How the mortgage interest deduction helps homeowners

Michele Lerner
The Mortgage Reports contributor

What is the mortgage interest deduction?

Buying a home is a proven method of wealth-building; you’ll build equity as you pay off your loan and the home grows in value.

But there’s another financial benefit for prospective homebuyers. Come tax time each year, you might qualify for the mortgage interest deduction.  

Always consult a tax professional before filing, but for some homeowners, the mortgage interest tax deduction can reduce their taxable income by thousands of dollars.

However, tax law changes over the past few years have led to a decrease in the number of Americans who claim the mortgage interest deduction.

Whether you’re a current or aspiring homeowner, here’s what you should know.

Verify your home loan eligibility (Apr 19th, 2021)

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Who qualifies for the mortgage interest deduction?

The Tax Cuts and Jobs Act of 2017 changed the rules for the mortgage interest deduction.

Since 2017, if you take the standard deduction, you cannot deduct mortgage interest.  

For the 2020 tax year, the standard deduction is $24,800 for married couples filing jointly and $12,400 for single people or married people filing separately.

But if you use itemized deductions instead of claiming the standard deduction, you can deduct the interest you pay each tax year on mortgage debt. This includes any mortgage loan used to buy, build, or improve your home.

You may also be able to deduct interest on a home equity loan or line of credit (HELOC), as long as the loan was used for one of those three purposes.

Mortgage interest deduction limits

The amount of mortgage interest you can deduct depends on the type of home loan you have and the way you file your taxes.

  • If you are single or married and filing jointly, and you’re itemizing your tax deductions, you can deduct the interest on mortgage debt up to $750,000
  • If you are married and filing separately from your spouse, you can deduct interest payments on mortgage debt up to $375,000 each tax year

For mortgages taken out prior to 2018, the rules are a bit different.

  • For any home loan taken out on or before October 13, 1987, all mortgage interest is fully deductible
  • For home loan taken out after October 13, 1987, and before December 16, 2017, homeowners can deduct interest on mortgage debt up to $1 million (or $500,000 if married and filing separately)
  • The $1 million limit also applies to homeowners who entered a binding purchase agreement between December 16, 2017, and January 1, 2018

You can deduct interest payments on home equity loans and lines of credit, too, as long as the debts were used to pay for home improvements or to purchase or build your home.

If you have a home equity loan or line of credit and the funds were NOT used to buy, build, or substantially improve your home, then the interest cannot be deducted.

Other requirements to claim your deduction

Along with staying within the IRS’s limits, to qualify for the mortgage interest tax deduction your home must:

  • Be listed as ‘collateral’ to secure the loan — Interest on a personal loan or credit card used for home improvements won’t go toward the tax deduction, because this debt isn’t secured by the property like home equity debt
  • Have basic accommodations — The home must have plumbing and other basic living requirements to qualify for the deduction
  • Be a part-time residence — Owners of second homes who also rent out their homes must live in the second home at least 14 days (or as much as 10% of the days the home is rented out if that number exceeds 14 days) to claim the deduction on Schedule A. Otherwise the interest must be reported on Schedule E as an investment property

How the mortgage interest tax deduction helps homeowners

Writing off home acquisition debt tends to help homeowners with higher incomes. That’s because high-earning homeowners typically have larger mortgage balances and are more likely to buy a second home or vacation property– both of which increase tax-deductible mortgage interest payments.

This means their home mortgage interest is more likely to exceed the federal income tax’s new, higher standard deduction of $24,800 for couples filing jointly or $12,400 for individual tax filers.

Real estate agents and home builders still tout this tax deduction as an incentive to buy a home. They like to claim that it increases the homeownership rate and helps people transform from renters to homeowners.

However, thanks to the new standard deductions created by the 2017 Tax Act, a larger share of homeowners will not itemize their taxes and thus won’t be able to deduct mortgage interest.

What other costs are tax-deductible?

Mortgage interest isn’t the only cost of homeownership that’s tax-deductible. If you choose to take itemized deductions, you could also deduct:

  • Mortgage points — Homebuyers often pay cash upfront to lower their mortgage rate for the life of the loan. For example, paying an extra 1% of the loan amount can lower the interest rate by 0.25%. Cash paid for mortgage points can qualify for the interest deduction
  • Prepayment penalties — Most new mortgages don’t charge prepayment penalties, but older loans may still require them. If so, you could write off the prepayment penalty as part of your mortgage interest tax deduction
  • Late payment fees — Even late payment fees qualify for the mortgage interest tax deduction
  • PMI — Congress has extended the rule allowing homeowners to deduct mortgage insurance payments. This applies to loans with private mortgage insurance (PMI) as well as government-subsidized mortgage insurance on FHA, VA, and USDA loans

Property taxes are also tax-deductible, but they are not included in the mortgage interest deduction. They are written off elsewhere on the 1040 Schedule A tax form.

