Interest is an amount you pay for the use of borrowed money. To deduct interest you pay on a debt you must be legally liable for the debt. Also, you must itemize your deductions, unless the interest is on rental or business property or on a student loan. Interest payments typically deducted by individuals include mortgage interest, investment interest, and interest paid on home equity loans. If you own a home and are paying off a mortgage, you should probably be itemizing because mortgage interest payments are usually large enough to get most people over the standard deduction amount.
Home Mortgage Loans
Home mortgage interest is any interest you pay on a loan secured by your main home and/or a second home. The loan may be a mortgage to buy your home, a second mortgage, a line of credit, or a home equity loan. Home mortgage interest for a loan or loans totaling up to $1 million is deductible. If you borrow more than $1 million, the interest on the overage is not deductible.
If you are lucky enough to have more than one vacation home, you must select the one to be treated as the second home for purposes of the mortgage interest deduction. This selection is made anew each year, so you can select one vacation home as your second home one year, and another the next year.
Home mortgage loans can be complicated and include all sorts of charges not labeled “interest.” The largest of these is usually “points.” A point is equal to 1% of the loan amount—for example, one point on a $100,000 loan is $1,000. These charges are also called loan origination fees, maximum loan charges, or premium charges. If any of these charges (points) are solely for the use of money and not for a specific service such as appraisal services, they are prepaid interest for tax purposes. As a general rule, you must deduct points a little at a time over the life of your loan. However, there is a special exception for points to obtain a mortgage to buy or build your main home. These points can all be deducted in the year paid. Points paid for refinancing generally can only be deducted over the life of the new mortgage. However, you may deduct the points in a single year if you use the money to improve your main home—for example, add a new bathroom.
Most other expenses you pay to obtain a mortgage cannot be deducted as interest. Instead, they are added to your basis in the property and increase its value for tax purposes. These costs include:
- abstract fees
- charges for installing utility services
- legal fees
- appraisal fees
- mortgage commissions
- recording fees
- transfer taxes
- title insurance, and
- any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.
It’s easy to keep track of how much interest you pay each year on a home mortgage loan. If you paid $600 or more of mortgage interest (including certain points) during the year on any one mortgage, you will receive an IRS Form 1098 from the lender. This form lists how much interest you paid during the year.
Home Equity Loans
If you use a loan secured by your main or second home for purposes other than to buy, build, or improve your home, it is a home equity loan. For example, you might get a home equity loan to help pay for school or buy a car--but not to remodel your kitchen. Interest on home equity loans of less than $100,000 is deductible as an itemized personal deduction.
You may take an itemized deduction for investment interest, but you may not deduct more than your net annual income from your investments. Any amount that you can’t deduct in the current year can be carried over to the next year and deducted then.
Example: Donald borrows $10,000 on his credit card to invest in the stock market. The interest he pays on the debt is deductible as an itemized personal deduction on his Schedule A, Form 1040. But he can’t deduct more than he earned during the year from his investments.
Personal interest is not deductible. This is interest you pay to buy something for your personal use (except for interest paid for a mortgage for a personal residence or second home, and some interest on student loans). Thus, you may not deduct interest you pay on credit cards, car loans, or other loans where the proceeds are used for personal purposes. For example, if you buy a new dishwasher for your residence with a credit card, you may not deduct the interest you pay to the credit card company on the amount. Likewise, you can’t deduct any part of the interest you pay on a car loan unless you use your car for a business or investment activity.
Because personal interest is not deductible, but home equity loan interest is, you should consider borrowing against your home to make consumer purchases instead of charging them on your credit card or taking out a consumer loan. For example, if you need a $20,000 loan to buy a car for personal use, all the interest will be deductible if you obtain the money through a home equity loan. Of course, you must have a home and have equity to obtain such a loan.