One of the best
justifications for owning a home, at least for financial reasons, is
the tax savings that result from deducting mortgage interest. The
deduction for mortgage interest stands as one of the few remaining
tax deductions for the typical middle class taxpayer. Despite the
changes to the tax code over the past several years and the repeal
and limitation of many non-housing itemized deductions, mortgage
interest is still deductible. On first and second mortgages
and home equity lines of credit (with some limitations)
for first and second homes, your mortgage interest
deduction is still a good financial incentive to buy a
home.
Under the current tax code, mortgage interest on first and
second homes is generally deductible as long as these loans total
less than $1.1 million, making home ownership one of the best ways
to trim your tax bill. The examples below illustrate how the
mortgage income tax deduction affects the after-tax home
ownership.
Listed below are the topics
covered in this document.
- Homeowner Profile
Gross Income - $35,500
House Price/Mortgage Size - $115,000 - $23,000 down = $92,000
Loan Type - 30-year Fixed-Rate mortgage at 10%
Property Tax - 1.23% of home value ($1,415)
Filing Status - Files jointly/four exemptions
According to the tax code, this homeowner's deductions for
mortgage interest and property taxes would be evaluated at a 15
percent marginal tax rate. Non-housing itemized deductions (i.e.,
state and local taxes, non-mortgage interest and so on) is estimated
at $2,000 and the standard deduction is $5,450. Under the current
tax system, the homeowner saves $1,071 because of the mortgage
interest deduction. You can figure what your own costs and
savings will be by substituting your own tax figures for
those on the chart.
- Example of the impact of the Mortgage Income Tax
Deduction on Annual Home ownership Costs:
- Before-Tax Home ownership Costs
Mortgage Interest=$9,177
Property Taxes=1,415
Total of Before-Tax Home ownership Costs=10,592
- Itemized Deductions
- Home ownership Deductions
Mortgage Interest= $9,177
Property Taxes=1,415
Non-home ownership Deductions= 2,000
Total= 12,592
- Standard Deductions=5,450
- Total Itemized Deductions=$7,142
Multiply Total Itemized Deductions by Marginal Tax Rate
to get Home ownership Tax Savings:
$7,142 x .15 =
$1,071
- After Tax Home ownership Costs = Home
ownership Tax - Before Tax Savings:
$10,592 - 1,071 =
$9,521
Under the current tax system, there are two
different kinds if debt. Money you borrow to buy, build or
substantially improve your residence is called "acquisition
indebtedness." Money you borrow against the equity in your home, or
money you take out when you refinance your home for any reason
except home improvement, is called "equity indebtedness."
When you borrowed the money is also important. Home loans taken out before October 14, 1987, are exempted from the
new rules. You may fully deduct interest paid on these loans,
regardless of their size or what you used them for. Any refinanced
debt you incurred before October 14, 1987, is rolled into your total
acquisition indebtedness. On loans made on or after October 14,
1987, you can deduct mortgage interest paid on acquisition
indebtedness up to a total of 1.0 million. This means you could buy
a home for $250,000, a beach home for $200,000, and add a family
room to your first house for another $100,000, and still have
$450,000 to spend on these homes for further improvements before you
reached your limit for interest deductibility. The $1. 0 million is
not cumulative. As you pay off a loan, you would add that
amount to your total purchasing or improving up to two
residences.
Your equity indebtedness limit is $100,000. That
means that you can borrow up to $100,000 of the equity in your home
and use it for whatever you want. This is a change from the pre-1986
tax rule that limited your equity borrowing beyond the purchase
price to certain qualified expenses, such as home improvements,
medical and education expenses.
Interest rate have declined recently, and many
homeowners have taken advantage of this drop by refinancing their
mortgages. In the past, refinancing your mortgage has proved
to be an excellent opportunity both to lower your
interest rate and monthly payment and take equity out of
your home.
