Homeowner? Learn the Rules of Mortgage Tax Deduction

Most people use a mortgage to buy a home because of the investment involved. Taking on a mortgage spreads out the cost over many years and makes it more affordable. Even though mortgage interest rates are among the lowest of any loans, because they have such long payback terms, people who have them wind up paying tens and even hundreds of thousands of dollars in interest over the life of the loan. To help compensate for that financing burden, the government offers tax deductions for that interest. To be able to take full advantage of the deduction, you need to know the rules surrounding it.

Primary mortgage
Currently, the Internal Revenue Service allows a married couple to deduct up to $1 million worth of mortgage interest on both a first and second home, as well as up to an additional $100,000 on a second mortgage or home equity loan that is used for some other purpose than to improve the home. The amount is $500,000 for a single person or for a married couple that files individual tax returns. To deduct interest on a home that is not a primary residence, the home must be used as a vacation or second home and not rented out more than a couple weeks a year. Homes used primarily as investment properties are subject to different tax rules.

How to claim the deduction
To be able to claim a mortgage interest deduction, you must itemize your deductions rather than taking the standard deduction offered to everyone. For example, say your standard deduction is $12,600. If you have $10,000 in mortgage insurance and $5,000 in other deductions you can itemize, you will be able to claim all those deductions. On the other hand, if you only paid $8,000 in mortgage interest and have only $4,000 in other deductions to itemize, it makes more sense to simply take the standard deduction. Because of this, the mortgage interest deduction is more likely to help wealthier people who buy larger homes and finance more of the costs.

Deduction for mortgage points
When you are applying for a mortgage, you may have the option to pay what are called “points.” A point is simply a prepaid amount you pay to lower your interest rate. One point is usually equal to 1 percent of your mortgage amount, and it will reduce your interest rate by a quarter point.

When you pay points on a mortgage used to purchase a home, you generally can deduct those points in the year you buy the home. For instance, if you got a $200,000 loan and paid two points, you would be able to add $4,000 to your itemized deductions when you file your income tax return. There are some general qualifications you have to meet to be able to do this.

You also can deduct points you pay for a refinance mortgage on your home, but the schedule to deduct them depends on how you use the money. If you use the refinance proceeds to improve your home, such as adding on or doing remodeling, you can deduct the full amount in the year in which you get the loan. If you use your refinance proceeds for another purpose, however — to pay off debt or pay for a child’s college education, for example — then the deduction must be spread out over the life of the loan. That means that same $4,000 worth of points spread out over a 30-year loan would give you a deduction of about $133.33 a year.