if a mortgage exceeds the limitation for home acquisition debt, it may qualify as home equity debt up to the home equity debt limitation. The limitation is the lesser of $100,000 ($50,000 each for married filing separately) or the fair market value of the home reduced (but not below zero) by the home acquisition debt and grandfathered debt. Mortgage interest expense in excess of the limitation is nondeductible personal interest.
It should be noted that for alternative minimum tax purposes, interest on home equity debt is generally not deductible unless the proceeds were used to acquire, build, or substantially improve a principal or second residence.
A mortgage taken out on or before October 13, 1987, will qualify as grandfathered debt if it was secured by a qualified home on October 13, 1987, and all times after that date. Mortgage interest expense on grandfathered debt is deductible without the limitations imposed on home acquisition and home equity debt. As mentioned above, however, grandfathered debt does reduce the $1 million limitation for home acquisition debt and the limit for home equity debt.
Refinanced grandfathered debt qualifies as grandfathered debt if the mortgage proceeds do not exceed the balance of the old mortgage prior to refinancing. Any debt in excess of the old mortgage balance is home acquisition debt or home equity debt, assuming that their limitations have not been exceeded. In addition, the debt will qualify as grandfathered debt only for the term remaining on the prior mortgage; thereafter, it is classified as home acquisition or home equity debt, subject to limitations. An exception exists for the refinanced mortgage of a balloon loan, which will qualify as grandfathered debt for the term of the first refinancing, up to 30 years.
In order for mortgage interest expense to be deductible it must be secured by a qualified home. A qualified home is the individual’s principal home or a second home. An individual can have only one principal home at any one time, and it is generally the home where she spends most of the time. A second home is one that the individual chooses to treat as such, and generally, an individual can treat only one home during any tax year as a second home. There are exceptions, however; if an individual buys a new home during the year, she can treat the new home as a second home as of the day it is purchased. If an individual’s principal home no longer qualifies as the principal home, it can be treated as a second home as of the day it is no longer used as the principal home. Finally, if the second home is sold during the year or becomes the principal home, an individual can choose a new second home as of the day the old second home is sold or used as the principal home.
Stock in a cooperative housing corporation owned by a tenant-stockholder can also be considered a qualified home if the tenant-stockholder is entitled to live in the apartment or house. Generally, the co-op passes through the share of the qualified mortgage interest paid by the co-op to the stockholders. In addition, the stockholder may have taken out a separate mortgage in order to purchase shares in the co-op. If all the requirements are met, both amounts of mortgage interest should be deductible, subject to any of the debt limitations that may apply.
If part of a home is used for business, such as a home office, only the portion used for residential living is a qualified home. The cost and fair market value for determining the home acquisition and home equity debt limitations must be divided between the business and the qualified home portions.
If a portion of a home is rented out, the home can still qualify as a residence used by the taxpayer if the tenant uses the rented portion primarily as a residence; if the rented portion is not a self-contained unit with separate sleeping, kitchen, and toilet facilities; and if there are no more than two tenants during the tax year. Two individuals sharing the same sleeping space are counted as a single tenant.
A second home that is rented out for part of the year can qualify as a second home if it is used as the taxpayer’s residence for more than 14 days or more than 10% of the number of days during the tax year that the home is rented, whichever is longer. If the second home is not rented out, it may qualify as a second home even if the tax payer doesn’t live there during the year.
If a taxpayer’s principal or second residence has been destroyed by a casualty such as a fire, earthquake, flood, etc., it can still be a qualified home if it is either rebuilt or the property is sold within a reasonable period of time after the home was destroyed. Thus, interest paid on the mortgage would remain deductible after the destruction.
A qualified home can be owned jointly or by one spouse if the taxpayers file a joint return. If they file separately, each spouse can only have one qualified home. However, if they agree in writing, then one spouse can treat both a main home and a second home as qualified residences.
Points and Other Payments
Points—also called loan origination fees, loan discount fees, maximum loan charges, or discount points —are charges paid by the borrower in order to obtain a mortgage; they often are paid in exchange for a lower interest rate. Generally, points are not deductible in the year paid unless the following requirements are met:
If the above criteria are not met, the points are deductible over the term of the mortgage loan. Points paid for the purchase of a second home and points paid to refinance a mortgage must also be deducted over the term of the mortgage loan. If, however, part of the refinancing was used to improve the principal home, the points allocable to the improvement are deductible in the year they are paid, provided the other criteria are met.
Late-payment charges and mortgage prepayment penalties are deductible if the charge was not for a specific service in connection with the mortgage loan.
William Bregman, CFP, CPA/PFS
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