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Deducting Your
Mortgage Interest Under the Tax Code
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.
Your
Mortgage Interest Deductions
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
Two
Kinds of Debt
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.
Refinancing
Your Mortgage
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.
Second
Mortgages
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.
Home
Equity Lines of Credit
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.
Loan
Type Varies Interest Deduction
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
Tax Benefits of Selling Your Home
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. |
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