You can take qualified mortgage interest as a deduction on both your main home and a second home if you itemize deductions on Schedule A. There’s a catch, though -- for the loan interest to be deductible, you must be legally liable for repayment of the loan.
You can increase the amount of your deduction by making extra mortgage payments during the year. For example, if you pay your January mortgage payment in December, you’ll have 1 month’s extra interest to deduct. It makes sense to do this if you’re also "bunching" other deductions such as charitable donations.
Most interest paid on home mortgages is fully deductible, but there are exceptions. It’s important to distinguish qualified mortgage interest from personal interest because the former is usually deductible while the latter is not. Home mortgage interest -- interest on debt secured by a principal residence or second residence -- must be categorized as interest on acquisition debt or interest on home-equity debt.
"Acquisition debt" is debt incurred to buy, build, or improve the home while home-equity is debt incurred for any purpose other than buying, building, or improving the home. Don’t confuse this with a home-equity loan or line of credit, though. A home-equity loan is secured by your home, but part of the money might be acquisition debt if you used it to build an addition onto your home, and part might be home-equity debt if you used it to fix the roof or to buy a boat.
Interest you pay on acquisition debt is fully deductible as long as the debt doesn’t exceed $1 million ($500,000 if your filing status is married filing separately) at any time during the tax year. You can also deduct the full amount of interest you pay on home-equity debt as long as the debt does not exceed the lesser of:
$100,000 ($50,000 if your filing status is married filing separately) at any time during the tax year, or
The difference between the fair market value (FMV) of your home and the remaining acquisition debt
Example: In 2005, you purchased your principal residence for $500,000. Four years later, when you owed $400,000 on the original mortgage, you took out a $60,000 home-equity loan and used the proceeds to build a sunroom and install an indoor pool. Now that your home is worth $700,000, you decide to take out another $130,000 home-equity loan and buy a sailboat. On your 2010 return, you can deduct the interest that you pay on:
The $400,000 left on the original mortgage (acquisition debt)
The $60,000 sunroom / pool loan (acquisition debt)
$100,000 of the sailboat debt (home equity debt)
You can’t deduct the interest paid on the $30,000 of sailboat debt because it exceeds the $100,000 limit on home-equity debt.
Caution: Interest paid on loan proceeds that are not used to buy, build, or improve your home (such as the “sailboat” debt in the example above) is not deductible for alternative minimum tax (AMT) purposes.
Under the mortgage interest rules, all debt incurred before October 14, 1987, and secured by a main or second residence is treated as acquisition debt. Such debt is not subject to the $1 million cap, but it does reduce the $1 million and $100,000 limits if any additional debt is incurred on the residence after October 13, 1987.
Example: Let's suppose that your principal residence is worth $3.2 million and you have $2 million outstanding debt on the residence, all incurred prior to October 14, 1987. On your (2010) return, you can deduct all the interest you pay on the $2 million debt. However, if you borrow additional money, even for a home improvement, you can't deduct the interest because you have already exceeded the $1 million acquisition-debt limit and the $100,000 home-equity debt limit.
In recent years, many mortgage lenders have allowed taxpayers to take out home equity loans or lines of credit that exceed the fair market value of their homes. These offers often include the caveat, "The interest is usually tax-deductible." When considering these offers, it’s important to remember that there are limits on the amount of interest you can deduct on home-equity debt.
Example: Suppose you purchased your home in 2006 for $155,000, and took out a $147,250 mortgage (acquisition debt). In January 2010, you took out a home-equity loan to consolidate your other debts at a lower interest rate (home-equity debt). At the time you took the loan, your remaining mortgage principal was $138,600 and the fair market value of your home was $165,000. The lender allowed you to borrow up to 110% of your home’s FMV, so you borrowed the maximum amount allowed -- $42,900.
The lender calculated the maximum amount that you could borrow as follows:
$165,000 (FMV) X 110% = $181,500 (Limit)
$181,500 (Limit) -- $138,600 (Existing mortgage) = $42,900
In 2010, the interest you paid on your home-equity loan is not fully deductible. Why? Because you have exceeded the home-equity debt limit. The maximum amount that you can deduct is the interest on the lesser of the difference between the FMV of your home ($165,000) and the remaining acquisition debt ($138,600):
$165,000 (FMV) -- $138,600 (Acquisition debt) = $26,400, or
$100,000.
Since $26,400 is less than $100,000, the maximum amount that you can deduct is the interest on $26,400. Since you borrowed $42,900, this means that the interest on $16,500 of your home-equity debt is not deductible:
As you can see, the computation of such mortgage interest limitations can get rather involved.
