Homeowners have, for many years, been allowed to deduct the mortgage interest on loans securing a principle residence and one second home. But the Internal Revenue Service (IRS) says there are limits to this deduction.
There is one limit for loans used to buy, build, or substantially improve a residence -- called home acquisition debt. There is another limit for loans secured by a qualified residence but used for other purposes -- called home equity debt.
Most homeowners probably aren’t affected much by the first set of limits. Under the law, taxpayers may deduct interest on the loan balance of up to $1 million of home acquisition debt secured by a qualified primary or secondary residence. Most people -- especially now -- spend a lot less than that for a house.
Home equity debt
Home equity debt is where some taxpayers could get into trouble. Home equity debt is any loan secured by a qualified residence whose purpose is other than to acquire, construct or substantially improve a qualified home. For example, if you borrow against the equity in your home to buy a boat or take a vacation, or even pay off credit cards, that’s what’s known as home equity debt.
You can deduct some of this interest, but the IRS says the amount is not unlimited.
Taxpayers can generally deduct interest paid on the first $100,000 of a home equity loan. The home equity debt limit is reduced to $50,000 for taxpayers who are married filing separately.
If the home equity loan was used to improve the taxpayer’s first or second home -- or to purchase a second home -- the taxpayer may be eligible for a deduction on an amount up to $1 million or the value of the home. However, the deduction for home equity interest may be reduced even below the $100,000 limit if the indebtedness exceeds the fair market value of your home.
For example, taxpayer B borrows $250,000 in a home equity line of credit, and the amount he borrows does not exceed the fair market value of his house. He used $100,000 to add a new kitchen to the house.
The remaining $150,000 pays for college tuition. The amount used to substantially improve the home -- $100,000 -- is treated as home acquisition debt as long as the taxpayer has not exceeded the $1,000,000 balance limitation.
The other $150,000 is treated as home equity debt because it was not used to improve the home. Taxpayer B would be able to deduct interest only up to the $100,000 limit on the home equity debt portion of the loan.
“While tax software packages may include an alert to remind taxpayers and tax return preparers that home mortgage interest deductions are limited, taxpayers need to keep good records to be able to consider these limitations when calculating their home mortgage deductions,” the tax agency says.
Recent loans might not be a problem
A bank lending you more than your home’s fair market value may now seem a quaint notion, but it wasn’t that long ago that banks were handing out loans for 125 percent or more of a home’s value, and that home's value is less today. If you took advantage of one of those deals several years ago and have been writing off all the interest, you may need to discuss that with a tax professional.
Taxpayers who disregard the home mortgage interest deduction limitations may be liable for the increase in tax, plus interest and penalties, computed back to the due date of the return, the IRS warns.