When refinancing your mortgage, you will probably
pay 3 percent to 6 percent of the loan amount in closing costs-for
surveys, legal fees and paperwork fees. Many of these closing costs
are deductible, but not necessarily in the year that you refinance. I f you are considering refinancing your mortgage under the current
tax rules, however, there are a couple of things to bear in mind. If
you refinanced before October 14,1987, for a longer term than was
remaining on the pre-October 14 loan, you may only de duct the
interest paid on the mortgage for the term that was remaining on the
old loan. So if you refinanced a loan with 15 years remaining for a
30-year loan with lower payments, you can only deduct the mortgage
interest paid on the new loan for 15 year s. The one exception is if
you had a balloon mortgage payment come due after October 13,1987
and you refinanced it to a loan of not more than 30 years; you get
the deductibility for the full term of the longer loan. Any
refinanced debt you incurred before October 14,1987, is
rolled into your total acquisition indebtedness.
In the past many homeowners have refinanced
mortgages on their appreciating properties to draw on their equity
to buy a new car or take a vacation. Under the new tax system,
homeowners will no longer have unlimited mortgage interest
deductions when drawing on equity. Any equity debt incurred is
subject to a limit of the amount of on equity. Any equity debt
incurred is subject to a limit of the amount of the existing debt
plus $100,000. Say, for instance, that you bought your house 10
years ago and have seen the property grow in value from $70,000 to
$230,000. If you refinance your mortgage (on which you now owe
$50,000), you may only deduct the interest paid on the total of your
acquisition indebtedness in the property ($50,000) plus $100,000. You will be able to deduct the interest paid on $150,000.
A second mortgage allows the homeowner to cash in
on some of the equity that has built up in the home over time. Some
lenders call a second mortgage a "junior lien." Getting a second
mortgage is very much like taking out your first mortgage (i.e.
you w ill be required to pay closing costs of 3 percent
to 6 percent of the loan value).
You may deduct the interest paid on second
mortgages made on or after October 13,1987, up to the $100,000 limit
had already been reached when the first mortgage was taken out. The
amount of second mortgages made before that date is part of your
acquisition indebtedness total figure. This means that if you had
$50,000 left on your first mortgage as of that date, and had taken
out a $25,000 second mortgage on the property prior to October
14,1987, you would have an acquisition indebtedness of $75,000.
While the 1986 tax reform called for consumer
interest deductibility to be phased out by 1991, interest deductions
on equity indebtedness now are limited only by the $100,000 cap.
This means that interest paid on home equity lines of
credit - loans secure d by your principal or second home
- is still deductible.
Where the traditional second mortgage gives the
homeowner money in one lump sum the home equity line of credit
allows homeowners to use the equity in their home like a giant
credit card. The lender allows the homeowner to borrow at will
against the equity in the home, and charges interest only on the
portion of the equity borrowed against. Therefore, your interest
deductions for a home equity line of credit depend on whether you
borrow against the equity during that year.
As we've said, the mortgage interest tax deduction
is one of the best financial reasons to buy a home. You may be
wondering, however, what total interest charges are like on the
typical home loan. In the chart, you can compare a 30-year
fixed-rate loan with 15-year and bi-weekly mortgages for the same
amount. As you can see, the amount of interest you pay over
the life of your loan depends on what kind of mortgage
you determine is best for you.
$75,000 MORTGAGE
30 Year 15 Year Bi-Weekly Fixed Rate Fixed Rate Mortgage
At 10% At 10% At 10% Monthly Payment $ 658 $ 806 $ 658 (329 X 2)
Interest Cost First Year $ 7,481 $ 7,398 $ 7,434 Fourth Year $ 7,336
$ 6,606 $ 7,061 Mortgage Balance First Year $ 74,583 $ 72,726 $
74,476 Fourth Year $ 73,052 $ 64,732 $ 69,817 Interest Cost/Life $
161,942 $ 70,062 $ 104,331 Difference from 30-year -$ 91,880 -$
57,611
The new tax code does not tax the profits from the
sale of a home if the proceeds are used to buy another house costing
at least as much as the sales price of the old one. If you or
your spouse are at least 55 years old, you may be able
to sell your home and exclude the first $125,000 of
gains from your taxable income without reinvesting the
money.