How the Home Mortgage Interest Deduction Works

While we wait for details on President Trump’s new tax plan, the important thing to note is that there has been no change to the home mortgage interest deduction…yet and it is still available for your 2016 individual income tax filings.

The mortgage interest deduction, in general, allows homeowners to deduct the amount of interest expense paid on secured loans taken out to finance their primary or secondary home from their taxable income so long as they itemize their income tax deductions.  

Introduced back in 1913, the mortgage interest deduction was drafted into the federal tax law to help individuals and families obtain their “American Dream” of home ownership – Yes, a place of their very own!

However, as politics would go, certain maximum limitations were placed on the mortgage interest deduction back in 1987 — that is, in lieu of a direct tax rate increase (i.e. “raising taxes”).  “Qualified residence interest” was then codified into the federal tax laws restricting the mortgage interest deduction to that paid on:

With a closer look at the federal tax law requirements, here’s how the home mortgage interest deduction works:

  • You must file Form 1040 and itemize deductions on Schedule A (Form 1040)
  • The mortgage must be a secured debt on a “qualified residence” in which you have an ownership interest.

Both you and the lender must intend that the loan(s) be repaid.

A “qualified residence” generally means your principal residence and a second home.  You may treat a house currently under construction as a qualified residence for a period of up to 24 months so long as it becomes your principal or secondary home at the time that the house is ready for occupancy.

In general, the amount of interest expense you can deduct will depend on the date of the secured home loan or mortgage, the amount of the mortgage and how you used the mortgage proceeds.

“Acquisition indebtedness” includes:  (1) “grandfathered debt”, a loan taken out on or before October 13, 1987 that is secured by your home and (2) “home acquisition debt” (incurred after October 13, 1987), a secured mortgage or loan to specifically buy, build, or substantially improve a qualified residence.   Any secured debt you use to refinance “acquisition indebtedness” will continue to qualify, however, ONLY up to the amount of the remaining principal balance of the original loan at the time of the refinance.  So, here is where you need to be careful — any additional debt (“cash out”) from the refinance not used to buy, build or substantially improve your principal or secondary home will not qualify for the mortgage interest deduction.

“Home equity indebtedness” (sometimes called “home equity line of credit” or “HELOC”) is debt incurred after October 13, 1987, of which the proceeds were used for purposes other than to buy, build or substantially improve a qualified residence.  For example, this is where a homeowner borrows against the built-up appreciation and/or equity in his or her home to consolidate credit card debts, purchase a car, or pay for college, etc.  Subject to the above-mentioned limitations, interest paid on home equity indebtedness is deductible under the rules for qualified residence interest.

Notwithstanding the above limitations, many homeowners do find that they are below the maximum debt limitations and avail themselves to an itemized tax deduction for the full amount of mortgage interest they paid during the calendar year as reported to them by their lender on Form 1098.

For homeowners with secured home loans, mortgages and home equity indebtedness in excess of the maximum debt limitations for the qualified residence interest, they are directed herein to see Part II of IRS Publication 936 for further instructions and to consult their tax advisor for assistance in determining their qualified loan limit and deductible home mortgage interest.

Having generally described the mortgage interest deduction for federal tax purposes above, homeowners have only begun to compute their ultimate income tax benefit from such interest expense paid.  As an itemized deduction, the mortgage interest deduction is subject to certain phase-outs in 2016 for high-income taxpayers for federal regular income tax purposes.  In addition, although interest paid on home equity loans, as described above, is deductible for regular income tax, such interest is not deductible for federal alternative minimum tax (“AMT”) purposes.   

Locally, while the state of Hawaii follows the 2016 federal rules and limitations for the mortgage interest deduction, it imposes its own set of rules for the phase-out of itemized deductions based on adjusted gross income.   It is also a relief to note that for tax years beginning after December 31, 2015 (i.e. 2016 and thereafter), the state of Hawaii has eliminated the overall cap on itemized deductions [Act 97, SLH 2011].  Hooray for Hawaii homeowners!

Finally, homeowners are advised that the tax rules vary substantially from state to state and are herein advised to consult their tax advisor.   

About the Author

Brandon Lau grew up in Kailua and currently resides in Honolulu with his wife Andee and children Caylah, Elijah, and David. His eighteen years in real estate led him to become a Partner at ChaneyBrooks Choice Advisors. Over the past 10 years he has developed the team and systems that has created a high level of service and value for his clients.

What differentiates Brandon and his team is his consultative approach to real estate. He advises clients with relevant data and expert insight to help them make the best choices in real estate. Good choices in planning for long term dispositions, negotiating for the best price or knowing when not to pursue an investment are ways his consultative services will give you an advantage in the marketplace. His bottom line is providing service with the utmost integrity and expertise.