Mortgage Interest Deduction: What You Need To Know

The decision to buy a home can be a stressful one, especially if you’re a first-time home buyer. Though you’ll have many new responsibilities as a homeowner, homeownership also comes with many benefits. The major benefit when you buy a home is that you have increased financial security. With a fixed-rate loan you’ll know that, unlike rent, your monthly payments (excluding taxes and insurance) will never increase. You can build equity in your home as you pay off your mortgage, and take comfort in the fact that your property will likely appreciate if you hold onto it long enough.

But that’s not all that homeownership gives you. It also offers tax incentives through a mortgage interest deduction. We’ll go over what a mortgage interest deduction is, how much you can subtract from your taxable income and what you’ll need to take advantage of this great tax incentive.

What Is A Mortgage Interest Tax Deduction?

The mortgage interest deduction is an itemized tax deduction that subtracts interest paid on any loan used to build, purchase or renovate a residence from your taxable income. This means that you can deduct a certain amount of mortgage interest every year for both your primary and secondary home, and pay less income tax.

Who Qualifies For A Mortgage Interest Deduction?

To benefit from a mortgage interest deduction, your mortgage, home equity loan or HELOC must have been used to purchase, build or improve your primary or secondary home, and the property must have been used as collateral for the loan. However, you can also claim a mortgage interest deduction if you refinanced your home.

To qualify, you must itemize your deductions. Therefore, it’s only worthwhile if, after adding your mortgage interest, your itemized deductions are greater than the standard deduction.

Tax deductions can change from year to year. The standard deductions for 2022 follow:

• Single: $12,950
• Married filing jointly: $25,900
• Married filing separately: $12,950
• Heads of households: $19,400

If your total itemized deductions are less than the standard, you should just take the standard deduction instead.

Mortgage Interest Deduction Calculator

Calculating your mortgage interest deduction is something you can do yourself. Divide the maximum debt limit by your remaining mortgage balance, then multiply that result by the interest paid to figure out your deduction.

Let’s consider an example: Your mortgage is $1 million, and since the deduction limit is $750,000, you’ll divide $750,000 by $1 million to get 0.75. You’ll pay $60,000 in interest for the year, and that multiplied by 0.75 will show that you can ultimately deduct $45,000.

Many people prefer to work with tax accountants in cases like these, just to make sure their calculations are accurate and there are no issues with the IRS.

What Payments Can You Deduct?

You can deduct the interest you pay on a primary and secondary residence, a home equity loan, prepaid mortgage points, prepayment penalties and even your private mortgage insurance, along with FHA mortgage insurance premiums, USDA guarantee fees and VA funding fee. Unfortunately, most of your home expenses can’t be deducted.

Here’s a list of other common home payments that aren’t tax deductible:

• Homeowners insurance
• Title insurance
• Deposits and down payments
• Extra payments made to pay down the principal
• Interest accrued on reverse mortgages

Your Mortgage Interest Deduction Limit

Since the Tax Cuts and Jobs Act took effect, the limit on mortgage interest deductions has decreased. If you took out a mortgage prior to December 15, 2017, the mortgage interest deduction limit is $1 million. Now that the limit has been lowered for homeowners who purchased or refinanced homes after that date, taxpayers who are single or married and filing jointly may only deduct up to $750,000 of interest. For married couples who file separately, the limit is now $375,000 each. However, there are certain exceptions to these new rules:

• Grandfathered debt: If you took out a mortgage before October 13, 1987, you can deduct all of the interest that you pay. There is no limit because you’ve been grandfathered in.
• Home acquisition debt: If you took out a mortgage to purchase, build or improve a home – utilizing either a primary or second mortgage – after October 13, 1987 but before December 16, 2017, you can deduct up to $1 million (or $500,000 if you’re married and filing separately).

Mortgage Interest Deduction For Prepaid Interest Points

There are also special rules regarding when you can apply your deduction for prepaid interest points. You may be able to deduct more of your points in the year you bought them. But, generally speaking, you can’t deduct the full cost of prepaid points in the year you paid them. Instead, you can deduct a portion of the points each year over the life of the loan.

To determine the amount you can deduct each year, use the following equation:

(Prepaid points / Full term of loan in months) x Number of mortgage payments made each year

As an example, let’s say you bought a house with a 30-year mortgage term and paid $3,400 in points upfront. Here are the steps you would need to complete:

1. Multiple the full term of the loan by 12 to determine what the loan term is in months:

30 x 12 = 360

2. Divide the cost of the points paid by the full term of the loan (in months):

$3,400 ÷ 360 = $9.44

3. Multiply the result by the number of mortgage payments made in the tax year:

$9.44 x 12 = $113.33 deduction each year.

How To Receive A Mortgage Interest Deduction

To receive a mortgage interest deduction, you need to ensure that you obtain and fill out all of the appropriate forms. At the beginning of the year, you should receive a Form 1098 from your mortgage servicer. This form will state exactly how much you paid in interest and mortgage points over the course of the year, and act as proof that you’re entitled to receive a mortgage interest deduction. Be aware that you will only receive this form if you have paid at least $600 in interest during the tax year.

To qualify, you will also need to itemize your deductions and report them on Schedule A, Form 1040. This form will have you list all of your deductions, including donations to charity, medical expenses and the information about your mortgage interest found on your 1098.

Are There Circumstances That Make Claiming A Mortgage Interest Deduction Harder?

There are certain circumstances that can make claiming a deduction more difficult or require more forms. Some of these outliers include living in a co-op building, renting out part of your residence and being under construction.

The stipulations for mortgage interest deductions in these situations can be incredibly confusing, which is why we recommend speaking with an expert. A professional financial planner or accountant will walk you through your options and ensure that you are able to deduct as much of your taxable income as possible.

The Bottom Line: Utilize Your Mortgage Tax Deduction

When it comes to the mortgage interest deduction, it’s normal to have questions, especially as a first-time homeowner. While the process may seem overwhelming, being able to utilize a mortgage tax deduction can be very beneficial. We encourage you to take the opportunity to speak with a financial planner or tax professional for any further questions related to mortgage interest deductions.