Not all Mortgage Interest is Deductible

The IRS is currently taking the initiative during audits to determine if taxpayers are deducting too much of their home equity debt interest. Typically, taxpayers are permitted to deduct the interest on $1 million of home acquisition debt (which includes future debt that is incurred to make renovations, but not repairs) and the interest on up to $100,000 of home equity debt. Equity debt is debt that is not incurred with the purposes of purchasing or renovating a home.

Taxpayers frequently exceed the equity debt limit and fail to make the proper adjustments to their interest deduction accordingly.

The easiest way to explain this limitation on interest deduction is by using an example. Let's say that you have never refinanced your original loan that you used to buy your home, and the principle balance is currently less than $1 million.

However, you have also taken out a line of credit on the home, and the debt owed for that line of credit is treated as equity debt. If the current balance on that line of credit is $120,000, then you have spent more than the equity debt limitation and only 83.33% ($100,000/$120,000) of the equity line interest is deductible as home mortgage interest via Schedule A. The balance is not deductible unless you can trace the excess debt to the investment or business use.

If the excess debt can be traced to investments, the interest that you pay on the amount that can be traced can be deducted as investment interest, which is also deducted using Schedule A but has a limit of the amount that is equal to your net investment income (investment income less investment expenses).

If the excess debt was used for business, you could deduct the interest on that excess debt via the appropriate business schedule. Alternatively, the IRS permits you to elect to treat the equity line debt as "not secured" by the home, which would allow the interest on the entire equity debt to be traced and deducted using the appropriate schedule if deductible.

For example, if you borrow from the equity line for rental down payment. If you make the election of "not secured," the interest is deductible for the amount borrowed for a rental down payment via Schedule E rental income and expense schedule and is not subject to the limitations on home equity debt.

However, the rules state that the home mortgage interest is deductible only if it is secured by the home. If the "not secured" election is used, none of the interested can be traced back to the home itself. So, for example, if the equity line was used in part for a down payment on a rent and also for personal reasons, the interested that is associated with the personal use of loan funds can not be deducted since you have elected to treat it as "not secured" by your home.

Sometimes unexpected results can occur from using the unsecured election in the current year and in future years. You should use that election only after contacting our offices for a consultation.

Typically, people that are not familiar with the sometimes complex rules of home mortgage interest think that the interest reported on Form 1098 as issued by their mortgage lenders at end of each year can be fully deducted. However, when taxpayers have refinanced or have equity loans, this may not be true and could result in an inquiry from the IRS potential multi-year adjustments.

In fact, for Form 1098 issued after 2016 (effective for 2016 information), the IRS will require that mortgage lenders include some additional details, including the outstanding mortgage principal amount as of the start of the calendar year, the origination date for the mortgage and the address for the property that secures the mortgage, which will provide the IRS with the additional information needed for audits.

If you are unsure about how much interest you are permitted to deduct or if you have questions about how additional home mortgage debt or refinancing will affect your taxes, please contact our office for future assistance. 

Need help with your mortgage interest deduction? Call us at 715-365-6512 for all your tax preparation needs!