Limits on home mortgage interest deduction

From TaxAlmanac

Home mortgage interest is generally any interest paid on a loan that is secured by a main or second home. The loan may be a mortgage to buy a home, a second mortgage, a line of credit, or a home equity loan. Home mortgage interest can be deducted only if all of the following criteria are met:

• Form 1040 must be filed and schedule A is filed to itemize deductions
• The taxpayer must be legally liable for the loan. Payments made on someone else's loan are not deductible.
• The mortgage must be a secured debt on a qualified home in which the taxpayer has an ownership interest.

The taxpayer can deduct mortgage interest from the following categories of loans:

1. Mortgages taken out on or before October 13, 1987. (This is often referred to as grandfathered debt)

2. Mortgages taken out after October 13, 1987 to buy, build, or improve a first or second home. (This is called home acquisition debt). The interest from these loans are allowed in full if, throughout 2007, these mortgages plus any grandfathered debt totaled $1 million or less. (NOTE: If the taxpayer is filing married filing separate, this limit is $500,000).

3. Mortgages taken out after October 13,1987 other than to buy, build, or improve the home. (These loans are also called home equity debt). The interest from these loans are allowed in full if, throughout 2007, these mortgages totaled $100,000 or less. (NOTE: If the taxpayer is filing married filing separate, this limit is $50,000). The home equity debt considered to generate deductible interest is limited further by comparing the home equity debt to the home acquisition debt. If the difference between the home acquisition debt and the home acquisition debt limits is less than the home equity debt limits, that becomes the limitation for the home equity debt.

For example, assume that two years ago a single taxpayer took out a $980,000 mortgage to acquire a home that is their primary home. Last year, they took out a $30,000 second mortgage, with the proceeds being used to buy a car that was used exclusively for personal purposes. In this scenario, only $20,000 of the second mortgage is considered to generate deductible interest. (1 million cap minus the $980,000 home acquisition mortgages = $20,000. Since the $20,000 is less than the $50,000 cap, this amount is used)

If the home acquisition debt exceeds the $1,000,000 limit mentioned above, the taxpayers home mortgage interest must be limited. Here are the steps for computing the limit, as shown in Publication 936, Home Mortgage Interest Deduction

___________________ 1. Average balance of the grandfathered debt

___________________ 2. Average balance of the home acquisition debt

___________________ 3. Enter $1,000,000 ($500,000 for married filing separate)

___________________ 4. Enter the larger of 1 or 3

___________________ 5. Add amounts from step 1 and 2

___________________ 6. Enter smaller of steps 4 or 5

___________________ 7. Enter $100,000 ($50,000 if MFS)

___________________ 8. Add the amounts on line 6 and 7. This is the qualified loan limit.

___________________ 9. Enter total of the average balance of all mortgages on all qualified homes.

___________________ 10. Enter total amount of interest paid

___________________ 11. Divide line 8 by the amount on line 9

___________________ 12. Multiply the amount on line 10 by the amount on line 11. This is the deductible home mortgage interest.

___________________ 13. Subtract the amount on line 12 from line 10. This is not deductible home mortgage interest.

• The taxpayer can also deduct points for a loan used to improve the main home, if tests 1 through 6 are met.

• Home office deduction: If there was a home office in a home, for the purposes of computing the home mortgage limits discussed here, the cost and fair market value of the home must be allocated between the business and non-business portion.

• Rental of part of the home: If a portion of the home is rented out, the rented portion can be treated as being used by the taxpayer if all of the following conditions apply:

• • The rented portion of the home is used by the tenant primarily for residential living
  • The rented part of the home is not a self-contained reidential unit having seperate sleeping, cooking, and toilet facilities.
  • The taxpayer does not rent, directly or by sub-lease the same or different parts of the home to more than two tenants at any time

during the tax year. If two persons (and dependents of either) share the same sleeping quarters, they are treated as one tenant.