Did you know that the home interest deduction taken on Schedule A of your personal income tax return is limited? There is one limit for loans used to buy or build a residence -- called "home acquisition debt." And there is another limit for loans not used to buy or to build a residence -- called "home equity debt." All loans, whether secured by your main home or your second home, are subject to the same overall limitations and are cumulative (i.e. debt must be aggregated to determine if you are limited).
As the cost of real estate rose over the last 10 to 15 years, and as people acquired second homes, many taxpayers face Home Mortgage Deduction Limitations. Another common scenario in the current real estate market is a taxpayer that has relocated, purchased a new home, and not sold their original house. Therefore, the taxpayer is faced with two mortgages and could easily exceed the debt limits discussed.
In addition, as more and more taxpayers use their home's equity to finance home improvements and other expenses, they are faced with an Alternative Minimum Tax Impact.
Home Acquisition Debt
In general, a joint filer may not deduct interest on more than $1,000,000 of home acquisition debt for their main home and secondary residence. Home acquisition debt means any loan whose purpose is to acquire, construct, or substantially to improve a qualified home.
For example, you borrowed $800,000 against your primary residence and $400,000 against your secondary residence. Both loans were used solely to acquire your residences. The loan amounts add up to $1,200,000. Since your loan amount exceeds the $1 million limit for home acquisition debt, your mortgage deduction is limited. Let's say both loans have a fixed interest rate of 6% and your total interest paid for the year was $72,000. You would only be able to deduct $60,000, which is the interest on the first $1 million of home acquisition debt.
Home Equity Debt
A joint filer may not deduct interest on more than $100,000 of home equity debt for your main home and secondary residence. Home equity debt means any loan whose purpose is not to acquire, construct, or substantially to improve a qualified home, or any loan whose purposes was to substantially improve a qualified home but exceeds the home acquisition debt limit. Your deduction for home equity interest may also be reduced even below the $100,000 limit if your indebtedness exceeds the fair market value of your home. This happens frequently during economic downturns such as we have recently faced.
For example, assuming you had no existing mortgage and you borrowed $300,000 in a home equity line of credit, and the amount you borrowed did not exceed the fair market value of your house. You used $150,000 to add a new family room to your house. You spent the remaining $150,000 to pay for college tuition. Half of the loan is treated on home acquisition debt (the amount used to substantially improve your home). The other half is treated as home equity debt (the amount not used to improve your home). You would be able to deduct interest only up to the $100,000 limit on home equity debt portion of the loan. Assuming you paid $21,000 interest on the loan, the amounts you can deduct would break down like this:
$10,500 - Fully deductible home acquisition debt (half the loan)
$7,000 - Deductible home equity debt (two-thirds of the home equity portion of the loan)
$3,500 - Non-deductible home equity debt (the interest paid on the home equity debt exceeding $100,000)
In addition, this taxpayer would have to report $7,000 as an AMT adjustment.
Furthermore, interest paid on home equity debt is an adjustment for Alternative Minimum Tax which was discussed in a prior Blog. You should understand whether you will be able to deduct interest on a home equity line of credit before your borrow.
For most taxpayers, figuring out the home mortgage interest deduction is straight-forward: add up the interest paid as reported to you on Form 1098, and put that total on your Schedule A. However, for others the computation can become much more complicated. It is always a good idea to check with a tax professional when you buy, sell, or finance property during the year.
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