Maximize Your Interest Deductions

Most of us prefer to be debt-free. If you do borrow, a loan against your home often is the least expensive debt. A mortgage also maximizes interest deductions, which further reduces the cost. Borrowers need to learn a few tricks to boost cash flow and to avoid some traps set for unwary taxpayers.

There are two types of deductible mortgage interest: acquisition indebtedness and home equity debt. The rules are a bit different for each type.

Acquisition debt is incurred when loan proceeds are used for construction, acquisition, or substantial improvement of a residence. Substantial improvement is not defined in the law. Home equity debt is any other debt against a house; the proceeds can be used for any purpose.
For either type of interest to be deductible, the residence must secure the loan. That usually means the debt must be recorded on the public record.

In addition, the debt must be against either your principal residence or one other house. If you have more than two residences, you select which residence is the second one. The choice can change from year to year.

A residence is any facility with sleeping, cooking, and toilet facilities. That means many boats, recreational vehicles, mobile homes, and other non-traditional structures qualify as residences for the purpose of deducting interest.

There also is a dollar limit on the debt. For acquisition debt, only interest on up to $1 million of debt can be deducted. That is the combined debt for both your first and second residences. In addition, you can deduct interest on up to $100,000 of home equity debt. Again, that $100,000 is the combined home equity total for both your first and second residences. Another limit is that the total debt on a residence cannot exceed its fair market value.

When interest does not qualify as deductible mortgage interest, it still might be deductible under other rules. For example, if the debt is used to purchase or carry investments, interest might be deductible as investment interest. If the proceeds are used in a business, the interest might be deductible against business income.

Those are the basic rules. Here are some guidelines for getting maximum deductions for your interest expenses.

Use a home equity loan when borrowing for most major purchases. For example, interest on a traditional auto loan is personal interest and not deductible. In addition, when special financing deals are not available, auto loans have fairly high interest rates. But if you borrow against home equity and use the proceeds to buy the car, the interest rate should be both lower and deductible.

Home equity also should be used to pay down credit cards or in lieu of carrying large balances. Credit cards tend to have nondeductible interest at rates of 18% or more.
Refinancing acquisition loans is a regular event whenever interest rates fall. Unfortunately, many taxpayers leave money on the table when they refinance.

Suppose you have owned a home and paid down a lot of the debt. Interest rates now are much lower than on your loan, so you refinance and borrow more than the outstanding balance on the old loan. You’ll use the refinancing proceeds to pay off the old loan. You’ll use excess to improve the house, make an investment, or buy a car.

The refinanced loan counts as acquisition indebtedness only to the extent of the outstanding debt on the original loan. If you have $80,000 of debt outstanding on the old loan, that’s the amount of acquisition indebtedness when you start paying on the new loan. The rest of the loan probably is a home equity loan. You deduct interest only attributable to the first $100,000 of that part of the loan. But if you use the excess loan proceeds to substantially improve your residence, that portion of the loan might qualify as acquisition indebtedness instead of home equity. If you use the loan proceeds for business or investments, those uses might make the interest deductible.

Points might be charged on your loans. These essentially are fees for making the loan. One point is 1% of the amount borrowed. When you take out an acquisition loan, points are deductible in the year paid. With other loans, the points are deducted in equal amounts over the life of the loan. In the year the loan is refinanced, however, all undeducted points on that loan become deductible.

Americans have $6.6 trillion in home equity. Managing that equity can increase your wealth. Exploit that opportunity to the fullest by maximizing deductions from mortgage loans.