Mortgage Interest Deductions

Tax News You Can Use . . .

Remember to Report Certain Foreign Bank and Financial Accounts by June 30 to the IRS

With globalization, more people in the U.S. have foreign financial accounts. "There are responsibilities that go along with owning such foreign bank and financial accounts," said IRS Commissioner Doug Shulman. "Foreign account owners must remember that they may have to report their accounts to the government, even if the accounts do not generate any taxable income."

eNewsletter & eNews Signup . . .

For website suggestions contact our webmaster at: This e-mail address is being protected from spam bots, you need JavaScript enabled to view it

With Portland going through a housing boom, and mortgage interest being one of the most common types of itemized deduction, we thought we would go over some of the rules of mortgage interest deductions. It is not as basic as it may first appear. This article also addresses some refinance issues. With rates in May 2005 being some of the lowest we have seen, this may apply to many of our clients.

Types of loans

Generally, any interest paid on a loan that is secured by your primary or secondary residence qualifies as mortgage interest. This includes standard loans, a line of credit or a home equity loan.

Mortgage interest deductions must meet all the following conditions:

You must file Form 1040 and itemize deductions.
You must be legally liable for the loan. You cannot deduct payments you make for someone else if you are not legally liable to make them. There must be a true debtor-creditor relationship between you and the lender.
The mortgage must be a secured debt on a qualified home.

In most cases, you will be able to deduct all of your home mortgage interest. Whether it is all deductible depends on the date you took out the mortgage, the amount of the mortgage, and your use of its proceeds.

If all of your mortgages fit into one or more of the following three categories at all times during the year, then you can deduct all of the interest on those mortgages. The three categories are as follows.

Mortgages you took out on or before October 13, 1987.
Mortgages you took out after October 13, 1987, to buy, build, or improve your home, but only if throughout 2004 these mortgages plus any debt from #1 above totals $1 million or less. The amount is $500,000 or less if married filing separately or a single filer.
Mortgages you took out after October 13, 1987, other than to buy, build, or improve your home, but only if throughout 2004 these mortgages totaled $100,000 or less. The amount is $50,000 or less if married filing separately or single. In addition, the total cannot be more than the fair market value of your home reduced by (1) and (2) above.

As outlined above, interest may be deducted on your main or second home Your main home is the home where you ordinarily live most of the time. A second home is a home that you choose to treat as your second home. If you have a second home that you do not hold out for rent or resale to others at any time during the year, you can treat it as a qualified home. You do not have to use the home during the year.

Second home rented out. If you have a second home and rent it out part of the year, you also must use it as a home during the year for it to be a qualified home. You must use this home more than 14 days or more than 10% of the number of days during the year that the home is rented at a fair rental value, whichever is longer. If you do not use the home long enough, it is considered rental property and not a second home.

More than one second home. If you have more than one second home, you can treat only one as the qualified second home during any year. However, you can change the home you treat as a second home during the year in the following situations.

If you get a new home during the year, you can choose to treat the new home as your second home as of the day you buy it.
If your main home no longer qualifies as your main home, you can choose to treat it as your second home as of the day you stop using it as your main home.
If your second home is sold during the year or becomes your main home, you can choose a new second home as of the day you sell the old one or begin using it as your main home.

Divided use of your home. The only part of your home that is considered a qualified home is the part you use for residential living. If you use part of your home for other than residential living, such as a home office, you must allocate the use of your home. You must then divide both the cost and fair market value of your home between the part that is a qualified home and the part that is not.

Home under construction. You can treat a home under construction as a qualified home for a period of up to 24 months, but only if it becomes your qualified home at the time it is ready for occupancy. The 24-month period can start any time on or after the day construction begins.

Home destroyed. You may be able to continue treating your home as a qualified home even after it is destroyed in a fire, storm, tornado, earthquake, or other casualty. You can continue treating a destroyed home as a qualified home if, within a reasonable period of time after the home is destroyed, you:

Rebuild the destroyed home and move into it, or
Sell the land on which the home was located.

Time-sharing arrangements. You can treat a time-sharing arrangement as a qualified home if it meets all the requirements. A time-sharing plan is an arrangement between two or more people that limits each person's interest in the home or right to use it to a certain part of the year.

Separate returns. If you are married filing separately and you and your spouse own more than one home, you can each take into account only one home as a qualified home. However, if you both consent in writing, then one spouse can take both the main home and a second home into account.

Mortgage prepayment penalty. If you pay off your home mortgage early, you may have to pay a penalty. You can deduct that penalty as home mortgage interest provided the penalty is not for a specific service performed or cost incurred in connection with your mortgage loan.

Prepaid interest. If you pay interest in advance for a period that goes beyond the end of the tax year, you must spread this interest over the tax years to which it applies. You can deduct in each year only the interest that qualifies as home mortgage interest for that year. However, there is an exception that applies to points, discussed later.

Divorced or separated individuals. If a divorce or separation agreement requires you or your spouse or former spouse to pay home mortgage interest on a home owned by both of you, the payment of interest may be alimony.

Points.

The term “points” is used to describe certain charges paid, or treated as paid, by a borrower to obtain a home mortgage. Points may also be called loan origination fees, maximum loan charges, loan discount, or discount points.

General rule. You generally cannot deduct the full amount of points in the year paid. Because they are prepaid interest, you generally deduct them ratably over the life (term) of the mortgage. However, you can fully deduct points in the year paid if you meet all the following tests:

Your loan is secured by your main home.
Paying points is an established business practice in the area where the loan was made.
The points paid were not more than the points generally charged in that area.
You use the cash method of accounting. Most individuals use this method.
The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.
The funds you provided at or before closing, plus any points the seller paid, were at least as much as the points charged. You use your loan to buy or build your main home.
The points were computed as a percentage of the principal amount of the mortgage.
The amount is clearly shown on the settlement statement.

Home improvement loan. You can also fully deduct in the year paid points paid on a loan to improve your main home, if tests (1) through (6) above are met.

Second home. You cannot fully deduct in the year paid points you pay on loans secured by your second home. You can deduct these points only over the life of the loan.

Refinancing. Generally, points you pay to refinance a mortgage are not deductible in full in the year you pay them. This is true even if the new mortgage is secured by your main home. However, if you use part of the refinanced mortgage proceeds to improve your main home and you meet the first 6 tests listed under the general rules , you can fully deduct the part of the points related to the improvement in the year you paid them with your own funds. You can deduct the rest of the points over the life of the loan.

Points paid by the seller. The term “points” includes loan placement fees that the seller pays to the lender to arrange financing for the buyer. The seller cannot deduct these fees as interest. The buyer reduces the basis of the home by the amount of the seller-paid points and treats the points as if he or she had paid them. If all the tests under the general rules are met, the buyer can deduct the points in the year paid. If any of those tests are not met, the buyer deducts the points over the life of the loan.

If you have any further questions on this, please do not hesitate to contact us.

< Prev		Next >

[ Back ]

Napier & Company, LCC