The mortgage interest deduction is one of the most important tax benefits that homeownership offers. You can reduce your taxable income by deducting the interest you paid on your mortgage. This article will explain how the deduction works, what its limitations are and how it could affect your tax situation.
What is the process of deducting mortgage interest?
You can deduct mortgage interest payments each year from your taxable income through the mortgage interest deduction
If the debt was used to purchase, build, or substantially improve the property, the deduction could be applied to a mortgage.
What types of mortgage interest can be deducted?
You may be eligible to deduct these types of mortgage interest, in addition to the interest portion of your mortgage payment:
- Late mortgage payment fees are not part of any specific service.
- For paying your mortgage early, you will be subject to prepayment penalties
- You must pay interest on your mortgage before you sell your house.
- Participation in the Hardest Hit Fund or an emergency homeowners loan program will result in interest payments.
- As part of your closing costs, prepaid interest or mortgage points are paid.
Interest payments from a second mortgage (such as a home equity loan, line of credit or home equity loan) can also be deducted. However, this is only allowed if the debt was used for the purchase, construction, or improvement of your primary or secondary home. The maximum mortgage interest deduction applies to both the first and second mortgages.
Cash-out refinances allow you to deduct interest on your original mortgage amount. However, you can only deduct interest on equity you cash out if the funds are used to improve your home.
A mortgage interest deduction example
Let’s look at two homeowners with two outstanding mortgages. They want to claim the mortgage interest reduction.
Homeowner A owes $400,000 on the mortgage for their main home that was purchased before December 16, 2021. Another $250,000 is due on a mortgage used in spring 2022 to buy a vacation house.
Homeowner B owes $600,000. This is on a mortgage that was issued before Dec. 16, 2021. They took out a $300,000.00 home equity loan in fall 2021 to pay college expenses and consolidate other non-mortgage debt.
What are the rules? Homeowner A’s $400,000 mortgage is below the $1,000,000 and $750,000 limits. We must use the $750,000 limit because the $250,000 was paid after the cutoff. Homeowner A borrowed money to buy a vacation home. They may be eligible to deduct interest from that loan and the mortgage on their main house.
The total amount of both loans exceeds $750,000, so Homeowner A can fully deduct both interest. However, they would not be able to deduct the interest on any home equity loan or credit line that they borrowed against their primary home in order to purchase their vacation home.
The situation of Homeowner B is slightly different. They can deduct the $600,000.00 mortgage interest, but not the $300,000.00 home equity loan interest. This is because it was not used for home improvement.
Mortgage interest deduction vs. standard deduction
The Tax Cuts and Jobs Act reduced the maximum mortgage interest deduction amount but increased the standard deduction amounts. These changes may result in fewer taxpayers choosing to itemize their deductions.
The 2019 standard deduction amounts for 2019 are:
- Single/married filing separately
- Head of household: $18,350
- Married filing jointly: $44,400