DEDUCTING YOUR MORTGAGE
INTEREST
One of the best justifications for owning a home, at least
for financial reasons, is the tax savings that result from
deducting mortgage interest. The deduction for mortgage
interest stands as one of the few remaining tax deductions
for the typical middle class taxpayer. Despite the changes
to the tax code over the past several years and the repeal
and limitation of many non-housing itemized deductions,
mortgage interest is still deductible. On first and second
mortgages and home equity lines of credit (with some limitations)
for first and second homes, your mortgage interest deduction
is still a good financial incentive to buy a home.
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 home ownership one
of the best ways to trim your tax bill. The examples below
illustrate how the mortgage income tax deduction affects
the after-tax home ownership.
- 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 Home Ownership Costs:
-
Before-Tax
Home Ownership Costs
Mortgage Interest=$9,177
Property Taxes=1,415
Total of Before-Tax Home Ownership Costs=10,592
-
Itemized
Deductions
-
Home
Ownership Deductions
Mortgage Interest= $9,177
Property Taxes=1,415
Non-Home Ownership Deductions= 2,000
Total= 12,592
-
Standard
Deductions=5,450
-
Total
Itemized Deductions=$7,142
Multiply Total Itemized Deductions by Marginal
Tax Rate to get Home Ownership Tax Savings:
$7,142 x .15 =$1,071
-
After
Tax Home Ownership Costs = Home Ownership 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 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
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 {back
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When interest rates decline, many homeowners take advantage
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 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 will 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. 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 secured 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 Affects 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. Use our mortgage calculators to
compare a 30-year fixed-rate loan with a 15-year and bi-weekly
mortgage 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.
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