Interest as a Tax

Interest as a Tax Deduction

At the end of each year, your lender should send you a form 1098. This form tells you how much you paid in interest and points during the year. This is your deductible interest, provided you meet certain conditions.

If you obtained the loan prior to October 13, 1987, the loan is considered "grandfathered." All interest paid on grandfathered loans in a given year is fully tax deductible. After that, there are conditions, but most conditions won’t apply to most homeowners.

An important IRS term is "home acquisition debt." Any first or second mortgage used to buy, build, or improve your home is considered to be home acquisition debt.

Acquisition debt can be a first or second mortgage used to buy your home. If you get a second mortgage and use it all for home improvement, that is also considered acquisition debt. If you do a "rate and term" refinance and don’t get any "cash out" – since you are just refinancing your acquisition debt – that also can be considered acquisition debt.

For any of the above types of loans that aren’t "grandfathered" -- you can still deduct all the interest -- but only if your total mortgage debt does not exceed one million dollars. For married couples filing separately, the limit is $500,000 each.

It gets more complicated with refinances and second mortgages.

The IRS has another term called "home equity debt." Basically, this is any loan amount in excess of what was spent to purchase, build, or improve your home.

If you get "cash out" when refinancing your home, the amount in excess of your original loan amount is considered "home equity debt" – unless some of it was used for home improvement. Anything in excess of the home improvement cost is considered "home equity debt."

For second mortgages, it works the same way – anything not used to improve the home is considered "home equity debt."

For the interest to be fully deductible, home equity debt cannot exceed $100,000 and the total mortgage debt on the home must not exceed its value. This can create a problem for those using 125% loan-to-value second mortgages to consolidate debt. That portion of the loan amount that exceeds the value of your home is not tax deductible (unless you used it for home improvement).