Dan Pilla's Featured Article

DEDUCTING HOME MORTGAGE INTEREST

Two Limits You Need to Know About

I’ve been asked more than once in the past several months whether the recent drop in housing values will have any impact on your home mortgage interest deduction. One reader asked whether it was true that you cannot take a mortgage interest deduction unless there is equity in the property. These questions are important and prompt me to discuss two important limits to the deduction for home mortgage interest.

1. Acquisition Indebtedness. The first limit has to do with the maximum amount of “acquisition indebtedness” that you can carry on your home and still get a full deduction for your interest. Acquisition indebtedness is debt that’s incurred to “acquire, construct or substantially improve” your main home. Code section 163(h). The debt must be secured by your main home in order to get any deduction. This debt would be your primary mortgage that you agreed to when you purchased the home. The deduction applies whether you purchased an existing home or built a new home, either from scratch or substantially remodeled an existing home. The dollar limitation that applies to acquisition indebtedness is $1,000,000. That is, you are allowed a deduction for interest on your main home as long as the debt does not exceed $1,000,000 ($500,000 for married filing separately). If the debt exceeds this limit, you are entitled to deduct only so much of the interest as is reflective of the limits. For example, if you’re married filing jointly, your debt cap is $1,000,000. Suppose your mortgage is for $1,200,000. In that case, you’re allowed a deduction of 83.33 percent of your mortgage interest (1,000,000/1,200,000). Banks across the nation are in the process of re-writing mortgages that are in trouble. In many cases, the mortgages are being reduced to reflect the current fair market value of the home. If your mortgage drops below the debt limits as a result of this process, you may be able claim a deduction for all the interest rather than a fraction of it.

2. Home Equity Debt. This is debt secured by your residence, other than acquisition indebtedness. A line of credit that you set up against your home, above and beyond the initial mortgage you took out to buy (or build) the house, is home equity debt. Generally, interest on home equity debt is also deductible even if you use the money to buy something that would not give rise to deductible interest expense. For example, suppose you have a $50,000 home equity line of credit. You use the money to buy a $20,000 car that you use strictly for personal purposes. If you take out a separate loan to buy the car, the interest would not be deductible because the interest is considered personal (not business or investment) interest. But because you use a line of credit secured by your home, the interest is deductible. There is an important limitation on the deductibility of interest on home equity debt. The home equity debt cannot exceed the greater of: 1) your net equity in the home, or 2) $100,000 ($50,000 for married filing separately). Your net equity in the residence is determined based upon your primary mortgage and equity line of credit. To illustrate, suppose your house is worth $250,000. You have a primary mortgage against the house of $200,000. In that case, your net equity (assuming no other claims against the house) is $50,000. The interest deduction on any equity line of credit is capped at the interest on $50,000. Suppose your outstanding equity line is $75,000. In that case, you’d get a deduction for 67 percent of the interest on the equity line of credit. In no case can you get a deduction for interest on more than $100,000 ($50,000 for married filing separately) of home equity debt. In this market, we’ve seen home values drop significantly. If the drop in your home value has eaten up the equity in your house, you are not allowed any deduction for interest on home equity debt. Please note, however, that you are still allowed to deduct the interest on acquisition indebtedness. The deductibility of acquisition indebtedness has nothing to do with the level of equity in your home. For this reason, you have to be very careful when using home equity to pay other debts. For years, tax and financial professionals have encouraged people to use home equity to pay off high-interest credit cards, car loans, etc. The credit card interest is often many times higher than the interest on an equity line and the credit card interest is not deductible. But if you exceed the debt limits, neither will be the interest on your equity line. So perform a careful analysis on the impact of using your equity line to pay other bills.

Some factors to consider are:

• The cost of the interest on credit cards, etc., given a) that it’s not deductible and b) that it’s probably much higher than the home equity interest,
• The tax consequence of pushing your home equity debt above the debt ceiling, and
• A cost comparison between the lower-rate, non-deductible interest and the higher-rate interest. Even at a lower rate, the home equity interest might not be a better idea if the tax consequences outweigh the cost savings of the lower interest.

But millions of people across the country did just that and we are now seeing the fallout of this folly. I warned about the consequence of high debt to equity ratios in personal housing in the late 1980s. Too many people didn’t listen to me then. Now millions of people have lost or are losing their homes as a result.