Points (also called loan origination fees, maximum loan charges, or loan discounts) are mortgage interest paid "up front" when the mortgage is granted. One point equals 1% of the mortgage loan amount. To be deductible as mortgage interest, points must be paid solely for the use of money. Fees paid to cover services such as the lender’s appraisal fee, notary fees, or the preparation of the mortgage note are not deductible. Because points represent interest paid in advance, they generally must be deducted over the life of the loan. However, points incurred to finance the purchase or improvement of your main home might qualify to be deducted in full in the year that you paid them.
Points are fully deductible in the year that you paid them if all of these conditions are met:
You are a cash method taxpayer.
The mortgage was used to purchase or build your main home.
The mortgage loan is secured by your main home.
The charging of points is an established business practice in the area.
The deduction doesn't exceed the number of points usually charged in the area.
You did not borrow the funds used to pay the points. You do not qualify to take this deduction if the lender withheld the amount of the points from the loan proceeds.
The settlement statement (generally a HUD-1) clearly states the amount of points paid in connection with the closing.
The points are computed as a percentage of the amount of principal of the mortgage.
. If any of these conditions are not met, then you must deduct points over the life of the loan. The flowchart in the "Interest Expense" chapter of Publication 17: Your Federal Income Tax can help you determine whether points are fully deductible in the year you paid them.
If you qualify to deduct the full amount of points when paid but don’t benefit from itemizing deductions for the first year of the mortgage, you can still deduct the points over the life of the loan.
Example: Let’s assume that you purchased your first home in November 2010, and that you’re filing as head of household. You paid 3 points ($3,000) to acquire your 30-year $100,000 mortgage, and you made your first mortgage payment on January 1, 2011.
For 2010, your itemized deductions, including points paid, total only $3,700 -- well less than your standard deduction. Since your standard deduction is greater than your itemized deductions, you should deduct your points over the life of the mortgage loan.
Points paid to refinance a home mortgage (often referred to as a "re-fi") or to purchase a second home must be deducted over the life of the loan. Generally, points deducted over the life of the loan must be amortized using the original issue discount (OID) rules. These rules are rather complex. However, most taxpayers can use a simplified method and deduct the points ratably (equally) over the life of the loan, if all of these conditions are met:
The loan is secured by a home.
The duration of the loan is not more than 30 years.
(For loans of more than 10 years, the terms of the loan must be the same as other loans offered in the taxpayer’s area for the same or longer period.)
Either the loan amount is $250,000 or less, or not more than 4 points were paid for a loan of 15 years or less (not more than 6 points were paid for a loan of more than 15 years).
Example: Let’s assume that you purchased your first home in November 2010, and that you paid 3 points ($3,000) to acquire your 30-year (360 months) $100,000 mortgage. Your first mortgage payment was made in December, 2010. To deduct points equally over the life of the loan, you would calculate it as follows:
$3,000 (Points paid) / 360 (Monthly payments) = $8.33 (Amount you can deduct per month)
For 2010, you can deduct only 1 month’s worth of points, or $8.33.
Each year from 2011 through 2038, you can deduct $100 of your points:
$3,000 (Points paid) / 360 (Monthly payments) X 12 (Payments per year) = $100
In 2038, you can deduct only 11 months’ worth of points, or $92.
Note: If refinancing proceeds are used to buy, build, or substantially improve your home, you have the option of deducting the points in the year the loan is refinanced.
If you’re deducting points over the life of a loan and you pay the mortgage off early, you can deduct any remaining points in the year in which you pay off the mortgage. This may not be the case if you refinance your mortgage, however. If you refinance with a new lender, you can deduct the remaining points on the original loan when the loan is paid off. But if you refinance the mortgage with the same lender, you must deduct the remaining points over the life of the new loan.
