Qualifying Mortgage Loan

In order to claim the tax deduction for home mortgage interest, you must be the person who is legally liable for the loan.  You cannot deduct payments of interest on a loan for someone else.   And the mortgage must be a secured loan on what the Internal Revenue Service (IRS) refers to as a qualified home.

Secured Loan

A secured loan is one in which you sign an instrument (mortgage, deed of trust, or land contract) that provides that:

• Your ownership in the home is security for payment of the debt,
• In the event of default, your home could be used to satisfy the debt, and
• The instrument is recorded or perfected under any applicable state or local law.

The basic idea is that you put your home up as collateral.

Qualifying Home

The definition of a qualifying home includes a house, condominium, mobile home, boat, or similar property.  The home must provide basic living accommodations, including sleeping space, toilet, and cooking facilities.  Your main home is where you live most of the time.  If you have a second home that you do not rent out or hold for resale, you can treat it as a qualified home, even if you do not use it during the year.  But if you rent out your second home for part of the year, you must also use it yourself in order for it to be a qualifying home.  You must use the home for 14 days, or 10% of the number of days it was rented, whichever is longer.

A home under construction is treated as a qualifying home for a period of up to 24 months, if you occupy the home when it is ready for occupancy.  The 24-month period can start at any time on or after the date construction begins.

If your home is destroyed in a fire, storm, tornado, earthquake, or other casualty, you can continue treating it as your qualified home (and deducting mortgage interest) if within a reasonable period of time you rebuild the home and move into it, or sell the land on which the home was located.

A home that you own under a time-sharing plan can be considered a qualified home if it meets the requirements.  If you rent it out, it qualifies as your second home only if you use it yourself during the year.

Divided Use of Home

If you rent out part of your home to a tenant, an allocable portion of your interest expense may be a deductible expense for producing rental income.  This would be reported on Schedule E, Supplemental Income and Loss.  If you have a home office or use part of your home in your business, part of the mortgage interest can be claimed as a deduction related to the business use of your home on Schedule C, Profit or Loss from Business.  Provided your home still qualifies, the rest of the mortgage interest would be deductible as an itemized deduction on Schedule A.

Mortgages that Qualify

Whether or not you can deduct all your home mortgage interest depends on the date you took out the mortgage, the amount of the mortgage, and how you used the proceeds of the loan.  There are three categories for determining whether your home mortgage interest is fully deductible.  If your mortgages fit into one of these categories during the whole year, your interest is fully deductible.

1. You took out your mortgage on or before October 13, 1987.  (This is referred to as “grandfathered debt”.)
2. Mortgages taken out after October 13, 1987 were used to buy, build, or improve your home, but only if the total of all your mortgages, including those taken out before October 13, 1987 is $1,000,000 or less ($500,000 if married filing separately) at all times during the year.
3. You took out any mortgages after October 13, 1987 and used the proceeds for purposes other than to buy, build, or improve your home, provided the total of these mortgages was $100,000 or less ($50,000 if married filing separately), and when combined with the mortgages in categories 1 and 2, do not exceed the fair market value of your home.  An example of this type of mortgage is a home equity loan used to pay off credit card bills, buy a car, or pay tuition.

Points

Points are charges incurred by a borrower in order to obtain a mortgage loan, generally expressed as a percentage of the loan amount.  They may also be referred to as loan origination fees.  For tax purposes, points are treated as prepaid interest, and are generally deductible over the life of the loan, rather than being fully deductible in the year they are paid. 

Points Fully Deductible in Year of Payment

Nevertheless, you may be able to deduct the full amount of the points in the year you paid them if you meet a series of tests:

1. The loan is secured by your main home.
2. Paying points is an established business practice in your area.
3. The points were not excessive.
4. You use the cash method of accounting.
5. The points were not in place of other amounts that are normally stated separately, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.
6. The amount you paid at or before closing, plus the points paid by the seller, was at least as much or more than enough to cover the points charged to you as the borrower.
7. You use the loan to buy or build your main home.
8. The points were calculated as a percentage of the principal amount of the mortgage.
9. The points are clearly shown on the settlement statement.

Points Not Fully Deductible in Year of Payment

If you do not meet the tests for fully deducting your points in the year they are paid, or if you prefer not to deduct them that year, you can deduct the points ratably over the life of the loan if you meet the following tests:

1. You use the cash method of accounting.
2. Your loan is secured by a home (not necessarily your main home).
3. Your loan period is not more than 30 years.
4. If the loan period is over 10 years, the terms of your loan are the same as other loans offered in your area for the same or longer periods.
5. Either your loan amount is $250,000 or less, or the number of points is not more than four for a loan period of 15 years or less, or six for a loan period longer than 15 years.

Other Situations

The following are some additional observations regarding points:

• Points paid on a loan secured by your second home are not fully deductible in the year you pay them.  They must be amortized and deducted over the life of the loan.
• Points you pay on a home improvement loan may be fully deducted in the year you pay them if you meet the first six tests mentioned above.
• Points paid to refinance a mortgage are generally not fully deductible in the year you pay them, unless you use the proceeds to improve your home.  In this case, the percentage of the proceeds you use to improve your home would be used to determine the portion of the points you can deduct that year.  The remaining balance of the points would be deductible over the life of the loan.
• If you paid off a mortgage early, deduct any remaining points in the year you paid off the mortgage.

