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Deducting Your Mortgage Interest Under the Tax Code

Your Mortgage Interest Deductions

Under the current tax code, mortgage interest on first and second homes is generally deductible as long as these loans total less than $1.1 million, making homeownership one of the best ways to trim your tax bill. The examples below illustrate how the mortgage income tax deduction affects the after-tax homeownership.

Homeowner Profile

Gross Income..............$35,500
House Price/Mortgage Size.$115,000 - $23,000 down = $92,000
Loan Type.................30-year Fixed Rate mortgage at 10%
Property Tax .............1.23% of home value ($1,415)
Filing Status.............Files jointly/four exemptions

According to the tax code, this homeowner's deductions for mortgage interest and property taxes would be evaluated at a 15 percent marginal tax rate. Non-housing itemized deductions (i.e., state and local taxes, non-mortgage interest and so on) is estimated at $2,000 and the standard deduction is $5,450. Under the current tax system, the homeowner saves $1,071 because of the mortgage interest deduction. You can figure what your own costs and savings will be by substituting your own tax figures for those on the chart.

Example of the impact of the Mortgage Income Tax Deduction
on Annual Homeownership Costs:

Before Tax Homeownership Costs:

Mortgage Interest........................$9,177
Property Taxes...........................$1,415
Total of Before Tax Homeownership Costs..$10,592

Itemized Deductions:

1. Homeownership Deductions

Mortgage Interest..............$9,177
Property Taxes.................$1,415
Non-homeownership Deductions...$2,000
Total..........................$12,592 

2. Standard Deductions=$5,450

Total Itemized Deductions=$7,142

Multiply Total Itemized Deductions by Marginal Tax Rate to get Homeownership Tax Savings:

$7,142 x .15 = $1,071

After Tax Homeownership Costs = Homeownership Tax - Before Tax Savings:

$10,592 - 1,071 = $9,521

Two Kinds of Debt

Under the current tax system, there are two different kinds of debt. Money you borrow to buy, build or substantially improve your residence is called "acquisition indebtedness." Money you borrow against the equity in your home, or money you take out when you refinance your home for any reason except home improvement, is called "equity indebtedness."

When you borrowed the money is also important. Home loans taken out before October 14, 1987, are exempted from the new rules. You may fully deduct interest paid on these loans, regardless of their size or what you used them for. Any refinanced debt you incurred before October 14, 1987, is rolled into your total acquisition indebtedness. On loans made on or after October 14, 1987, you can deduct mortgage interest paid on acquisition indebtedness up to a total of 1.0 million. This means you could buy a home for $250,000, a beach home for $200,000, and add a family room to your first house for another $100,000, and still have $450,000 to spend on these homes for further improvements before you reached your limit for interest deductibility. The $1. 0 million is not cumulative. As you pay off a loan, you would add that amount to your total purchasing or improving up to two residences.

Your equity indebtedness limit is $100,000. That means that you can borrow up to $100,000 of the equity in your home and use it for whatever you want. This is a change from the pre-1986 tax rule that limited your equity borrowing beyond the purchase price to certain qualified expenses, such as home improvements, medical and education expenses.

Refinancing Your Mortgage

Interest rate have declined recently, and many homeowners have taken advantage of this drop by refinancing their mortgages. In the past, refinancing your mortgage has proved to be an excellent opportunity both to lower your interest rate and monthly payment and take equity out of your home.

When refinancing your mortgage, you will probably pay 3 percent to 6 percent of the loan amount in closing costs-for surveys, legal fees and paperwork fees. Many of these closing costs are deductible, but not necessarily in the year that you refinance. If you are considering refinancing your mortgage under the current tax rules, however, there are a couple of things to bear in mind. If you refinanced before October 14,1987, for a longer term than was remaining on the pre-October 14 loan, you may only deduct the interest paid on the mortgage for the term that was remaining on the old loan. So if you refinanced a loan with 15 years remaining for a 30-year loan with lower payments, you can only deduct the mortgage interest paid on the new loan for 15 years. The one exception is if you had a balloon mortgage payment come due after October 13,1987 and you refinanced it to a loan of not more than 30 years; you get the deductibility for the full term of the longer loan. Any refinanced debt you incurred before October 14,1987, is rolled into your total acquisition indebtedness.

