What it means
When a homeowner makes a mortgage payment, part of it repays the loan and part is interest. Only the interest portion can be deducted, and the lender reports the total paid in the year on a tax form.
The deduction applies to loans secured by the home and used to buy, build or substantially improve it. There are limits on the size of the loan on which interest can be deducted, and these rules have changed over time.
Because the thresholds and conditions are set by tax law and can be amended, homeowners should check the current rules with the tax authority or an adviser. Interest on loans above the limit, or on borrowing used for other purposes, may not qualify.
The benefit depends on choosing to itemise. Taxpayers can either take a standard deduction, which is a fixed amount set by the tax authority, or list their deductions individually, and they should pick whichever is larger.
If mortgage interest, local taxes and other allowed items together do not exceed the standard deduction, itemising gives no extra benefit. For this reason, the practical value of the deduction varies widely.
A household with a large mortgage in an early year of repayment, when most of each payment is interest, is likely to gain the most. Someone with a small or nearly repaid mortgage may find the standard deduction larger and get no tax saving from their interest at all.
The deduction also matters for decisions on property. Buyers sometimes assume it makes borrowing cheap, but a deduction only returns a portion of the interest, equal to the taxpayer's marginal tax rate.
Spending a dollar in interest to save 24 cents in tax is still a net cost of 76 cents. Business use of a home can change the treatment.
Interest on a mortgage for a rental property is generally treated as a business expense rather than as a personal itemised deduction. The rules for mixed-use and for second homes are detailed, so records of how the loan proceeds were used are important.
In practice
Real-world examples.
Example
A couple with a $400,000 mortgage pays $20,000 of interest in the year and has other deductions of $18,000. Their total itemised deductions of $38,000 are above the standard deduction available to them, so they itemise and gain from the full amount of the interest.
Example
A retired homeowner has almost repaid his mortgage and pays only $1,500 in interest. His itemised deductions are far below the standard deduction, so he takes the standard deduction and gains nothing from the interest.
Example
A consultant works from a home office and uses 15% of the space for business. She deducts the business share of her mortgage interest as part of her home office claim and treats the rest as a personal deduction if she itemises.
Formula
Calculation
Tax saving = deductible mortgage interest x marginal tax rate (only if itemised deductions exceed the standard deduction)
Suppose a homeowner pays $12,000 in mortgage interest during the year and is in a 24% marginal tax bracket. If her total itemised deductions exceed the standard deduction, the tax saving attributable to the interest is 12,000 x 0.24 = $2,880. The after-tax cost of the interest is 12,000 - 2,880 = $9,120. The 24% rate is used only as a round figure for illustration.Case study
Seen in the real world.
Calloway Family is an illustrative, fictional household that bought a home with a $350,000 loan. In the first year, interest came to $17,500, and the couple assumed that it would reduce their tax by the full amount.
Their adviser explained that their total itemised deductions of $26,000, including the interest, fell short of the standard deduction available to them, so the interest produced no extra saving at all. She suggested they make a larger charitable gift and pay property taxes in the same year to bring their itemised total above the standard figure, a technique known as bunching.
The illustrative lesson is that the deduction is only valuable when total itemised deductions pass the standard deduction. Planning the timing of deductible payments can make the difference between a saving and none.
Watch out
Common mistakes.
- Deducting the full mortgage payment, when only the interest portion qualifies.
- Assuming the deduction is automatic, when it is only available to taxpayers who itemise and whose total deductions exceed the standard deduction.
- Treating the deduction as returning the whole interest cost, when it only returns the interest multiplied by the taxpayer's marginal rate.
Questions
People also ask.
Can I deduct interest on a second home?
Often yes, if the loan is secured by the home and meets the qualifying rules, but limits on the total loan size apply and should be checked.
Where do I find the amount of interest paid?
The lender sends an annual statement showing the interest received, which is the figure to use.
Does a home equity loan qualify?
Only if the money was used to buy, build or substantially improve the home that secures the loan, not for other purposes such as paying off credit cards.
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