What you need to know about the mortgage interest deduction

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The mortgage interest deduction allows homeowners to reduce their taxable income by the amount of interest paid on the loan. (Shutterstock)

Many people think of tax time as frustrating, confusing, or downright dreadful. But if you’re familiar with some potential deductions, you may be able to boost your tax refund (or at least reduce the amount you’ll owe).

One potentially valuable tax deduction for property owners is the mortgage interest deduction. This article will help you understand the mortgage interest deduction, who can claim it, and how to include it on your tax return.

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What is the mortgage interest deduction?

The mortgage interest deduction allows homeowners to deduct interest they paid on their mortgage. The mortgage can be on your main home and one second, or vacation, home.

To claim the mortgage interest deduction, you have to itemize deductions. That means your total itemized deductions — including out-of-pocket medical expenses, state and local taxes, deductible mortgage interest, and charitable contributions — must be greater than the standard deduction available for your filing status.

Because owning a home can significantly increase your itemized deductions through property taxes and mortgage interest, many homeowners think of the mortgage interest deduction as a perk of homeownership.

How does the mortgage interest deduction work?

Your home mortgage interest deduction can be limited depending on the size of your mortgage and when you took out your mortgage.

The Tax Cuts and Jobs Act (TCJA) of 2017 capped this deduction for people who took out mortgages after Jan. 1, 2018. If your mortgage started after that date, you can deduct interest paid on up to $750,000 of "home acquisition debt," which is debt used to buy, build, or substantially improve your home. That $750,000 applies whether you’re single or married, although married couples filing separate returns are limited to interest paid on up to $375,000 of home acquisition debt each. That limit still applies if you took out your mortgage before Jan. 1, 2018. 

If you took out your mortgage before Jan. 1, 2018, you’re allowed to deduct the interest paid on up to $1 million of home acquisition debt, plus $100,000 of home equity debt. 

The $750,000 limit is set to expire on Dec. 31, 2025, unless Congress acts to extend it. The TCJA also eliminated the deduction for home equity debt. But that doesn’t mean all interest paid on a home equity loan or home equity line of credit (HELOC) is no longer deductible.

Home equity loans and HELOCs

The IRS considers any home equity loan or line of credit funds used to buy, build, or substantially improve the home to be home acquisition debt, so the interest is still deductible.

For example, say you take out a $700,000 mortgage to buy your home, then a $100,000 HELOC to remodel the kitchen. You could deduct all interest paid on the first mortgage and half the interest on the HELOC. All funds were used to buy and improve your home, but you’re limited to $750,000.

On the other hand, say you take out a $700,000 mortgage to buy your home, then take out a $20,000 HELOC to refinance some high-interest credit card debt. Interest on the first mortgage is deductible, but none of the HELOC interest is deductible because it doesn’t count as home acquisition debt.

Also, keep in mind that the $750,000 limit applies to all combined mortgages on your main residence and second home.

What qualifies as mortgage interest?

Mortgage interest doesn’t just apply to single-family homes. It also applies to condominiums, cooperatives, mobile homes, RVs, and houseboats, as long as they have sleeping, cooking, and toilet facilities.

And it’s not strictly limited to amounts you paid for interest. You can also deduct:

  • Points — Points are upfront fees paid to your mortgage lender to lower the interest rate on your mortgage. One mortgage point typically costs 1% of your loan amount. For example, if you take out a $400,000 mortgage, one mortgage point will cost you $4,000. Points are essentially prepaid mortgage interest, and in most cases, you can fully deduct the points paid when you purchase your home in the year you paid them. But if you pay points to refinance your mortgage, you typically have to deduct them equally over the life of the loan.
  • Mortgage insurance premiums — Mortgage insurance, also known as private mortgage insurance (PMI), is a type of insurance policy that protects the lender if you stop making payments on your loan. It’s typically required when you make a down payment of less than 20% of the home’s purchase price. You might pay PMI as a lump sum at closing, as a monthly premium added to your mortgage payment, or a combination of the two. For tax purposes, you can deduct amounts you pay for mortgage insurance just like you deduct mortgage interest.
  • Late charges — You can deduct any fees or penalties resulting from making a late mortgage payment.
  • Mortgage prepayment penalties — Some lenders charge a prepayment penalty if you pay off your mortgage early. That penalty can be deducted as home mortgage interest.

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What’s not deductible?

The amount you pay your mortgage lender each month typically includes several components other than interest. If your payment includes any of the following, it’s not deductible home mortgage interest:

  • Regular principal payments
  • Extra principal payments designed to pay off your loan early
  • Property taxes paid into an escrow account (property taxes are deductible, but not as part of the mortgage interest deduction)
  • Homeowners insurance premiums

How to claim the mortgage interest tax deduction

If you think you might benefit from claiming the mortgage interest deduction, here’s how to go about it:

  1. Get your Form 1098 from your lender. After the end of each year, your lender or lenders should send you a Form 1098 showing the total interest, mortgage insurance premiums, and deductible points you paid that year. To complete your tax return you will need this form.
  2. Decide whether to claim the standard deduction or itemize. You can only deduct mortgage interest if you itemize deductions. Add up your total itemized deductions for the year, including medical expenses, taxes, interest, and charitable contributions. If your total is higher than the available standard deduction — $12,550 for single filers and $25,100 for joint filers in 2021 — you’ll probably benefit from itemizing. Otherwise, you’re better off claiming the standard deduction. If you’re not sure which option is most beneficial, most tax software will run the numbers and tell you which option is best for you.
  3. Complete Schedule A. Schedule A is the form used for itemizing deductions. It has lines for entering mortgage interest and points, mortgage insurance premiums, and other itemized deductions. You can find more information about filling out Schedule A in the IRS Instructions for Schedule A. You’ll need to attach it to your Form 1040. You don’t need to send a copy of your Form 1098 to the IRS — just keep it with your tax records.

When should you use the mortgage interest deduction?

While nearly all homeowners qualify for the mortgage interest deduction, it doesn’t make sense in every situation. Here are a couple of scenarios when claiming the mortgage interest deduction might make sense for you:

  • You have a lot of other itemized deductions. Itemizing only makes sense if your total itemized deductions are greater than the standard deduction available to your filing status. Since the TCJA nearly doubled the standard deduction for every filing status, nearly 90% of taxpayers claim the standard deduction. But you might benefit from itemizing if you have a high mortgage balance, live in a high-tax state, make a lot of charitable donations, or have a lot of out-of-pocket medical expenses.
  • You file separately from your spouse, and your spouse itemizes. One tricky aspect of filing a separate tax return from your spouse is if one spouse itemizes, both must itemize — even if one would benefit more from claiming the standard deduction. If you and your spouse file separate returns and your spouse itemizes, claiming the mortgage interest deduction can increase your deductions on Schedule A.

If you’re not sure if you should take the mortgage interest deduction, or have any questions about your tax obligations, it’s a good idea to speak with a qualified tax professional for guidance.

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