How Does the Mortgage Interest Deduction Work?

Owning a home is more commonly preferred by people than renting. This is because you are likely to get a return on your investment.

However, besides the investment element, there is another benefit to owning a home which comes once a year and can save you thousands of dollars and that is the mortgage interest tax deduction.

What is a Mortgage Interest Deduction?

The Mortgage Interest Deduction was established in 1913 along with the income tax, soon becoming one of America’s biggest tax deductions.

The deduction is any sum of money you can subtract from your taxable income. It reduces the amount of taxes you have to pay to the IRS whereas mortgage interest is an interest or loan that is secured by your home. For example, a mortgage that is used to buy your home, a home equity loan or a second mortgage.

How Does the Mortgage Interest Deduction Work?

If you plan on borrowing money to buy, improve or build your home, the mortgage tax deduction will allow you to avoid paying taxes on the interest of that loan.

For example, you purchase a home for $300,000 that has a fixed-rate mortgage at a 4.5 percent interest rate for 30 years. You would be paying interest on the home for about $1,000 per month and $12,000 per year.

The interest you pay on the mortgage in the first year would total to $8,900. But if you claim the mortgage interest tax deduction, you will not be taxed $8,900 of your income. Which means the tax on mortgage interest can end up reducing the amount you owe or end up increasing your tax refund.

Home mortgage interest is typically reported on Schedule A of the 1040 tax form. Reported on Schedule E, the mortgage interest paid on rental properties can also be deductible.

What Qualifies as Mortgage Interest?

Even though IRS Publication 936 has a detailed list on their website, here is a list summing up the qualifications for mortgage interest.

Besides the interest part of your monthly payment qualifying for the mortgage interest deduction, you can also deduct late payment fees, mortgage insurance premiums and discount points.

You can deduct the points either in the year you pay them or during the course of your loan. The same can be done for the points the seller pays you when you buy a home or when you pay for the home equity loan or HELOC whose proceeds are used to build, buy or improve your home.

If you pay points on a mortgage for a second home, they can only be deducted over the loan’s life and not in the year you pay them. Refinancing points should also be deducted over the loan’s life.

In 2019 and 2020, mortgage insurance premiums have been tax deductibles as mortgage interest. Some of the qualifying products are private mortgage insurance, FHA up-front mortgage insurance, FHA mortgage insurance premiums, the VA funding fee, the USDA’s annual mortgage insurance and the USDA guarantee fee.

However, this mortgage payments tax deductible is not for married-filing-jointly taxpayers that have an adjusted gross income (AGI) above $100,000 or for single or married-filing-separately taxpayers that have an AGI above $50,000. And if your AGI reaches $109,000, you will no longer be able to deduct mortgage insurance at all.

What’s Not Deductible?

1. Homeowners insurance.
2. Extra payments you make on your mortgage.
3. Title Insurance.
4. Settlement costs.
5. Interest accrued on a reverse mortgage.
6. Deposits, down payments or earnest money that was forfeited.

How to Claim the Mortgage Interest Deduction?

The IRS has detailed guidelines on how to claim the mortgage interest tax deduction. However, here is a summary of those guidelines.

You can choose to deduct the interest on up to 1 million dollars of your home mortgage debts. It can be up to $500,000 if you are married and filing separately.

Moreover, you can deduct the interest from a home equity debt on up to $100,000. But in order to take the mortgage tax deduction, you have to meet the following criteria:

1. Use IRS Form 1040 to file your taxes and itemize your deductions on Schedule A.
2. Have a secured loan that has an ownership interest on a qualified home.
3. You should also be legally liable for your home in order to claim a tax deduction which would not work if you are making payments for someone else’s home loan.

You can use the workbook provided by the IRS to figure out if you are qualified for a mortgage tax deduction.

The standard deduction amount is present each year which varies depending on your marital status and whether you are filing jointly or as head of household. This is where you need to decide whether itemizing your deductions or taking the standard deduction will save you the most money.

Once you do decide to itemize, you need to ensure that there are not any common mistakes made when claiming your mortgage tax deduction.

Where there are multiple borrowers on a loan, one borrower ends up receiving the Form 1098 which is the mortgage interest statement that your lender sends you every year in January or early February. Both the borrowers will be eligible to claim the deduction on your taxes. However, you would only be able to claim the amount you each have paid during the year.

If you are married, it is important for you to claim the mortgage tax deduction correctly. If you and your spouse are the joint owners of your home and file taxes together too, you can claim the total of the mortgage interest adjustment on your returns. However, if you are married yet file separately or own the home with someone you are not married to, you can only claim the amount of the mortgage you paid during the year.

The Bottom Line

Thanks to the mortgage interest tax deduction, borrowing money to buy a home for yourself is now less of a financial burden. This is especially true if you have a high income and a large mortgage.

However, the deduction is neither a reason to get a mortgage nor a reason to keep one that you are now ready to pay off.

There are many exceptions and rules for the standard mortgage interest tax deduction but a guide on how the mortgage interest deduction works can help you decide whether you are eligible for the deduction and will benefit from it.