Mortgage Interest Deductions - Get Your House In Order
Mortgage Interest Deductions - Get Your House In Order In order to maximize your mortgage interest deduction, you need to first get your house in order. Many people recognize that the deduction for home mortgage interest is one of the most potent tax breaks available today. Most people are surprised at how complex and full of pitfalls the mortgage interest deduction rules really are and more are surprised about how big of a role their house plays in their wealth strategy.
How to get your house in order depends on how your loan will be categorized.
CATEGORY 1: Did you obtain your loan to buy your residence?
Usually the interest paid on a loan if the proceeds are used to buy or build a residence (a main home and one vacation home) is fully deductible. This type of financing is called acquisition debt. There are two important rules to remember:
1. The acquisition debt must be less than $1.1 million in order for all interest to be deductible
2. The acquisition debt must be secured by your home
If your acquisition debt exceeds the $1.1 million limit, then your mortgage interest deduction is limited to the interest on $1.1 million.
In most situations, any points you pay to the lender in the year you get a mortgage loan to buy your main residence are fully deductible.
How to get your house in order for Category 1:
If your acquisition debt exceeds the limit, then taking advantage of other tax deductions will be even more important in your tax strategy.
For example, using a portion of your home as a home office will maximize your deductions because the home office rules do not have a maximum acquisition debt rule.
If you own business or real estate investments, you may consider getting a loan within the business or real estate investment to provide you with cash to pay down or refinance your acquisition debt. This will lower your acquisition debt. Even though your overall debt balance between the acquisition debt and the business or real estate investment debt is the same, this strategy maximizes your interest deduction by:
Reducing the amount of acquisition debt, which in this example is over the $1.1 million threshold so the interest on the excess is non-deductible.
Increasing your business or real estate investment debt, the interest on which is usually deductible. The interest may be currently deductible or deductible in future. Both are a better result than non-deductible.
You may also want to consider this "debt shifting" strategy if your itemized deductions are subject to limitations, which turns a portion of your deductible mortgage interest into a non-deductible expense.
CATEGORY 2: Did you refinance your loan to remodel?
If you refinance your existing loan to pay for an expansion or remodeling of your home, all of the interest you pay on the new loan usually will be deductible as acquisition debt and subject to the same rules in Category 1.
Follow the same tips to get your house in order as Category 1.
CATEGORY 3: Did you refinance for better rates or terms?
If you pay off the loan you got to buy your home with a new loan carrying a lower rate of interest or more favorable terms overall, all of your interest on the loan usually will be deductible as acquisition debt and subject to the same rules in Category 1 - EXCEPT any points you pay on the new loan will be deductible over the loan term and not all at once in the year you refinance.
Follow the same tips to get your house in order as Category 1.
CATEGORY 4: Did you refinance to raise cash for a personal asset or expense?
Interest paid on a consumer loan to pay for a personal asset or expense, such as buying a new car, or paying medical expenses, is not deductible. However, you can transform that non-deductible expense into fully deductible interest if you use your home as collateral for the loan, and the total amount of such home-equity loan doesn't exceed $100,000. The loan can be a first mortgage, a second mortgage, or a home equity type loan.
How to get your house in order for Category 4:
You will want to make sure the debt related to the personal asset or expense doesn't exceed $100,000. If the debt does exceed this limit, then your interest deduction is limited. Be sure to keep track of the loan balance related to the personal asset or expense and provide that information to your tax preparer.
CATEGORY 5: Did you refinance to raise cash for an investment or business asset or expense?
Interest paid on a loan to pay for an investment or business asset or expense is usually deductible as an investment or business expense. This portion of the loan is not considered acquisition debt.
How to get your house in order for Category 5:
In most cases, you will need to "trace" the portion of the loan that was used for acquisition debt and the portion used for investment or business assets or expenses. This enables you to properly allocate the portion of interest that is related to your home and the portion that is related to the investment or business. Keeping proper documentation on this is key because in many cases a greater interest deduction is taken.
Proper documentation includes proof of the portion that was used towards the business or real estate investment or expense, the calculation of interest on that portion, and how the business or real estate investment paid its portion of the interest. Be sure to provide this information to your tax preparer.
As I mentioned at the beginning of this article, many people are surprised at how complex and full of pitfalls the mortgage interest deduction rules really are and even more are surprised about how big of a role their house plays in their wealth strategy. This all means opportunity - opportunity to increase your overall interest deduction and opportunity to turn taxes into wealth to add velocity to your wealth strategy.
About the Author:
Tom Wheelwright is not only the founder and CEO of Provision, but he is the creative force behind Provision Wealth Strategists. In addition to his management responsibilities, Tom likes to coach clients on wealth, business, and tax strategies. Along with his frequent seminars on these strategies, Tom is an adjunct professor in the Masters of Tax program at Arizona State University. For more information, visit www.provisionwealth.com
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