Many people ask me whether they would be able to deduct the mortgage interest they pay. In this article we look into what is considered as home mortgage interest and what conditions are to be fulfilled to avail the mortgage interest deductions.

Mortgage interest is the interest a person pays on a loan secured by his home, which can be the main home or a second home. The loan can be a mortgage to buy a house, a 2^nd mortgage, a home equity loan or a line of credit.

A borrower can deduct mortgage interest only if all of the following conditions are fulfilled:

• Borrower is legally liable for the mortgage. It means, borrower cannot deduct payments he makes for someone else if he is not legally liable to make those payments.

• There must be a true creditor-debtor relationship between borrower & lender.

• Both borrower & lender must intend that the mortgage be repaid.

• Borrower must file Form 1040 & itemize deductions on Schedule A of Form 1040.

• Mortgage should be a secured debt on a qualified home. In the following sections we will look into what is meant by secured debt & qualified home.

Whether the mortgage interest would be fully deductible or not depends on the date mortgage was taken, mortgage amount and how the proceeds are used. If a mortgage falls into one or more of the under mentioned 3 categories at all times during the year then the borrower would be able to deduct all of the interest on such mortgage.

The 3 categories are:

(1) Mortgage was taken out on or before October 13, 1987 (known as grandfathered debt).

(2) Mortgage which is taken out after October 13, 1987 with the purpose of buying, building or improving the house, but only if throughout the current year this mortgage plus any grandfathered debt totaled $500,000 or less if borrower is married and filing separately & otherwise $1 million or less.

(3) Mortgage which is taken out after October 13, 1987 for any purpose other than to buy, build or improve the house, but only if throughout the present year this mortgage totaled $50,000 or less in case borrower is married and filing separately & otherwise $100,000 or less. And also totaled not more than the fair market value (FMV) of the house reduced by (1) & (2).

In the previous section while mentioning the conditions under which a borrower can deduct mortgage interest we mentioned that the debt should be a secured debt and the home needs to be a qualified home. We now look at what is meant by a secured debt and qualified home.

Secured Debt

A secured debt is defined as a debt in which borrower signs an instrument like a land contract, deed of trust or a mortgage which:

1. Is recorded under any state or local laws,

2. Makes borrower’s ownership in the house security for payment of debt and

3. Specifies, that in case of default, borrower’s home would satisfy the debt.

Qualified Home

A qualified home means borrower’s main home or second home that is used for residential living. A home can be a house, mobile home, cooperative, condominium, house trailer, boat or similar property having cooking, sleeping & toilet facilities.

Let us now look at some situations when it becomes difficult to understand whether the home will be considered as qualified home or not or exactly which portion will be considered as qualified home.

1. Divided use of house

There may be situation where part of the house is used as home office. In such situation, borrower has to allocate the use of his house. He will have to divide cost as well as fair market value of his home between the part which is a qualified home & the other part which is not.

2. What happens if the home gets destroyed?

As per laws borrower is allowed to continue treating his home as a qualified home even if it is destroyed in an earthquake, fire, tornado, storm or other similar disaster. He can continue to deduct the interest he pays on the mortgage if within a reasonable period of time borrower:

• Sells the land on which house was located or

• Rebuilds the house & moves into it.

3. Part of the house rented out

Many of us rent out some part of the house. So will the house considered as qualified home for claiming mortgage interest deductions despite the fact that some part has been rented out?

If borrower rents out part of his qualified home then rented part can be treated as being used by borrower himself for residential living if all of the following conditions fulfill:

• The tenant uses the rented part for residential living.

• Rented part is not a self-contained residential unit with cooking, sleeping & toilet facilities.

• Same or different parts of the house are not rented out to more than 2 tenants at any time during the tax year. Two persons (and dependents of either) are treated as one tenant if they share the same sleeping quarters.

For further information please visit: http://www.irs.gov/publications/p936/ar02.html

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This entry was posted on Monday, October 8th, 2007 at 7:38 pm and is filed under Mortgage, Personal Finance. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.