In the past many homeowners have refinanced mortgages on their appreciating properties to draw on their equity to buy a new car or take a vacation. Under the new tax system, homeowners will no longer have unlimited mortgage interest deductions when drawing on equity. Any equity debt incurred is subject to a limit of the amount of on equity. Any equity debt incurred is subject to a limit of the amount of the existing debt plus $100,000. Say, for instance, that you bought your house 10 years ago and have seen the property grow in value from $70,000 to $230,000. If you refinance your mortgage (on which you now owe $50,000), you may only deduct the interest paid on the total of your acquisition indebtedness in the property ($50,000) plus $100,000. You will be able to deduct the interest paid on $150,000.

Second Mortgages

A second mortgage allows the homeowner to cash in on some of the equity that has built up in the home over time. Some lenders call a second mortgage a "junior lien." Getting a second mortgage is very much like taking out your first mortgage (i.e. you w ill be required to pay closing costs of 3 percent to 6 percent of the loan value).

You may deduct the interest paid on second mortgages made on or after October 13,1987, up to the $100,000 limit had already been reached when the first mortgage was taken out. The amount of second mortgages made before that date is part of your acquisition indebtedness total figure. This means that if you had $50,000 left on your first mortgage as of that date, and had taken out a $25,000 second mortgage on the property prior to October 14,1987, you would have an acquisition indebtedness of $75,000.

Home Equity Lines of Credit

While the 1986 tax reform called for consumer interest deductibility to be phased out by 1991, interest deductions on equity indebtedness now are limited only by the $100,000 cap. This means that interest paid on home equity lines of credit - loans secure d by your principal or second home - is still deductible.

Where the traditional second mortgage gives the homeowner money in one lump sum the home equity line of credit allows homeowners to use the equity in their home like a giant credit card. The lender allows the homeowner to borrow at will against the equity in the home, and charges interest only on the portion of the equity borrowed against. Therefore, your interest deductions for a home equity line of credit depend on whether you borrow against the equity during that year.

Loan Type Varies Interest Deduction

As we've said, the mortgage interest tax deduction is one of the best financial reasons to buy a home. You may be wondering, however, what total interest charges are like on the typical home loan. In the chart, you can compare a 30-year fixed-rate loan with 15-year and biweekly mortgages for the same amount. As you can see, the amount of interest you pay over the life of your loan depends on what kind of mortgage you determine is best for you.

$75,000 Mortgage

  30 Year Fixed Rate
At 10%
15 Year Fixed Rate
At  10%
Biweekly Mortgage
At 10%
Monthly Payment $ 658 $ 806 $ 658 (329 X 2)
Interest Cost First Year $ 7,481 $ 7,398 $ 7,434
Mortgage Balance First Year $ 74,583 $ 72,726 $ 74,476
Interest Cost Fourth Year $ 7,336 $ 6,606 $ 7,061
Mortgage Balance Fourth Year $ 73,052 $ 64,732 $ 69,817
Interest Cost/Life $ 161,942 $ 70,062 $ 104,331
Difference from 30 year $ 0 $ 91,880 $ 57,611


The Tax Benefits of Selling Your Home

You may be able to exclude up to $500,000 of the gain on the sale of your main home if you are married and file a joint return. If you and another person owned the home jointly but file separate returns, each of you can exclude up to $250,000 of gain from the sale of your interest in the home. To claim the exclusion, during the 5-year period ending on the date of the sale, you must have owned the home for at least 2 years and lived in the home as your main home for at least 2 years. If you owned and lived in the property as your main home for less than 2 years, you can still claim an exclusion in some cases. The maximum amount you may be able to exclude will be reduced.


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