Home
mortgage interest
If you own a home, the interest you pay on your home mortgage
provides one of the best tax breaks available. The technical
term is "qualified residence interest." Interest deductions
are available for both the principal residence and a second
residence (such as a vacation home).
There
are two types of qualified residence interest that can be deducted:
"acquisition indebtedness" interest and "home equity indebtedness"
interest. To qualify, the debt or loan must be secured by the
residence. This is usually done by signing a deed of trust or
a mortgage at the same time the loan is obtained.
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Acquisition
indebtedness
When
you borrow money to buy a home, the interest you pay is usually
deductible from your gross income. To be deductible, the interest
payments must be on a loan "secured" by your home. This happens
whenever you sign a mortgage or a deed of trust.
You
are limited to the first $1,000,000 ($500,000 if you are married
filing separate tax returns) borrowed, which for most people
is plenty.
Acquisition
indebtedness also includes construction and home improvement
expenses, so if you borrow money to add a bedroom or remodel
a kitchen, the interest on that loan is also deductible as acquisition
indebtedness interest.
But
if you refinance your loan, the deduction is limited to the
loan balance at the time of the refinancing. For example, suppose
you borrowed $200,000 to buy your home. You now owe $150,000
and want to refinance. Let's say you want an extra $25,000 in
cash, so you borrow $175,000 (to pay off the $150,000 loan and
have an extra $25,000). You may deduct only the interest on
the first $150,000 as acquisition indebtedness interest, because
that was the balance when you refinanced.
But
the extra $25,000 might qualify as "home equity indebtedness."
Home
equity indebtedness
You
are allowed to deduct interest on up to $100,000 ($50,000 if
you are married filing separate tax returns) of home equity
loans. It doesn't matter why you borrow the money, so long as
the loan is secured by your home.
This
provides some real savings opportunities if you have equity
in your home and other debts. Credit card debt is not deductible
and is usually at a higher interest rate than home equity interest.
By converting your non-deductible, higher rate, credit card
debt to home equity indebtedness (i.e., use the home equity
loan to pay off your credit card balance), you will save both
on taxes and on the interest rate.
