One of the biggest benefits of buying a home is being able to deduct many of the expenses associated with home ownership. A home mortgage is the largest debt that many people will ever incur, and the interest on mortgage loans can be substantial. That makes the ability to deduct mortgage interest extremely valuable for many, and it can be the defining factor in deciding between buying a home versus renting. Below, we'll look at the mortgage interest deduction to help you figure out if you qualify.
The general rules on the mortgage interest deduction
The first thing to understand about the mortgage interest deduction is that it's an itemized deduction. If you currently take the standard deduction, then it's possible that the mortgage interest deduction won't give you any tax benefit at all if it's not enough to push you above the standard deduction threshold for your filing status. Even if you do end up itemizing, the true benefit might be just a fraction of your total mortgage interest paid, because you could always take the standard deduction even if you had nothing to itemize at all.
In addition, the mortgage interest deduction is available on limited number of properties. You're allowed to take deductions for your primary residence as well as a second home, but additional real estate holdings aren't allowed in determining the deduction.
There are limits to how much interest you can deduct. If you obtained a mortgage to buy, build, or improve the property, then the limit on outstanding loans is $1 million. Therefore, if you have a 5% mortgage and borrowed the maximum $1 million, you'd be able to deduct 5% of $1 million or a maximum of $50,000 in interest for the qualifying mortgage debt. In addition, you can claim interest on mortgage debt of up to an additional $100,000 for other purposes, such as getting a home equity loan to finance non-home-related expenses. These $1 million and $100,000 limits are cut in half for those who are married but file separately.
Special cases with the mortgage interest deduction
Some special situations deserve separate treatment in considering the mortgage interest deduction. For instance, many homeowners decide to pay upfront points on a mortgage in order to reduce their interest rate. If you pay points that are in line with what the industry typically charges and you use the loan to buy or build your primary residence, then you can deduct points immediately. Otherwise, you'll have to amortize what you paid over the lifetime of your loan. That reduces your immediate deduction, although you'll eventually get full credit for what you paid.
Also, temporary provisions of the tax laws allow homeowners to deduct the amount they pay for private mortgage insurance as if it were mortgage interest. That isn't technically correct, since insurance payments aren't really interest. But because many mortgage servicing companies take the two amounts out of borrowers' bank accounts at the same time, it's convenient to treat them in similar ways for tax purposes. The PMI provision is slated to expire, but it has been extended numerous times since its enactment nearly a decade ago.
Is the mortgage interest deduction going away?
Policymakers have noted that the mortgage interest deduction benefits higher-income taxpayers more than their low- and middle-income counterparts. First, the value of a tax deduction is always directly proportional to the tax bracket for a given taxpayer. Therefore, someone in the 35% or 39.6% tax brackets get a tax break that's two to four times larger than a homeowner in the 10% or 15% bracket. Also, the richer someone is, the more likely it is that they'll have a larger mortgage, and that makes it easier for high-income taxpayers to pay enough in interest to make itemizing deductions worthwhile. By comparison, low-income taxpayers often don't have other itemized deductions available, and relatively small mortgage interest payments can make sticking with the standard deduction the best move.
As a result, some have suggested replacing the deduction with a credit. The credit would have a fixed percentage that could potentially give low-income taxpayers more of a break while limiting the amount that high-income taxpayers receive. So far, Congress hasn't taken action on this idea, but the potential exists for a possible cut in future years.
Home ownership is one of the backbones of American prosperity, and many people still see owning a home as giving them access to the American Dream. The mortgage interest deduction plays a vital role for many taxpayers in being able to afford a home, and it's important to understand exactly what tax benefits that mortgage interest can provide so that you have realistic expectations about the financial impact of home ownership.