Mortgage Interest: What Can You Deduct at Tax Time?

By Benny L. Kass
Saturday, January 10, 2009

Second in a series of articles

"Income tax returns are the most imaginative fiction being written today."

-- Herman Wouk

Deducting the interest you pay on your home mortgage is one of the big tax benefits available to American homeowners.

If you have a mortgage, by the end of this month your lender will send you a Form 1098, which tells you how much interest you paid in 2008. When you do your taxes, that number goes on Line 10 of Schedule A of Form 1040.

If you have a loan from a private person, such as a relative, you will need to determine yourself how much interest you have paid. That number goes on Line 11.

There are three major limitations on the amount of interest you can deduct.

First, you can deduct the interest only on the first $1 million in mortgage loans on your first and second homes combined -- what's known as a qualified home. Interest on debt over that limit is not deductible.

The second limitation involves "acquisition indebtedness." According to the Internal Revenue Service, "Home acquisition debt is a mortgage you took out after Oct. 13, 1987, to buy, build or substantially improve a qualified home (your main or second home)."

Let's take this example. In 2000, you bought a condominium for $300,000 and obtained a $240,000 loan. Based on the rapid appreciation in the years after you bought, your unit is now worth $500,000, even if it has lost value recently. You still owe $230,000. You refinance and get a new loan in the amount of $400,000. Your acquisition indebtedness is the amount you owed on your old loan, $230,000. Subject to the third limitation, discussed below, you can deduct the interest only on that amount.

If some of the money you borrow is used to "substantially improve" the home, that also can be counted as acquisition debt. So if you spend $20,000 from your refinancing on a major upgrade, that becomes deductible, for a total of $250,000 in acquisition indebtedness.

The third limitation involves home-equity loans. You can deduct interest on up to $100,000 of home equity mortgage indebtedness, on top of your acquisition debt. This applies whether you incur the debt via a home equity line of credit or a cash-out refinancing.

So, in our example, you can deduct the interest on $350,000 -- that is, $230,000 on the original acquisition debt, $20,000 added to that for your substantial improvement and $100,000 in home equity debt. The interest on the final $50,000 of the $400,000 you borrowed is not deductible.

For more details about these points and others involving mortgage interest, see IRS Publication 936, "Home Mortgage Interest Deduction," available at http://www.irs.gov. Here are some other things to keep in mind about interest deductibility:

· Cooperative housing. A qualified home can be a recreational vehicle or a boat, as long as it contains a kitchen, sleeping quarters and a toilet. But what about housing cooperatives, of which there any many in the Washington area?

According to the IRS, "A qualified home includes stock in a cooperative housing corporation owned by a tenant-stockholder. This applies only if the tenant-stockholder is entitled to live in the house or apartment because of owning stock in the cooperative."

The IRS suggests that to qualify for the interest deduction, the cooperative must have only one class of stock outstanding. However, especially in the District, there are a number of associations that do not have stock certificates but only documents called "proprietary leases." My informal discussions with IRS representatives have led me to believe that those co-ops count as qualified homes. However, co-op owners should consult with their financial and legal advisers on their specific situations.

Generally, if you are a co-op owner, you can deduct payments you make for your share of the interest paid by the cooperative, as well as any interest you pay for your individual share loan that you obtained when you bought your unit.

· Reverse mortgages. More people are obtaining reverse mortgages, either from commercial lenders or from their families. These loans -- generally available only to people 62 and older who have little or no current mortgage obligations -- provide cash to the homeowner in monthly annuities, a line of credit or a lump sum. Interest accrues until the homeowner sells the house or dies. This interest is not deductible until the loan is paid in full. It should be noted that the home acquisition debt limits discussed above apply to reverse mortgages, and your tax accountant should be consulted to determine exactly how much interest will be tax-deductible.

· Points. This is money that a borrower pays upfront to the lender, usually to reduce the mortgage interest rate. Generally, one point equals one percent of the loan. So if you borrow $400,000, one point will cost you $4,000. It is likely to reduce your mortgage rate by about one-eighth of a percentage point.

In recent years, points have fallen into disfavor among borrowers. Why pay $4,000 to a lender just to save a few dollars a month on mortgage payments, especially if the additional money paid is probably tax-deductible anyway? We can be too concerned about interest rates. If you do the numbers, you will see that the savings are not really that great.

A $400,000 loan amortized over 30 years at 5.5 percent will cost you $2,271.16 per month in principal and interest. That same loan at 5.375 carries a monthly mortgage of $2,239.90 -- a savings of $31.26 per month. While I do not belittle any savings, no matter how small, the fact is that this is a small amount. And if you are in a 28 percent tax bracket, that reduces the savings to $22.50.

However, points are deductible, again with limits. When you buy a house, the points you pay for your loan are deductible in full when you file your next tax return. If you obtain a refinance loan and pay points, you must deduct them ratably -- equally -- over the life of the loan. In the example above, if your $400,000 loan is for 30 years, each year you can deduct only 1/30 of the $4,000 you paid ($133.33). When you pay off that loan, any unused points are fully deductible. There are several restrictions on deducting points, and you should discuss this with your tax adviser.

· Mortgage insurance premiums. If you put down less than 20 percent when you buy a home, your lender may require you to obtain private mortgage insurance. The Federal Housing Administration and the Department of Veterans Affairs require their own variations on mortgage insurance; the VA calls it a funding fee.

Congress finally recognized what legal scholars have been saying for years: The payment for such insurance is no different from mortgage interest and should also be deductible. If you obtained a home loan in 2008 that included mortgage insurance, you may be able to take a deduction and list it on Line 13 of Schedule A. There is a limit on the amount you can deduct. If your adjusted gross income is more than $109,000 for a single person or married couple filing jointly -- $54,500 if you're married but filing separately -- you cannot deduct these premiums.

The IRS has provided a relatively simple worksheet to assist you in determining this deduction. It's on page A-7 of "2008 Instructions for Schedules A & B, Form 1040." This is also available from the IRS Web site.

Next Saturday: Home sales and capital gains tax.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, http://www.kmklawyers.com.

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