Tax Deductible Mortgage Interest

[taxforum]

Registered users do not see advertisement

As a homeowner, one of the best ways to reduce your annual tax liability is through the mortgage interest tax deduction. There are two basic categories of loans, also called debts, and each is treated a little differently.

1) Home Acquisition Debt
As the name implies, secured loans used to buy, build, or improve a home fall under this category. Depending upon when you took out a mortgage, the interest on this type of debt is usually fully tax deductible and applies to a first and second home.

*Interest on Home Loans acquired prior to October 13, 1987 are fully tax deductible regardless of the loan amount.
*Interest on Home Loans secured after October 13, 1987 are fully tax deductible up to a combined loan value of $1 million.
*Example: Let's say you purchased a primary residence for $195,000; a second home in Florida for $350,000; and borrowed $100,000 to build an addition to you primary or second home. The combined loan value is $645,000 and all the interest is tax deductible, with room to spare. You could borrow an additional $255,000 before reaching the maximum loan value for deducting mortgage interest.
*Exception: If married and filing separately, the maximum loan value is now reduced to $500,000.

2) Home Equity Debt
In this category, you can borrow up to $100,000 against the equity in your home, for whatever purpose you choose, and fully deduct the interest. The IRS specifically defines this category as debt incurred for reasons other than to buy, build, or improve a home.
*Example: A possible alternative to financing a new car is to take out a home equity loan. This would then make the car payment' tax deductible and possibly secure a better interest rate. In addition, you could stretch out the payment plan to around 10 years. That's not advisable, but it is possible. The point being the added flexibility in the length of the loan plus the tax deductibility makes this a smart financial decision.
*Exception: Once again, if married and filing separately, the maximum loan value is reduced by half, or $50,000.
Investment Property versus Personal Property
If an individual owns a rental home, for instance, the mortgage interest on this property does not count towards the $1 million loan limit mentioned above. Provided the owner did not live in the rental home for any time during the year, or more specifically less than 10% of the time (14 days), the interest is tax deductible as an investment property and not as a first or second home.

More Rules From the IRS
Now that we've looked at how much mortgage interest can be deducted, it's time to move on to some required rules set for by the IRS.
1) In order to deduct mortgage interest, you must complete an itemized tax return using form 1040 and Schedule A. Otherwise, you will not be able to take advantage of the tax deduction.
In general, it behooves the tax payer to file with itemized deductions if they exceed the standard deduction. Homeowners typically find their itemizations easily surpass the standard deduction due to mortgage interest. (To find out more, check out "Common tax deductions for individuals")
2)You must be the person who is legally responsible and liable for the debt. In other words, you signed the loan and all required documents.

If you make mortgage payments for someone else, you cannot deduct the interest on your tax return. There must exist a debtor to creditor relationship that is well documented and recognized legally. Otherwise, any payments made for or to someone else without proper proof of liability are not eligible as a tax deduction.
3) Finally, the mortgage or home equity loan must be secured against a qualified home.

Again, a qualified home is a first or second home, and can be a condo, house, mobile home, boat, cooperative, or any property that has provisions for sleeping, cooking, and toil facilities.

Secured refers to a lien being placed on the home for collateral should the payer fail to meet the monthly obligations of making payments.
For more information see IRS Publication 936.

[taxforum]

Having a mortgage on your primary residence is often touted as "the last great tax break for the common man." While that may be true, I would like to introduce you to a more fiscally savvy method of saving money in the process of owning your own home.

Interest Tax Deduction
The interest tax deduction is cited as a great reason to take out and keep a mortgage on your primary residence. This is how it works.
Each year you pay interest on your mortgage, you can deduct that amount from your Adjusted Gross Income (AGI). For instance, if you paid $8,000 in mortgage interest last year, and your AGI for the same year was $70,000, you would pay taxes on $62,000 instead of $70,000. At a tax bracket of 28%, that would mean you saved $2,240 on your taxes. Sounds good, no?

Other Options?
What other options exist alongside having a mortgage on your home? One is to pay it off early and have no debt on your primary residence.
Wait, wouldn't that eliminate this wonderful tax break? Wouldn't that be throwing money away? Let's go back to the original example. In that example, you paid $8,000 in mortgage interest. That $8,000 did not go towards building equity in your home, it went directly to the bank. The IRS gave you back $2,240 of that $8,000 in the form of a tax deduction. Now, let's see.

