Know the Limits for Your Interest Deduction

One of the most popular and frequently-used deductions that taxpayers take on their tax return is the home mortgage interest deduction. Though most people assume that the interest information provided each year by their lender on Form 1098 is fully deductible, there are circumstances in which the rules are not as straightforward as that.

If a taxpayer has taken out a home equity loan or refinanced their original loan, additional calculations need to be made in order to ensure that the correct deduction is taken. Because so many taxpayers are taking deductions incorrectly and reporting too much home equity debt interest, the IRS has begun an aggressive audit initiative.

Interest Deductions Rules

The rules regarding interest deductions allow up to $1 million in home acquisition debt to be taken, as well as home equity debt interest of up to $100,000. The acquisition debt includes any additional debt that has been incurred for improvements to the home (though loan repairs are not included).

Understanding the difference between acquisition debt and equity debt is important to understanding the mistake that is often made in the calculation. Equity debt is not debt assumed for either improvements or the home’s acquisition.

In order to understand how the limits on the two different types of home debt interest are supposed to be taken, imagine that you are still paying the original loan that you took out when you bought your home. You never refinanced it and the principal balance is less than $1 million. That debt is specifically acquisition debt.

In addition to the original loan, you also took out a home equity line of credit, which is specifically equity debt. Because the government imposes a $100,000 limit on the equity debt that you can deduct interest on, if your debt is $120,000 then you can only deduct a portion of the interest on that debt – the 83.33% that represents the $100,000 limit – as home mortgage interest on your taxes.  

The remaining $20,000 is only deductible if you are able to show that you used it for another deductible purpose, such as a business use or an investment. If you can show that the $20,000 was used for a business expense, then you would take the deduction on its interest on the business schedule, and if you can show that it was used to purchase an investment then you can deduct it on Schedule As as investment interest – but this ability is also limited. It can not be greater than your net investment minus your investment expenses.

Other Options

There are other options available that allow you to deduct the interest on the entire equity debt. If you do not treat it as secured by the home, then you can trace it to an alternate use for which the interest is deductible and then take the interest deduction on the appropriate schedule.

Examples of uses for which this would be appropriate include using the money for a rental’s down payment, which could be deducted on Schedule E: the rental income and expense schedule does not impose the same limitation that the home equity debt interest deduction does.

If you choose to pursue this option, you must remember that the government requires that home mortgage interest is secured by the home. Choosing to identify the home equity debt as unsecured in order to write off a portion of it on the rental schedule means that no portion of that debt can be written of as home equity debt – and that means that if you only used a portion of the loan for the rental down payment, the balance of the loan would not be eligible for the home equity debt write off.

Because this issue has been so confusing and so many people have taken deductions that are too high, the IRS is making changes to their requirements of lenders for the way that they prepare Form 1098. Starting with information provided by 2016, lenders will include the mortgage origination date, the address of the home that is being secured by the mortgage, and the specifics on the amount of the outstanding mortgage principal at the beginning of the year.

With this information the IRS will be able to more effectively review and audit the information submitted on tax forms. If you are concerned about whether you are doing the calculations correctly or are considering using the unsecured election, contact our office to give yourself the protection and understanding that you need. 

Do you need some help understanding your tax deductions? Give us a call at (770) 268-3434 for a consultation!