Recently the IRS has begun to scrutinize personal residence mortgage interest deductions on tax returns more closely. While mortgage interest on your personal residence still provides one of the best tax deductions, you must be aware of the rules related to deduction limits.

Taxpayers are allowed to deduct mortgage interest paid on up to two personal residences each year: the primary residence and a second residence. The amount of interest that is deductible is based upon the related mortgage debt.

There are three basic types of mortgage debt:

Grandfathered debt is mortgage debt, secured by a primary or second residence, that was taken out prior to October 14, 1987. Interest paid on grandfathered debt is deductible regardless of the use of the mortgage proceeds.

Home acquisition debt is a mortgage taken out after October 13, 1987 to buy, build, or substantially improve the taxpayer’s main or second home. The debt must be secured by the home. Interest on this type of debt is deductible; however there is a limit of $1 million dollars of acquisition debt ($500,000 for married filing separate returns). Therefore, if a taxpayer purchases a primary residence with a mortgage of $2 million dollars, only 50% of the interest charged is deductible as acquisition debt.

Home equity debt is any debt secured by a primary or second residence that is not acquisition or grandfathered debt. This interest is deductible regardless of the use of the proceeds. There is a limit of $100,000 of home equity debt that will generate tax deductible interest ($50,000 for married filing separate returns). Interest from home equity debt is not allowed as a deduction when calculating the Alternative Minimum Tax (AMT), unless the proceeds from the debt are used to substantially improve a primary or second residence.

The mortgage interest limitation can reduce the amount of interest that otherwise might be deductible in several situations.

The first situation occurs when a taxpayer purchases a primary residence with a mortgage in excess of $1 million of acquisition debt. The mortgage lender will prepare a mortgage interest statement at the end of the year on form 1098 to report the total amount of interest the homeowner paid. This form will report ALL of the interest paid, not just the amount that is related to acquisition debt of $1 million and therefore tax deductible. The total interest on the form must be adjusted on the tax return to reflect only the amount of interest paid on the first $1 million of acquisition debt during the year. The remainder of the interest is classified as non-deductible personal interest.

The second situation relates to a taxpayer who has a mortgage on both a primary and second home with a combined balance that exceeds $1 million of acquisition debt. In this situation, the taxpayer will receive a mortgage interest statement at the end of the year for each residence. On the tax return, the taxpayer must reduce the total amount of reported interest in order to reflect the total acquisition debt mortgage interest deduction that corresponds only to the first $1 million of combined acquisition debt on both residences. The remainder of the interest paid is non-deductible personal interest.

The third situation relates to a taxpayer who has home equity debt that exceeds the $100,000 limit. Again, once the year-end mortgage interest statement is received, the total amount of home equity interest reported on the tax return can only be related to home equity debt of up to $100,000. The remainder of the interest from a home equity loan that exceeds the personal residence interest is characterized based on the various interest tracing rules as personal, trade or business, passive, or investment based upon the use of the proceeds. If related to business, investment, or passive activities, the interest may then be deducted on the applicable section of the tax return; otherwise the interest is non-deductible personal interest.

The last and most common situation occurs when a mortgage classified as acquisition debt is refinanced and the proceeds are not used entirely to pay off the original acquisition debt. For example, assume that a taxpayer purchased a primary residence in 1990 for $200,000, paid $25,000 as a down payment, and used an acquisition debt mortgage to finance the remaining $175,000 of the purchase price. In 2000, when the original mortgage balance is $150,000, the taxpayer refinances the mortgage for $275,000, using $150,000 of the proceeds to pay off the original mortgage and receives the remainder of the debt proceeds of $125,000. In this situation the remaining mortgage will generate three types of interest for the taxpayer: 1) Interest on $150,000 of the mortgage will continue to be deductible as acquisition debt; 2) interest on $100,000 will be deductible as home equity interest; and 3) interest on the remaining $25,000 of debt will not be deductible as it will be classified as personal interest. If the proceeds were used for investment, business, or passive activity purposes the personal interest may be deductible under the interest tracing provision of the tax code.

It is important to understand the different types of interest that a personal residence will generate as well as to be aware of situations in which the amount of interest paid during the year is not fully deductible on your tax return. Please call our office if you have any questions related to the mortgage interest rules or your personal tax situation.