The political debate on federal tax reform touches many topics, including the tax deduction for interest on home mortgage loans. At the time of publication, there was no way to determine if this deduction will continue or at what level, but we thought it would be a good time to review current federal law on deducting residential mortgage loan interest. If there is a law change, this information will help you assess its impact.
Interest paid on qualified residence debt is deductible, but limitations apply. Qualified residence debt can be either (a) home acquisition indebtedness (purchasing a home), or (b) home equity indebtedness (borrowing against the equity in your home). Qualified residence interest expense incurred on up to $1 million ($500,000 for married filing separately) of home acquisition indebtedness if fully deductible as an itemized deduction for regular tax purposes. Taxpayers generally can deduct interest on up to $100,000 ($50,000 for married filing separately) of home equity indebtedness. However, there are restrictions on the deductibility of qualified residential mortgage and home equity loan interest for alternative minimum tax (AMT) purposes.
Mortgage interest is only deductible when paid by the taxpayer who is the legal or equitable owner of the property. Thus, a taxpayer cannot deduct interest he or she pays on the mortgage of another person. This may occur, for example, if parents make mortgage payments for their adult children. Similarly, a taxpayer who holds a mortgage generally cannot deduct the interest if it is paid by another person.
A qualified residence (for determining if the underlying debt is qualified residence debt) can be the taxpayer’s principal residence and on other residence selected by the taxpayer for the tax year. In other words, if the taxpayer has several vacation homes in addition to a principal residence, the taxpayer can designate a different vacation home as the second qualified residence for different tax years. A residence, for regular tax purposes, is defined as (a) a house, (b) a condominium, (c) a mobile home, (d) a boat, (e) a house trailer, or (f) other property than under all the facts and circumstances can be considered a residence. Vacant land used for occasional camping does not qualify as a residence.
Planning Tip: Taxpayers with more than two homes should consider keeping a mortgage on their principal residence, and one other residence selected as a qualified residence, and paying off debt on any house(s) for which interest will not be deductible.
Spouses who file a joint return may treat their common principal residence, as well as property that otherwise qualifies as a second residence, whether it is owned jointly or by one spouse only, as a qualified residence.
Conversely, spouses who file separate returns may each take into account only one residence as the qualified residence, regardless of how the properties are owned. However, a deduction for a second residence is available if both spouses consent in writing to one of them taking into account both the principal and the second residence.
A residence under construction can be treated a qualified residence for up to 24 months, but only if the residence actually becomes a qualified residence when it is ready for occupancy. However, the land a home is constructed on does not qualify as a residence under this rule until construction begins. Interest on debt to acquire a lot that is incurred before construction begins is personal interest. However, that interest might be deductible if a home equity loan is used to acquire the lot.