DEDUCTING MORTGAGE INTEREST

“Qualified residence interest” (i.e. interest on debt secured by the residence), also known as mortgage interest, paid on your primary residence and one secondary residence can be deducted on Schedule A, subject to certain limitations. 

You can only deduct interest on two properties at a time.  If you own a personal residence in New Jersey and two separate person-use vacation properties, one in Florida and one in the Pocono Mountains, and all three properties have a mortgage, you can only deduct the mortgage interest on two of the properties

There are three kinds of deductible qualified residence interest - 

1) Grandfathered debt – debt acquired on or before October 13, 1987, that was secured by your main residence or a qualified second home.  It does matter what the proceeds of the loan were used for, as long as the debt was secured by the property.

2) Acquisition debt - debt acquired after October 13, 1987, to buy, build, or substantially improve your main residence or a qualified second home. A “substantial improvement” is one that adds value to the home, prolongs the home’s useful life, or adapts the home to new uses.

3) Home equity debt – debt acquired after October 13, 1987, that is secured by a principal residence or second home that is not used to buy, build, or substantially improve the property.  There is no restriction or limitation on what the money can be used for; you can use it to buy a car, to pay for college, or to pay down credit card debt. 

The amount of principal on which interest can be deducted is limited –

•  Grandfathered debt is not limited.  Interest on grandfathered debt is deductible in full as mortgage interest.  

•  Acquisition debt is limited to $1 Million ($500,000 if Married Filing Separately). Qualified acquisition debt cannot exceed the cost of the home and any substantial improvements.  The $1 Million (or $500,000) debt limit is reduced by any grandfathered debt.

•  Home equity debt is limited to $100,000 ($50,000 if married filing separately).  The $100,000 (or $50,000) debt limit is reduced by any grandfathered debt in excess of $1 Million (or $500,000).

Refinanced acquisition debt actually qualifies as acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing.

If you have done nothing but refinance acquisition debt to get better rates over the years - and you never took out a home equity loan, or opened a home equity line of credit, or refinanced to get cash and used the money for anything other than to buy, build, or substantially improve a personal residence, you still may have home equity debt.  The additional closing costs of each refinance that were added to the principal of the refinanced mortgage represent home equity borrowing. 

The only way you would avoid home equity debt in this case is if you literally refinanced only the principal from each old mortgage and paid all closing costs in cash.

John and Mary purchased a home in 2011.  They have one mortgage, from the original purchase, and no home equity debt.  They want to refinance their original mortgage in 2014 to get a better rate.  The principal balance on the original mortgage is $197,374.  The principal balance of the new mortgage will be $200,000.  They did not take any money “out”, and actually paid a little over $1,000 at the closing.  The difference is the closing costs for title insurance, inspections, fees, etc. etc.  John and Mary now have acquisition debt of $197,374 and home equity debt of $2,626. 

None of my clients have purchased homes for anywhere near $1 Million, and I doubt no more than a handful of my readers have.  So excess acquisition debt is not an issue for me.  But I have had several clients who have constantly refinanced over the years, often using additional borrowings to pay down credit cards or other debt or to purchase a car or pay for college.  Here is where the potential problem lies.

To be perfectly honest, I do not know of a single taxpayer, client or otherwise, who actually keeps track of acquisition debt and home equity debt from purchase through all refinances and borrowings. 

So, while it is clearly the responsibility of the taxpayer to keep track of acquisition and home equity debt, if anyone is actually doing this it is the professional tax preparer.  More work for us, thanks to complexity in the Tax Code that has been provided by the idiots in Congress.

I expect that at least 90% of all taxpayers who “self-prepare” their return, either by hand or by using tax preparation software, simply deduct the gross amount of mortgage interest reported in Box 1 of each Form 1098 they receive, regardless of the amount of their acquisition and accumulated home equity debt.  I also expect that at least two thirds (66.67%) of all tax preparers also do this.

Congress has successfully placed the burden for maintain records of the cost basis of investments (going forward) on the individual broker or mutual fund house.  Would it be possible to place the burden for maintaining records of acquisition and home equity debt on the banks and mortgage companies? 

A mortgage applicant would need to certify, under some kind of penalty, the purpose of the borrowing.  And the Form 1098 could include four separate entries for mortgage interest paid-

1. Covered Qualified acquisition interest

2. Covered Qualified home equity interest

3. Non-Deductible mortgage interest

4. Non-Covered mortgage interest

“Non-covered mortgage interest” would be interest on loans that originated before the inception of the new rules.

I doubt this will ever happen.  You can bet that the banking and mortgage lobby would line the pockets of the idiots in Congress aggressively combating such requirements.

Oh well, I can dream, can’t I?   

In an upcoming TWTP post I will discuss the rules for determining the amount of mortgage interest that can be deducted and some ways to get around the acquisition and equity principal limitations.

TTFN