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Mortgage interest deductions do have some restrictions

robbins largeQ: We are in the process of financing a new home and have heard that we may not be able to deduct all the mortgage interest we will be paying. Is this true? We did not think there was any limitation on deducting the interest paid on a mortgage.

A: Your mortgage interest deduction may be limited in more ways than one. There is a limitation if the total amount of your loan exceeds a certain threshold and a second limitation if your income exceeds another threshold.

Under the first limitation, the deduction for qualified residence interest is limited when your acquisition indebtedness exceeds $1 million plus $100,000 of home equity indebtedness ($500,000 and $50,000 respectively for married filing separately). There are many defined terms in that last sentence, but I am assuming by your question that the mortgage you are seeking is specifically for, and secured by, the acquisition of a new personal residence. This assumption is important, since there are many conditions and exceptions in the mortgage interest rules.

It is important to differentiate between acquisition indebtedness and home equity indebtedness. Acquisition indebtedness is a loan to purchase, construct or substantially improve a qualified residence. It can also include debt used to refinance earlier acquisition indebtedness, but only to the extent of the balance of the original acquisition indebtedness at the time of refinancing. So if you take out a mortgage to purchase your home and pay off that loan, and later take out another loan secured by your house, the new loan will not qualify as acquisition indebtedness. Rather, it is considered home equity indebtedness – debt (other than acquisition debt) secured by a qualified residence. This is a very important distinction because of the differing thresholds for the two types of debt. In addition, home equity indebtedness cannot be greater than the fair market value of the residence less any acquisition indebtedness.

Once the distinction between the types of debt is determined, the potential limitations must be applied by computing the average balances of each mortgage during the year and then allocating the total interest paid between the loan balance under the limit (the deductible portion), and over the limit (the non-deductible portion). The average loan balance can be determined using your monthly mortgage statements, the average of the first and last balance during the year (with certain restrictions), or by using the actual interest paid divided by the interest rate, or a reasonable approximation of one of these methods. Also, if you own two homes, you may be able to treat the interest on both homes as qualified mortgage interest.

Confused? Let’s look at an example: You and your wife own a principal residence in the Treasure Valley and also a lake house. The mortgage on the principal residence had a balance at the beginning of the year of $850,000, and at the end of the year it was paid down to $800,000. The mortgage on the lake house had balances at the beginning and ending of the year of $350,000 and $320,000, respectively. The average of the combined beginning and ending loan balances is $1.16 million, which exceeds the tax law limit; consequently your mortgage interest deduction will be limited to 94.42 percent ($1.1 million divided by $1.16 million). So if the total mortgage interest you paid was $45,000, your total allowable deduction would be $42,489 ($45,000 times 94.42 percent). Notice that the acquisition indebtedness and home equity indebtedness limits were combined in this example, as allowed under IRS guidance.

As if that is not enough, there is also a second potential limitation on your mortgage interest deduction. If your adjusted gross income exceeds $300,000 for married couples and $250,000 for singles, itemized deductions (including mortgage interest) are phased out depending on the extent to which your AGI exceeds those thresholds.

For many, the mortgage interest deduction limitations will not come into play. But for those who do have large mortgages and/or high incomes, these limitations can severely restrict the tax benefit of paying mortgage interest. The rules can obviously be very complicated, so do your homework. My advice is to not take out a bigger mortgage just to “save taxes.” But do be aware of what your opportunities will be when it comes to filing your tax return, and always take best tax advantage of your mortgage interest deduction.

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To ensure compliance imposed by IRS Circular 230, any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities. The answers in this column are meant to offer general information. You should consult your tax adviser regarding the specifics of your situation.

Peter Robbins is a partner in the Boise office of CliftonLarsonAllen, LLP specializing in tax matters for small businesses, individuals, and trusts and estates.

Have a question for Robbins? Email your question to news@idahobusinessreview.com. Enter “Talking Tax” in the subject line.

About Peter G. Robbins, CPA