Form 1098

If you paid $600 or more in mortgage interest (including points) in a year, you should receive a Form 1098, Mortgage Interest Statement, from the mortgage company.  This statement should show the interest and the deductible points you paid during the year.  Form 1098 generally includes only the points you can fully deduct in the year paid.  You may have other points you can deduct, such as points your are amortizing over the life of another mortgage loan, points you paid to a another lender, or points from a settlement statement that are not reported on a Form 1098.

How To Report

The amount of mortgage interest you are deducting based on the amount reported on Form 1098 is reported on Schedule A.  If you have mortgage interest or points that you paid to the seller of your home, report this amount separately on Schedule A and include the name, address and social security number or employer identification number of the person on Schedule A next to the amount.

If you and another person (other than your spouse) are liable for the mortgage and each paid interest on it, but the other person received a Form 1098, you should attached a statement to your return explaining this.  The statement should include the other person’s name and address and the amount of interest each of you paid.  You would then report the amount of interest you paid on Schedule A and next to the amount write “See attached”.

Limits on Deduction

Limits on the amount you can deduct as home mortgage interest refer back to the three categories previously defined under “Mortgages that Qualify”, in order to determine what is referred to as a “Qualified Loan Limit” in the IRS provisions.  These three categories, for purposes of determining the limit, are:

• Grandfathered debt
• Home acquisition debt
• Home equity debt

In effect, the limits for the three different categories depend on each other, in cases where all three are present.

Grandfathered Debt

Grandfathered debt refers to mortgages taken out on or before October 13, 1987.  Interest on these mortgages is fully deductible without limit, but the loan amount reduces the $1 million limit for home acquisition debt (mortgages taken out after that date) and the limit based on your home’s fair market value for purposes of the home equity debt limit, as indicated below.

If you refinance grandfathered debt after October 13, 1987, the refinancing mortgage is still considered grandfathered debt provided the new loan is not more than the balance outstanding on the old loan.  If the new loan is for a greater amount, the difference can be considered home acquisition debt or home equity debt.

Home Acquisition Debt

These are mortgages you took out after October 13, 1987 to buy, build, or substantially improve a qualified home (your main home or a second home).  The debt that qualifies as home acquisition debt is limited to the cost of the home plus any substantial improvements.  And, the average outstanding balance on home acquisition debt is limited to $1 million ($500,000 if married filing separately), reduced by any grandfathered debt.  But loan amounts over these limits may qualify as home equity debt.

A mortgage can qualify as home acquisition debt even if it is not actually used to buy or build a home, or substantially improve a home at the time you take out the mortgage.  You can buy your home within 90 days before or after you take out the mortgage loan.  Or, if you build or improve your home and take out the mortgage before the work is finished, the mortgage will be treated as qualifying home acquisition debt up to the amount of your expenses.  And, if you build or improve your home and take out the mortgage within 90 days after the work is completed, the loan will still qualify as home acquisition debt up to the amount of expenses you incurred during the 24-month period before the work is completed.  

A loan to refinance home acquisition debt will still qualify as home acquisition debt for purposes of the limits, up to the balance of the old mortgage just before refinancing. 

Home Equity Debt

These are loans you take out that are secured by your home (main home or second home), but do not qualify as home acquisition debt.  For example, you may take out a home equity loan to pay for college.  And, home equity debt, for these purposes, can include the amount by which home acquisition debt exceeds the limit.

The limit for home equity debt is the lesser of either $100,000 ($50,000 if married filing separately), or the excess of the fair market value of the home over the total of grandfathered debt and home acquisition debt.

Calculating Deductible Interest if Limits Apply

If the limits apply, there is a table in IRS Publication 936, Home Mortgage Interest Deduction, that will help you go through the calculation to see how much of your interest you can deduct.

Calculating Average Mortgage Balance

You can use the highest balances during the year on each mortgage loan you have in order to determine your limit, but it may be more beneficial to use an average balance for each loan.  There are different ways to calculate this average, as follows:

• Average of first and last balance method.  Under this method, you add the mortgage balance as of January 1st and December 31st and divide by two.  You can use this method provided you did not borrow any new amounts on the mortgage during the year, you did not prepay more than one month’s principal, and you had to make payments at regular intervals.
• Interest paid divided by interest rate method.  Here you take the total interest you paid during the year and divide it by the annual interest rate.  If the rate was variable, you use the lowest rate.  You can use this method if interest was paid at least monthly.
• Statements provided by your lender.  You can use either the closing balance or the average balance reported on each month’s statements, add them together and divide by the applicable number of months.

Mixed-use Mortgage

A mixed-use mortgage is a loan that involves more than one of the three categories of debt (grandfathered debt, home acquisition debt, and home equity debt).  For example, if you took out a mortgage loan partly to refinance a previous loan to buy your home (home acquisition debt) and partly to pay college expenses (home equity loan), this would be considered a mixed-use mortgage.  In this case, rather than using the methods previously mentioned, you should calculate the average balance of each portion of the loan separately, using the following method:

1. Determine the portion of the loan that applies to grandfathered debt and home acquisition debt for each month.  Reduce this amount by the principal payments applied in full to each category until that balance is zero, in the following order:
1. First, any home equity debt
2. Next, grandfathered debt
3. Finally, home acquisition debt
2. Add together the average monthly balances determined in step 1.
3. Divide the result of number 2 by 12.

Deductible Interest and Points

If you are subject to the limits, your deductible interest will be a percentage of the actual interest you paid.  This percentage is determined as the ratio between the applicable limits and the total of your average mortgage balance.  Your deductible points (after determining whether your points are fully deductible in the year paid or whether they have to be amortized over the life of the loan, according to the rules described under Points) will be subject to the limits in the same manner as your interest, and are calculated based on the same ratio.