The tax benefits associated with owning a home are often vital in making the economics of homeownership work. In particular, those who borrow to buy their homes can typically deduct the mortgage interest they pay as an itemized deduction, and for many taxpayers, mortgage interest proves to be the biggest deduction they take. Yet there are some tricky aspects of the mortgage interest deduction that you need to understand fully in order to make sure you're getting the most you possibly can from the tax provision.
How much mortgage interest can you claim?
Taxpayers aren't limited to a specific amount of deductible mortgage interest, but the amount of mortgage debt on which that interest gets charged is subject to limits. Specifically, one can typically deduct interest on up to $1 million of home acquisition debt, which represents the money that you spent when you originally bought or built your home. Money used to make substantial improvements to your home also count as home acquisition debt. If you choose to refinance an original mortgage that was treated as acquisition debt, then the refinanced mortgage also qualifies.
In addition, most taxpayers can deduct interest on up to an additional $100,000 in home equity debt. This debt does not have to be tied to the initial purchase of the home, reflecting the greater flexibility that home equity loans tend to offer.
On how many homes can you deduct interest?
Many tax breaks for homes are restricted to principal residences, but the mortgage interest break actually offers more flexibility. You can claim a mortgage interest deduction not only on your main residence but also on a second home.
If you own two homes, then the limits above apply to the total amount of debt outstanding. For instance, if you buy your principal residence by borrowing $600,000 and get a vacation home with a $400,000 mortgage loan, then the $1 million total will exactly match the $1 million total limit.
What can you claim as mortgage interest?
In every mortgage payment you make, a portion pays down principal and the rest goes toward interest. You can generally deduct the interest portion as mortgage interest.
Some special cases often come up. When you first get a mortgage, you might have an opportunity to reduce your interest rate by paying points at the beginning. This essentially represents prepaid interest payments, and the IRS lets you deduct what you pay in points immediately if it's consistent with industry practice and you use the loan to buy or build your main home. In other cases, such as for refinancing or borrowing for other purposes, you might have to spread out deductions for points paid over the lifetime of your loan, taking only a portion each year during its entire term.
In recent years, taxpayers have been able to deduct what they pay in private mortgage insurance premiums, treating it as home mortgage interest even though it's really not the same at all. However, that provision expired at the end of 2016. At least one bill in Congress has been introduced to extend the tax break permanently, but at this point, it's uncertain whether taxpayers will be able to claim the mortgage interest deduction for private mortgage insurance premiums in 2017.
Keep your eyes open
Tax reform is on the agenda for 2017, and some major changes could happen to the way that Americans pay tax. At this point, it's unclear whether the mortgage interest deduction is in jeopardy, although most of those following the issue believe that this popular deduction is among the least likely to get taken away through tax reform efforts.
Nevertheless, given how important tax breaks are for many homeowners, you'll want to keep a close eye on Washington to see what comes from discussions among lawmakers and the Trump administration. For now, the rules you'll follow to file your 2016 tax return this April are all set, but the future could bring major changes that affect the finances of homeownership substantially.