Thursday, November 6, 2014


I recently prepared a memo to explain how mortgage interest and investment interest are deducted on Schedule A for a client who was considering taking out a mortgage on his home, which currently has no mortgage, to either buy a vacation home or to invest in the stock market.  I have adapted it slightly for posting here.


There are two types of deductible mortgage interest – acquisition debt interest and home equity debt interest.

Acquisition debt is debt that is used to buy, build, or substantially improve a residence, and it is “secured” by that residence.  You can deduct interest on up to $1,000,000 of acquisition debt.  Once acquisition debt on a residence is paid off, or if the residence was purchased with all cash, it can never be “reinstated” (except for moneys borrowed to pay for subsequent substantial improvement to the property) for that property.  You can deduct allowable acquisition debt interest on up to two residences – usually your principal residence and one vacation or other residence.  Acquisition debt interest is deductible for calculating both the “regular” tax and the dreaded Alternative Minimum Tax (AMT) 

Home equity debt is debt that is used for any other purpose – to pay down credit cards, pay for college expenses, purchase a car, etc, etc.  You can deduct interest on up to $100,000 of home equity debt.  While home equity debt interest is fully deductible in calculating the “regular” tax, it is NOT deductible in calculating AMT.

If you took out a mortgage secured by your current primary principal residence to purchase a personal-use vacation residence it would be treated as home equity debt and you would only be able to deduct the interest on up to $100,000 on Schedule A.  You would get no actual federal tax benefit for this interest if you are a victim of AMT.  But you could probably deduct the interest on this debt on your state return (depending on your state or residence – not deductible in NJ or PA, for example). 

If you purchased a vacation residence with a mortgage secured by that new vacation residence you could deduct interest on up to $1,000,000 (if you are not already deducting mortgage interest on two properties).

For more detailed information on deducting mortgage interest consult my MORTGAGE INTEREST GUIDE – available for only $1.00 (check out My Dollar Store)!


If you take out a mortgage on your primary personal residence and use the money to purchase taxable investments you can elect to deduct the interest as investment interest instead of home equity interest.  Investment interest is deductible to the extent of current taxable net investment income.  Unused investment interest can be carried forward.

Because qualified dividends and long-term capital gains are taxed at a lower capital gain rate - 0%, 15%, or 20% instead of at your “regular” marginal tax rate - your net investment income for purposes of deducting investment interest is reduced by qualified dividends and long-term capital gains. 

If you use part of the money to purchase tax-exempt municipal investments you must pro-rate the deductible interest (investment interest is not deductible on money used to purchase tax-exempt investments such as municipal bonds).

If you take out a mortgage for $100,000 to invest in taxable stocks, bonds, mutual funds, etc, and your total mortgage interest treated as investment interest is $5,000, and you earn $7,000 in taxable income on the investments, but $3,000 of this is qualified dividends and long-term capital gain, you can only deduct $4,000 currently ($7,000 - $3,000).  $1,000 of the investment interest is carried forward. 

However you could deduct the full $5,000 of interest if you elect to treat $1,000 of the qualified dividends and long term capital gain as “ordinary income” and be taxed at your “regular” marginal tax rate.

The IRS uses tracking rules to determine how to treat interest.  To be safe you would need to deposit the $100,000 check from the mortgage directly into your brokerage account (not into a checking or savings account first, and then into the brokerage account) and purchase the investments.   

Any questions?


No comments: