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Home Mortgage Interest
California's Franchise Tax Board recently reviewed a sampling of Form 540 tax returns with large Schedule A mortgage interest deductions and found that 75 percent of the returns did not comply with the home mortgage interest deduction limitation rules.
There is a significant difference between the deduction for mortgage interest and for home equity interest. Mortgage interest is deductible on Schedule A of Form 1040 and under the Alternative Minimum Tax ("AMT"). Home equity debt is not deductible under AMT. Since most of our clients are subject to AMT, home equity interest is usually not deductible.
First, let's look at mortgage interest. To qualify for a deduction, the mortgage must be used to buy or improve your principal residence, or a second home, and must be secured by the home.
Interest on mortgage debt up to $1,000,000 is deductible. The interest on debt that exceeds $1,000,000 is not deductible. You can deduct only the portion of the interest that applies to the first $1,000,000 of debt ($500,000 for Married Filing Separately).
Home equity interest is treated differently; it is not deductible under AMT, thus you are unlikely to receive a tax benefit from home equity interest.
The deduction for home equity debt is limited to interest on up to $100,000 of home equity debt ($50,000 for MFS).\
Finally, the deduction for home equity debt is limited to your home equity, which is the fair market value of your home minus outstanding debt against your home. So, if your home has declined in value, it is possible that home equity interest that was deductible in an earlier year may no longer qualify.
Here are the implications:
- If you refinance the original mortgage debt, only the interest on the principal at the time of refinance is deductible. If you took cash out from a refinance, even to pay closing costs, only the interest on the original principal is deductible.
- If you refinanced into a larger loan (even for closing costs), the interest on the additional loan balance is home equity interest, limited to $100,000, limited to your actual home equity, and taxable under AMT.
- If your home has declined in value, your home equity interest is limited to the lesser of your home equity or $100,000 ($50,000 MFS).
Interest that does not meet these criteria is considered personal interest, and is not deductible.
There has been increased scrutiny by the IRS of taxpayers' deductions for mortgage interest.
If you have refinanced your mortgage at any time and increased the principal, you need to tell us how much was financed above the original loan amount, and whether the funds were used to improve your home or for personal use or closing costs.
