Tax Consequences of Mortgage Payments

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