Understanding Deductible Home Interest and Purchase Expenses
Interest expenses for certain types of loans can be deducted from your taxes if you itemize deductions. These deductions include the interest home mortgage payments and loans for home improvements, but you must be the homeowner and be legally responsible for the loan. The rules aren't simple, and you must itemize deductions, but deducting home-loan interest payments could result in big tax savings for many homeowners.
Understanding Deductible Interest
The first thing taxpayers need to determine is what constitutes a “home” to the IRS. You must use the property for at least 14 days each year, and you can only deduct interest for one primary and one secondary home. The property must have sleeping, cooking and toilet facilities, and properties that qualify include primary and secondary homes, trailers, condominiums, mobile homes and boats.
Your Home Loan Payment
Your home loan payment is divided into percentages that go toward property taxes, interest, insurance and remaining loan balance or principle. A helpful way to remember this formula is with the acronym “PITI.”
- Principle: This is the loan balance
- Interest: The first “I” stands for interest.
- Taxes: These are the property taxes that must be paid each year.
- Insurance: Part of your loan payment goes toward insurance.
The taxes and interest for qualified homes are deductible on IRS Schedule A, itemized deductions. The amount you pay toward your insurance and loan balance doesn't qualify for tax deductions. You should estimate your total deductions to see whether taking the standard deduction or itemizing deductions provides the larger deduction against your income. Most homeowners pay enough interest to make itemizing worthwhile. You should receive form 1098 each year that identifies how much mortgage interest you paid in the previous year.
What You Can't Deduct
You can't deduct insurance premiums or money that goes toward the loan principle unless you rent the property and generate income by incurring these expenses. The IRS also limits your total deductible interest on all mortgages to $1 million for married couples and $500,000 for single filers. You can use multiple mortgages for primary loans, second mortgages and home improvement loans as long as the total remains under the limits. You can also get an additional deduction for interest on a home equity loan.
You can't deduct settlement costs for obtaining a mortgage, forfeited deposits, earnest money, depreciation, down payments and most insurance premiums such as fire, title and comprehensive insurance coverage.
- The rules apply to mortgages taken out after October 13, 1987.
- Home equity loans can only total $100,000 for married couples and $50,000 for single filers, but these figures extend the limits from $1 million and $500,000 to $1.1 million and $550,000.
- The total of all deductible mortgages must be lower than the current value of your home.
You can't deduct any interest you pay to settle old debts on a property, but you can add these expenses to the value of the property. Your mortgage must also be secured by the property; unsecured loans don't qualify for home mortgage interest deductions but are considered personal loans.
Deducting Closing Points
You can deduct the one-time charges that are known as points for the year that you paid them under the following conditions:
- You use the cash method of accounting, which is the most common.
- The points charged are similar to what other lenders charge in your area.
- The loan is secured by your primary residence.
- You provide cash or equity up-front that covers at least the amount of the points.
- The points are computed as a percentage of the loan.
- The amount of the points is clearly stated on the settlement paperwork.
Most people pay “points” when they refinance their mortgage. These points are prepaid interest, meaning you pay them right away to get a lower interest rate during repayment. Luckily, these points are deductible, and figuring out how much you will deduct can be easy. One point is the same as 1 percent of the loan amount, so 1 point on a $100,000 loan would be $1,000. You could potentially deduct the full $1,000 – the tax software that you use should automatically calculate this as long as you are able to input your loan amount and the number of points you paid. Points may also be referred to as discount points, a maximum loan charge, a loan discount, or a loan origination fee.
If you own a rental property, mortgage deductions are trickier. Rent is considered taxable income, so it counts toward your gross income on your return. However, any improvements that you make to the property or money that you spend on the property is usually deductible from the total rental income that you earn from that property. Both the interest that you pay on the mortgage for that rental property and the points are deductible from your rent income.
When using a rented vacation home for both personal and business use, business expenses are tax deductible, subject to limitation. When a taxpayer uses the vacation home for personal use, however, he cannot deduct business expenses. In this context, "personal use" is defined as exceeding the greater of 14 days or 10 percent of the days rented at a fair market value.
Sometimes, special payments and circumstances qualify for mortgage interest deductions. If your mortgage has an early payment penalty, you can deduct the penalty from your annual taxes. If you sell your home during the year, you can still deduct the interest you paid until you sold it. Late payment charges that you paid can also usually be deducted as long as these fees don't apply to some other service such as insurance or maintenance of common grounds.
Congress passed a law to help first-time home buyers by allowing them to deduct mortgage insurance premiums from their taxes on loans issued from 2007 to 2013. This insurance helps people get mortgages who couldn't afford the usual down payment of 20 percent. Congress must renew the deduction if it is to apply after 2013.
All tax laws have exceptions and special circumstances, so if you feel that your situation is unusual, consult a qualified professional for advice. Most home mortgage loan interest generates bigger deductions than taking the standard deduction, so you should estimate the benefits of itemizing your annual deductions before filing taxes.