So, what does tax law exclude from the home mortgage interest deduction?

  • Homeowners insurance premiums — Homeowners insurance premiums are not tax-deductible. However, you may be able to write off this expense if you have a home office and deduct those expenses on Schedule C
  • Other home buying costs — Title searches, earnest money, moving expenses — none of these costs qualify for this tax deduction
  • Reverse mortgage interest — Since interest on these loans comes due when the property sells, they aren’t tax-deductible

Should you claim the mortgage interest deduction?

Remember, you can take the mortgage tax deduction only if you itemize your taxes. And that’s only worth doing for taxpayers whose write-offs exceed the standard deduction.

For example, say you and your spouse own a home with a $315,000 mortgage loan. Your itemized deductions might look something like this:

  • Mortgage interest: $9,500
  • Property taxes: $3,000
  • Charitable donations: $2,000

Your total itemized deductions come out to $14,500. In this case, as a couple filing jointly, you’d want to take the $24,800 standard deduction because it far exceeds your itemized deductions.

But if you were a single homeowner with the same itemized deductions — or a married one filing separately — you’d want to itemize. That’s because the sum of your itemized deductions is greater than the standard deduction of $12,400. 

Consult a professional tax advisor

As with any major decision, consult a professional when deciding how to file taxes. A licensed tax advisor can review your situation and let you know how to deduct mortgage interest – or if you should at all.

How to claim the home mortgage interest deduction

To claim the mortgage interest deduction, a taxpayer should use Schedule A which is part of the standard IRS 1040 tax form.

Your mortgage lender should send you an IRS 1098 tax form which reports the amount of interest you paid during the tax year. Your loan servicer should also provide this tax form online.

Using your 1098 tax form, find the amount of interest paid and enter this on Line 8 of Schedule A on your tax return. Seems pretty simple, right?

Claiming the deduction gets more complicated if you earn income from the property. If you own rental properties or a vacation home you rent out most of the year, for example, you’ll need to use Schedule E.

If you’re self-employed and write off business expenses, you’ll need to enter interest payments on Schedule C.

Should the mortgage interest tax deduction affect your home buying decision?

Buying a home requires a series of financial decisions.

You’ll have to choose a home and find the right loan type, but you’ll also decide how much money to put down and whether to lower your interest rate with mortgage points.

The decisions continue after closing on the loan: Should you pay off the mortgage quickly by making higher monthly payments, or invest your extra money elsewhere? Should you get a new loan to tap home equity, or find another way to finance repairs and projects? 

All these decisions could impact a homeowner’s ability to save money through the mortgage interest tax deduction.

For example, making a larger down payment reduces your loan balance, which lowers interest payments that can be deducted.

Likewise, buying mortgage points at closing lowers the interest rate of the new loan, which also reduces tax-deductible interest paid to the lender.

And, of course, paying off a mortgage entirely eliminates interest payments altogether, which could bump some taxpayers into a higher tax bracket.

So, should you maintain higher mortgage payments for the purpose of lowering your taxable income through the mortgage interest deduction?

Only you and your tax professional can answer this question, because the answer depends on your unique situation and your broader financial life.

However, unless you itemize deductions, you can’t claim the home mortgage interest deduction anyway. In that case, the tax deduction should not affect your home buying and mortgage paying decisions.

Verify your home buying eligibility (Apr 19th, 2021)

Politics behind the mortgage interest tax deduction

After Congress passed the Tax Cuts and Jobs Act of 2017 (TCJA), the number of U.S. households claiming the home mortgage interest deduction declined from about 22% in 2017 to below 10% in 2018, according to the IRS.

Fewer homeowners have written off their home mortgage interest after 2017 because the TCJA raised the standard deduction. This meant fewer Americans had an incentive to itemize their deductions with the IRS.

Also, the TCJA lowered the cap on mortgage interest deductions from $1 million to $750,000 for married couples filing jointly, and from $500,000 to $375,000 for single filers.

In response to the TCJA’s changes, the Brookings Institution has called for Congress to eliminate the mortgage interest deduction altogether and replace it with a one-time tax credit of $10,000 for each new mortgage.

The current tax deduction lowers a taxpayer’s federal taxable income which has the potential to change a taxpayer’s tax bracket; a tax credit would lower the amount of income taxes due regardless of income and could be claimed by more Americans.

The IRS has used tax credits as incentives for homebuyers before, most recently during the housing crisis of 2009 and 2010. Some states still offer targeted tax credits to encourage home buying in specific areas.

What are today’s mortgage rates?

Mortgage and refinance rates repeatedly set new record lows in 2020.

With such low rates, mortgage payments are more affordable than ever. Homebuyers have not needed tax incentives to encourage buying or refinancing.

But if you do decide to use it, the mortgage interest deduction is a nice perk, and yet another way homeownership can bolster your personal finances.

Verify your new rate (Apr 19th, 2021)

The Mortgage Reports does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.