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| The Basics | America's favorite loophole: Mortgage interest
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If you're a homeowner, you know you can deduct the interest on your mortgage. But the mortgage deduction can generate additional tax breaks. Here's what I mean.
By Jeff Schnepper
There's no doubt about it: Deducting the interest on mortgage debt is our favorite tax loophole.
Some 37.2 million taxpayers claimed the deduction in 2002, writing off $336.6 billion -- or about $9,000 per taxpayer. It represented 37% or so of itemized deductions and generated slightly more in deductions than itemized deductions for deductible state and local taxes and twice as much in deductions as charitable donations.
The amount deducted has been growing at an 8.5% annual rate since 1980 -- a reflection of rising property values in this country.
And you would be wise to use it as long as you can.
As with anything else involving taxes, there are rules and stipulations you must know in order to claim the deduction.
Its the real estate that counts
Mortgage and related debt -- but little else -- generates big tax breaks for taxpayers because it is always secured by the property. And you can buy a second home and deduct the mortgage interest (in addition to the real estate taxes on both properties) on it as well. But whether you borrow the money from the bank or your rich cousin, you must be legally liable for the debt.
As good as the mortgage deduction is, there is a limit to how much you can borrow and still be able to deduct the interest: Its the smaller of:
- The total cost to buy or build your home plus make any improvements, up to $1 million,
- or $500,000 in the case of a married individual filing a separate return.
Remember, the cost of your house includes more than the amount paid to the seller. It also includes appraisal fees, title search, title insurance, transfer taxes, broker's commissions paid by the buyer, survey fees, bank or lender fees, legal fees, mortgage taxes, and any other nondeductible closing costs such as postage. It could also include the purchase of additional land adjacent to your home.
Home equity loans: Seize the opportunity
Since you cant deduct interest on credit card loans and personal loans(consumer debt), home equity loans have become increasingly popular. That is because the interest on these loans, too, is deductible. Home equity indebtedness is any amount owed (other than the original acquisition mortgage debt) secured by a qualified residence. Interest on home equity debt is deductible to the extent the debt does not exceed $100,000 (or $50,000 for a married individual filing separately).
(Technically, the limit is the homes fair market value in excess of any outstanding home acquisition debt, with a $100,000 maximum. But, youre rarely -- more likely never -- going to get a bank to lend more than the equity you have in the property.)
Here's the beauty of home equity interest: How you use the money is irrelevant. Money can be borrowed for vacations, parties or to pay off other debt.
The deductibility of home equity interest provides substantial opportunity for sophisticated tax planning. The interest rate on home equity debt is usually calculated based on the current prime rate, plus one or two percentage points. If you own a home and owe several thousand dollars in credit card debt at rates of 18% to 21%, it would be a financial slam dunk to pay off that debt with a home equity loan. Not only would you pay a lower rate, but you could also write off the interest as a tax deduction.
Getting to the points
A mortgage -- and the related real estate transaction -- generates some additional tax breaks, to wit:
- Mortgage interest or "points," if you are the buyer.
- Mortgage prepayment penalties.
Many people routinely miss potential tax savings from the points they pay to borrow money. Banks often charge fees, or points, for the privilege of borrowing money. The term "points" is sometimes used to describe the charges paid by a borrower. They are also called loan origination fees, maximum loan charges or premium charges. If the payment of any of these charges is solely for the use of money, then it is considered interest.
A point is equal to 1% of the loan amount. Thus, on a $100,000 mortgage, each point costs you $1,000. If you pay off a mortgage over 30 years, each point on a 6% loan adds 0.22 percentage points to the interest rate. Thus, a 6% loan that includes four points has an effective interest rate of 6.88%.
If you pay off your mortgage early, you may have to pay a penalty. The penalty is deductible as home mortgage interest. There's one caveat: The penalty can not be for a specific service performed or cost incurred in connection with your mortgage.
Deductible points -- if you do the right thing
The amount you pay in points is deductible in full in the year of payment -- but only if the loan is to buy or improve your main home.
Points paid to refinance your home mortgage are NOT deductible in the current year. They must be deducted on a pro-rated basis over the life of the loan. For example, assume $2,400 in points is paid on a 20-year refinancing loan. You would deduct $10 per month for each month of each year the loan remains due ($2,400 divided by 240 months).
However, and this is important: If you refinance again, or sell the property, ALL non-deducted points would be deductible in that year.
Staying on top of the law
The key in all of these explanations is making sure you know the tax laws.
As a final note, for instance, you can cut your tax bill by paying legitimate interest to another family member in a lower tax bracket.
Assume you are in the 25% tax bracket in 2005 or 2006 and you borrow money from your daughter's custodial account and pay $1,500 in interest secured by your home (home equity interest).
Regardless of what you do with the money, you have created a $375 tax savings ($1,500 x 0.25) because the loan can be deducted from your tax bill.
And, if she has no other income, your daughter will pay no tax on the first $750 of interest paid and, thanks to some nifty maneuvering by Congress in the fall of 2001, only 10% on the balance for a total tax bill of $75 ($750 x 0.10). By merely reshuffling the paper, you saved the family $300 ($375-$75).
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