FAQS ON DEDUCTING MORTGAGE INTEREST

If you're a homeowner, read up on all the rules to be sure you're getting the full mortgage-interest tax break.

You can usually deduct the interest you pay on a mortgage for your main home or a second home.

Here are the answers to common questions about this deduction:

• What counts as deductible mortgage interest?
• Is my house a home?
• Who gets to take the deduction?
• Is there a limit to the amount I can deduct?
• What if my situation is special?
• What kind of loans get the deduction?
• What if I refinanced?
• What kind of records do I need?

What Counts as Deductible Mortgage Interest?

Deductible mortgage interest is interest you pay on a loan secured by a main home or second home. These loans include:

• A mortgage to buy your home
• A second mortgage
• A line of credit
• A home-equity loan

If the loan is not a secured debt on your home, it is considered a personal loan and the interest you pay isn't deductible.

Is My House a Home?

For the IRS, a home can be a house, condominium, cooperative, mobile home, boat, recreational vehicle, or similar property that has sleeping, cooking, and toilet facilities.

Your home mortgage must be secured by your main home or your second home. You can't deduct interest on a mortgage for a third home, a fourth home, and so on.

Who Gets to Take the Deduction?

You do, if you are the primary borrower, you are legally obligated to pay the debt, and you actually make the payments. If you are married and both of you sign for the loan, then both of you are primary borrowers.

Is There a Limit to the Amount I Can Deduct?

Yes, but very few homeowners run up against it.

You can deduct interest paid on up to $1 million of mortgage debt used to buy or improve your home. (In the event that your mortgage debt exceeds the value of your home, the deduction is limited to the interest paid on the amount of debt equal to the value of your home. This used to seem like a very unlikely event, but when zero-down-payment mortgages are combined with a recent housing slump, it can be a real threat to some homeowners.)

In addition to interest on the $1 million in secured debt used to buy or improve your home, you can also deduct interest on up to $100,000 of home-equity debt—which is debt secured by a first or second home—used for any purpose, be it to pay for a car, pay college tuition, pay off credit card debt, whatever.

For details, see IRS Publication 936, Home Mortgage Interest Deduction.

What About Special Situations?

Here are a few special situations you may encounter.

• If you have a second home that you rent out for part of the year, you must use it for more than 14 days or for more than 10 percent of the number of days you rented it out at fair market value (whichever number of days is larger) for the home to be considered a second home for tax purposes. If you use the home less than the required number of days, your home is considered a rental property, not a second home. That means the interest is not deductible as personal mortgage interest, although part or all of it is deductible to offset rental income.
• You may treat a different home as your second home each tax year, provided each home meets the qualifications as your residence.
• If you live in a house before your purchase becomes final, any payments you make for that period of time are considered rent. You cannot deduct those payments as interest, even if the settlement papers label the payments as interest.
• If you used the proceeds of a home loan for business purposes -- money borrowed through a cash-out refinancing, say, or a home-equity line of credit -- deduct that interest on Schedule C if you are a sole proprietor and on Schedule E if the money was used to purchase rental property. The interest is attributed to the activity for which the loan proceeds were used.
• If you own rental property and borrow against it to buy a home, the interest does not qualify as mortgage interest because the loan is not secured by the home itself. Interest paid on that loan can't be deducted as a rental expense either, because the funds were not used for the rental property. The interest expense is actually considered personal interest, which is no longer deductible.
• If you used the proceeds of a home mortgage to purchase or "carry" securities that produce tax-exempt income (municipal bonds) or to purchase single-premium (lump-sum) life insurance or annuity contracts, you cannot deduct the mortgage interest. (The term "to carry" means you have borrowed the money to substantially replace other funds used to buy the tax-free investments or insurance).

What Kind of Loans Get the Deduction?

If all your mortgages fit one or more of the following categories, you may deduct all of the interest paid on your mortgages, up to the $1 million and $100,000 limits mentioned above (unless you are squeezed by the deduction reduction for high-income taxpayers discussed below).

1. Mortgages you took out on your main home and/or a second home on or before October 13, 1987 (called "grandfathered" debt, because this covers any mortgages that existed before the laws were changed in 1987).
2. Mortgages you took out after October 13, 1987 to buy, build, or improve your main home and/or second home (called acquisition debt), plus grandfathered debt that totaled $1 million or less throughout 2007 ($500,000 if you are married and filing separately from your spouse).
3. Mortgages you took out after October 13, 1987, other than to buy, build, or improve your main home and/or second home (called home-equity debt) that totaled $100,000 or less throughout 2007 ($50,000 if you are married and filing separately from your spouse), and all of the mortgages on the home totaled no more than its fair market value.

If a mortgage does not meet these criteria, your interest deduction may be limited. To figure out how much interest you can deduct in that situation, see IRS Publication 936, Home Mortgage Interest Deduction.

Restriction on deductions for high-income taxpayers: If your adjusted gross income for 2007 is more than $156,400, many itemized deductions (including the home mortgage interest deduction) are reduced by 2% of the amount by which your AGI exceeds the threshold. (In 2008, the trigger point will rise a bit and the reduction will drop to 1% of the amount by which AGI exceeds the threshold.)

What If I Refinanced?

If you had a grandfathered mortgage and refinanced it, the mortgage balance replaced by the new mortgage remains grandfathered.

Example: Your principal mortgage balance on October 13, 1987 was $51,000. On April 15, 1989, you borrowed $101,000. You used that money to pay the existing loan (which had a balance of $49,000) and all your credit cards, then used the rest of the loan proceeds to buy a new car. Of the total amount borrowed, $49,000 is grandfathered and $52,000 is a home-equity loan. If this is your only mortgage debt, then all the interest remains deductible.

What Kind of Records Do I Need?

In the event of an IRS inquiry, you'll need the records that document the interest you paid:

• Copies of Form 1098, Mortgage Interest Statement, showing the interest and points you paid this year.
• Your closing statement from a refinancing that shows the points you paid, if any, to refinance the loan on your property.
• The name, social security number, and address of the person you bought your home from, if you pay your mortgage interest to that person, as well as the amount of interest you paid for the year
• Your federal tax return from last year if you refinanced your mortgage last year or earlier and if you're deducting the eligible portion of your interest over the life of your mortgage

Form 1098 is the statement your lender sends you to let you know how much mortgage interest you paid and, if you purchased your home in the current year, any deductible points you paid. Sometimes, these forms don't look like tax forms; scan the statement you get in January looking for the words "Form 1098."

If you paid more interest than your Form 1098 shows, check with your lender for an explanation of the discrepancy. If you made a payment in late December, for example, it might not show up on the lender's statement. But you still deduct it for the year paid. Another reason you might have paid more interest than shown on the 1098 is if the seller of the house took back a note (which is secured by the home). There's a special line on the Schedule A for reporting mortgage interest that's not reported on a Form 1098. If you paid it to the person who sold you the house, the IRS wants to know that person's Social Security number, so it can make sure he or she is reporting the interest income.

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