Home Mortgage Interest: Minimizing Taxes

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While you might not be able to eliminate your taxes, there are legitimate steps you can take to minimize the tax bite. Some steps are simple and logical. Others are more complicated.

Home Mortgage Interest
If you own a home, the interest you pay on your home mortgage provides one of the best tax breaks available. The technical term is qualified residence interest. Interest deductions are available for both the principal residence and a second residence (such as a vacation home).

There are two types of qualified residence interest that can be deducted: acquisition indebtedness interest and home equity indebtedness interest. To qualify, the debt or loan must be secured by the residence. This is usually done by signing a deed of trust or a mortgage at the same time the loan is obtained.

Acquisition Indebtedness
When you borrow money to buy a home, the interest you pay is usually deductible from your gross income. To be deductible, the interest payments must be on a loan secured by your home. This happens whenever you sign a mortgage or a deed of trust.

You are limited to the first $1,000,000 borrowed ($500,000 if you are married filing separate tax returns), which for most people is plenty.

Acquisition indebtedness also includes construction and home improvement expenses, so if you borrow money to add a bedroom or remodel a kitchen, the interest on that loan is also deductible as acquisition indebtedness interest.

But if you refinance your loan, the deduction is limited to the loan balance at the time of the refinancing. For example, suppose you borrowed $200,000 to buy your home. You now owe $150,000 and want to refinance. Let’s say you want an extra $25,000 in cash, so you borrow $175,000 (to pay off the $150,000 loan and have an extra $25,000). You may deduct only the interest on the first $150,000 as acquisition indebtedness interest, because that was the balance when you refinanced.

But the extra $25,000 might qualify as home equity indebtedness.

Home Equity Indebtedness
You are allowed to deduct interest on up to $100,000 ($50,000 if you are married filing separate tax returns) of home equity loans. It doesn’t matter why you borrow the money, so long as the loan is secured by your home.

This provides some real savings opportunities if you have equity in your home and other debts. Credit card debt is not deductible and is usually at a higher interest rate than home equity interest. By converting your non-deductible, higher rate, credit card debt to home equity indebtedness (i.e., use the home equity loan to pay off your credit card balance), you will save both on taxes and on the interest rate.

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