Deducting Your Mortgage Interest
One of the best justifications for
owning a home, at least for financial reasons, is the tax savings
that result from deducting mortgage interest. The deduction for
mortgage interest stands as one of the few remaining tax deductions
for the typical middle class taxpayer. Despite the changes to the
tax code over the past several years and the repeal and limitation
of many non-housing itemized deductions, mortgage interest is still
deductible. On first and second mortgages and home equity lines of
credit (with some limitations) for first and second homes, your
mortgage interest deduction is still a good financial incentive to
buy a home.
Your
Mortgage Interest Deductions
Under the current tax code, mortgage interest on first and second
homes is generally deductible as long as these loans total less than
$1.1 million, making home ownership one of the best ways to trim
your tax bill. The examples below illustrate how the mortgage income
tax deduction affects the after-tax home ownership.
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Homeowner Profile
Gross Income - $35,500
House Price/Mortgage Size - $115,000 - $23,000 down = $92,000
Loan Type - 30-year Fixed-Rate mortgage at 10%
Property Tax - 1.23% of home value ($1,415)
Filing Status - Files jointly/four exemptions
According
to the tax code, this homeowner's deductions for mortgage interest
and property taxes would be evaluated at a 15 percent marginal tax
rate. Non-housing itemized deductions (i.e., state and local taxes,
non-mortgage interest and so on) is estimated at $2,000 and the
standard deduction is $5,450. Under the current tax system, the
homeowner saves $1,071 because of the mortgage interest deduction.
You can figure what your own costs and savings will be by
substituting your own tax figures for those on the chart.
Two
Kinds of Debt
Under the current tax system, there are two different kinds of debt.
Money you borrow to buy, build or substantially improve your
residence is called "acquisition indebtedness." Money you borrow
against the equity in your home, or money you take out when you
refinance your home for any reason except home improvement, is
called "equity indebtedness."
When you
borrowed the money is also important. Home loans taken out before
October 14, 1987, are exempted from the new rules. You may fully
deduct interest paid on these loans, regardless of their size or
what you used them for. Any refinanced debt you incurred before
October 14, 1987, is rolled into your total acquisition
indebtedness. On loans made on or after October 14, 1987, you can
deduct mortgage interest paid on acquisition indebtedness up to a
total of 1 million. This means you could buy a home for $250,000, a
beach home for $200,000, and add a family room to your first house
for another $100,000, and still have $450,000 to spend on these
homes for further improvements before you reached your limit for
interest deductibility. The $1 million is not cumulative. As you pay
off a loan, you would add that amount to your total purchasing or
improving up to two residences.
Your equity
indebtedness limit is $100,000. That means that you can borrow up to
$100,000 of the equity in your home and use it for whatever you
want. This is a change from the pre-1986 tax rule that limited your
equity borrowing beyond the purchase price to certain qualified
expenses, such as home improvements, medical and education expenses.
Refinancing Your Mortgage
When interest rates decline, many
homeowners take advantage by refinancing their mortgages. In the
past, refinancing your mortgage has proved to be an excellent
opportunity both to lower your interest rate and monthly payment and
take equity out of your home.
When
refinancing your mortgage, you will probably pay 3 percent to 6
percent of the loan amount in closing costs for surveys, legal fees
and paperwork fees. Many of these closing costs are deductible, but
not necessarily in the year that you refinance. If you are
considering refinancing your mortgage under the current tax rules,
however, there are a couple of things to bear in mind. If you
refinanced before October 14,1987, for a longer term than was
remaining on the pre-October 14 loan, you may only deduct the
interest paid on the mortgage for the term that was remaining on the
old loan. So if you refinanced a loan with 15 years remaining for a
30-year loan with lower payments, you can only deduct the mortgage
interest paid on the new loan for 15 years. The one exception is if
you had a balloon mortgage payment come due after October 13,1987
and you refinanced it to a loan of not more than 30 years; you get
the deductibility for the full term of the longer loan. Any
refinanced debt you incurred before October 14,1987, is rolled into
your total acquisition indebtedness.
In the
past, many homeowners have refinanced mortgages on their
appreciating properties to draw on their equity to buy a new car or
take a vacation. Under the new tax system, homeowners will no longer
have unlimited mortgage interest deductions when drawing on equity.
Any equity debt incurred is subject to a limit of the amount of the
existing debt plus $100,000. Say, for instance, that you bought your
house 10 years ago and have seen the property grow in value from
$70,000 to $230,000. If you refinance your mortgage (on which you
now owe $50,000), you may only deduct the interest paid on the total
of your acquisition indebtedness in the property ($50,000) plus
$100,000. You will be able to deduct the interest paid on $150,000.
Second
Mortgages
A second mortgage allows the homeowner to cash in on some of the
equity that has built up in the home over time. Some lenders call a
second mortgage a "junior lien." Getting a second mortgage is very
much like taking out your first mortgage (i.e. you will be required
to pay closing costs of 3 percent to 6 percent of the loan value).
You may
deduct the interest paid on second mortgages made on or after
October 13,1987, up to the $100,000 limit. The amount of second
mortgages made before that date is part of your acquisition
indebtedness total figure. This means that if you had $50,000 left
on your first mortgage as of that date, and had taken out a $25,000
second mortgage on the property prior to October 14,1987, you would
have an acquisition indebtedness of $75,000.
Home
Equity Lines of Credit
While the 1986 tax reform called for consumer interest deductibility
to be phased out by 1991, interest deductions on equity indebtedness
now are limited only by the $100,000 cap. This means that interest
paid on home equity lines of credit, loans secured by your principal
or second home, is still deductible.
Where the
traditional second mortgage gives the homeowner money in one lump
sum, the home equity line of credit allows homeowners to use the
equity in their home like a giant credit card. The lender allows the
homeowner to borrow at will against the equity in the home, and
charges interest only on the portion of the equity borrowed against.
Therefore, your interest deductions for a home equity line of credit
depend on whether you borrow against the equity during that year.
Loan
Type Affects Interest Deduction
As we've said, the mortgage interest tax deduction is one of the
best financial reasons to buy a home. You may be wondering, however,
what total interest charges are like on the typical home loan. Use
our mortgage calculators to compare a 30-year fixed-rate loan with a
15-year and bi-weekly mortgage for the same amount. As you can see,
the amount of interest you pay over the life of your loan depends on
what kind of mortgage you determine is best for you.
The Tax Benefits of Selling Your Home
The tax code does not tax the profits from the sale of a home, if
the proceeds are used to buy another house costing at least as much
as the sales price of the old one. If you or your spouse are at
least 55 years old, you may be able to sell your home and exclude
the first $125,000 of gains from your taxable income without
reinvesting the money.