That means you paid out $8,000 to the bank in order to get back $2,240 from the IRS. Imagine this as an investment. Would you invest in a mutual fund that was guaranteed to lose 72% every year? Of course not!
If you owned your own home outright, you would keep that $8,000 in your pocket instead of sending it to the bank. You lose the $2,240 tax deduction, but you are still ahead by a net of $5,760 by owning outright.
Argument: I Could Invest and Make More!
This is a myth which I am going to debunk right now. Those who use this rationale are thinking in an unsophisticated, nave manner. Here is an example of their argument.
If I invest the $2,240 I saved on the mortgage tax deduction in the stock market, I could make a 13% return on that money (very optimistic). If I put it towards the mortgage at a 7% mortgage interest rate, that's 6% less.
There are 3 major pieces of information being left out of this nave calculation.

Missing Piece #1
The argument does not take taxes into consideration. When you cash out that mutual fund, you are going to pay a tax on the gains. If you leave it in there for more than a year, it would be the 15% capital gains rate.

Missing Piece #2
The argument does not admit that fact the mortgage amortize in such a way that you pay much more than the face value interest rate in the first years of the mortgage. For instance, on a $115,000, 30-year loan amount at 7% fixed, you would pay around $8,000 in mortgage interest the first year. Your total payments towards principal and interest were about $92,000. About 87% of your payments went to interest that first year. In fact, the actual ratio of P&I (principle and interest) payments to interest doesn't get below 7% until the 30th year of the loan.
At the end of a 7% fixed rate 30-year loan for $115,000 you would have paid in over $160,000 in interest payments. That money is gone. For the same rate and amount on a 15-year loan, you would have paid in about $71,000. That's an $89,000 difference. What about the tax breaks? Well, the 30 year loan would have added up to about $45,000 in tax breaks, while the 15 year loan added up to about $20,000 in tax breaks. So, if you did the 30 year loan, you gave up $89,000 in interest payments to get $25,000 in tax breaks. In the end, you lost $64,000.

Missing Piece #3
Risk is missing piece #3. Investing in the stock market, real estate, or anything else carries a risk with it. When you evaluate an investment, you are usually taking more risk to get a higher possible return. There is a chance you will lose money.
When you pay off your mortgage early, the risk factor is 0. Paying off debt is a guaranteed return equivalent to the APR you are paying to the bank. Factor in the method by which a fixed rate loan amortizes (where you pay out the most interest in the first years), and it becomes evident that the sooner you pay off that mortgage, the better off you will be financially.

The Bottom Line
Interest and compounding can either work for you or against you. Despite tax incentives, owning your own home outright will free up your cash to go out into the marketplace and work to your benefit!

[taxforum]

The biggest purchase the majority of us make is our home and in the US there can major tax benefits to buying your own home. To gain this benefit you have to be an income tax payer of course, but most of us are. What Uncle Sam allows you to do is deduct the interest payments you make on your mortgage from your income. This means that you get a tax benefit at the highest rates you pay income taxes.
For example; let's say that you pay $10,000 dollars at your top tax band of 35% and pay $5000 dollars in interest payments on your mortgage. You are allowed to deduct the $5000 from your income which gives you a tax credit of $1750. The great thing is you don't have to wait to get this credit till the end of the year as you can adjust you tax payment schedule to spread this payment through the year. This makes a mortgage one of the cheapest ways to borrow money and why many of the wealthy choose interest only mortgages.

Let's understand why. Say you have an $1,000,000 mortgage at 6%. This means you pay $60,000 in interest a year. Now if you have a mortgage this large you're probably in the top tax bracket of 40%. This means, if you are lucky enough to earn so much money that you pay $60,000 dollars at this level, your mortgage gives you a tax credit of $24,000!
Another way to look at this is to adjust the interest rate, because in effect you only really pay $36,000 to borrow $1,000,000 (you would have never got the other $24,000 as it would have gone to the IRS), so the effective interest rate is 3.6%. Now a savings strategy would be to take the repayment part of a normal 30 year mortgage put it in tax exempt bonds or tax deferred mutual fund where you can earn 4.5-15%. So in 30 years you could pay off your mortgage and have a little nest egg saved, as well as enjoying the probable appreciation in the value of your home. Now before you go and buy trump tower as "your cottage in the city", you have to be aware of a couple of gotchas.