Example: You refinanced your original home mortgage during 2010. The original 30-year loan, which you took out in July 2000, was for $125,000, and you paid 2½ points ($3,125) to obtain the loan:
$125,000 (Mortgage amount) X .025 (Points paid) = $3,125
You made your first payment on September 1, 2001, and you have been deducting points over the life of loan. From September 2001 through December 2008 (88 months), you deducted $764:
$3,125 (Points paid) / 360 (Monthly payments) = $8.68 (Amount you can deduct per month)
$8.68 X 88 months = $764
You made your last payment on the original loan on February 1, 2010. On February 20, 2010, you took out a 15-year (180 months), $110,000 re-fi loan with a new lender, and paid 2 points ($2,200) to obtain it:
$110,000 (Loan amount) X .02 (Points paid) = $2,200
And you made the first payment on your new loan on April 1, 2010. You must deduct the points on the re-fi loan over the life of the loan, which means that you can deduct $110 for 2010:
$2,200 (Points paid) / 180 (Monthly payments) = $12.22 (Amount you can deduct per month)
$12.22 (Amount you can deduct) X 9 months = $110 (2010 deduction for new loan)
Additionally, you can deduct all the remaining points from your old loan on your 2010 return, which means that you can deduct $2,361 for 2010:
$3,125 (Points on original loan) -- $764 (Points deducted before 2010) = $2,361 (2010 deduction for old loan)
So, on your 2010 return, your total deduction for points paid will be $2,471:
$110 (New loan) + $2,361 (Old loan) = $2,471
Example: Now, suppose you took your new loan with the same lender. This means that you would have to deduct the 2,344 points remaining ($3,125 -- $764 + ($8.68 monthly deduction X 2) = 2,344) from your original loan over the life of the new loan:
$2,344 (Remaining points) / 180 (Monthly payments) = $13.02 (Amount you can now deduct per month)
This means that your 2010 deduction for points paid on your old loan would be $135:
($8.68 X 2) + ($13.02 X 9) = $135
And your total 2010 deduction for points paid for both your old and new loans would be $245:
$135 (Old loan) + $110 (New loan) = $245
Important: Remember that any deduction you take for points paid is in addition to the deduction for the normal monthly interest payments you made on both loans.
Points paid by the seller in connection with a loan to the buyer are usually considered, for tax purposes, to be paid by the buyer and are deductible by the buyer. When you deduct points paid by the seller, you must reduce the basis of your home by the amount of points the seller paid.
If you paid $600 or more in mortgage interest (not mortgage payments, just the interest portion of the payments), your lender must send you and the IRS a Form 1098. However, if your mortgage interest totals less than $600, your lender is not required to send you one.
Box 1 shows the total amount of interest that you paid (not including points).
Box 2 shows any points that are potentially deductible. You usually see an amount in this box only if this is the mortgage that you took out when you purchased the home.
Box 3 shows any refund of interest made because you overpaid the amount you actually owed (this rarely happens).
Box 4 shows the total mortgage insurance payment you made (often referred to as PMI).
Box 5 may contain various information, such as the address of the home being mortgaged or amounts paid out of escrow (real estate taxes and homeowner’s insurance premiums).
You enter deductible interest (box 1) and points (box 2) reported on Form 1098 on line 10 of Schedule A. Keep in mind that the amounts shown on Form 1098 may or may not be deductible, depending on how they fit the guidelines discussed earlier.
If you paid deductible mortgage interest and points not reported to you on Form 1098, you enter these amounts on lines 11 and 12 of Schedule A, respectively. If the recipient of the interest is an individual, enter the recipient’s name, address, and identifying number (usually the Social Security number) on the dotted lines below line 11.
If you use the H&R Block tax software Interview, enter mortgage interest and points paid in the Mortgage Interest (Form 1098) section of the Deductions Interview. The program will make sure that your interest and points are correctly deducted on your return.
Mortgage interest on rental property is deducted as an expense of renting the property. It's reported on Schedule E rather than on Schedule A. Also, if you paid points when you took the mortgage on your rental property, the points must be amortized over the life of the loan - they cannot be deducted. See Points for details.
If you personally use part of the property and rent out another part of it (which you don’t personally use at all), any expenses that are applicable to the entire property, such as real estate taxes, are prorated according to the percentage of space rented. Only the rental portion of these expenses is deducted from rental income. You deduct the personal portion of real estate taxes, mortgage interest, and casualty losses on Schedule A, if you itemize. The personal portion of other expenses (such as utilities) is not deductible at all. For more information, see Rentals and Royalties.
The mortgage interest on a vacation home that you don’t rent out is fully deductible on Schedule A (remember -- you can deduct the mortgage interest for your main home and a second home). The rules are a little different if you did rent out the vacation home during the year. If you personally used the vacation home and rented it out for fewer than 15 days, then you don’t need to report the rental income at all, and you can deduct the mortgage interest you paid on Schedule A.
If you rented out the home for 15 days or more during the year, the IRS requires you to report the rental income, but allows you to deduct expenses related to renting the property. You report the mortgage interest for the period of time that you rented the property on Schedule E, and you deduct the remainder of the mortgage interest that you paid as a deduction on Schedule A. The split is based on a ratio between the number of days rented and either:
The number of days owned during the year, or
The number of days used for personal purposes
For more information, see the "Personal Use of Vacation Homes" section of Rentals and Royalties.