Tax Deductions and Your Mortgage Loan: Understanding the Basics

“But it’s deductible!”

How often have you heard that from people, especially when they talk about mortgages? And more importantly, the Washington Post asks, what does it mean for you?

Let’s say you plan to purchase a condominium for $300,000 and put $30,000 (10 percent) as a down payment. You will need a $270,000 mortgage loan.

One lender has offered you a fixed-rate 30-year mortgage at 6.25 percent, with a monthly payment of $1,662.45. Another lender is trying to persuade you to take an adjustable-rate mortgage that will stay fixed for three years at 5.5 percent interest. The monthly mortgage payment for the first three years will be $1,533.04.

You analyze the numbers and see that there is a difference of $129.41 per month between each mortgage loan. But that’s not the end of your inquiry. You know that you are in the 25 percent income tax bracket, meaning that you are married and jointly you earn between $61,301-123,700.

That means that for every dollar you pay in home mortgage interest, you can deduct 25 cents on your tax return. So when you plug in these deductions, the difference between the two mortgages drops to $97.06 a month.

You should ask yourself whether the monthly saving of $97.06 for the three-year ARM is really worth it, taking into account that the payment on that home loan could jump considerably if mortgage rates are higher when it is recalculated in three years.

The deductibility of mortgage interest is one of the big breaks the tax code gives to homeowners, as well as points paid. Here’s a look at how deductions operate:

Mortgage interest: Interest on a 1st or 2nd mortgage is fully deductible, subject to the following limitations: acquisition loans may total up to $1 million, and home equity loans may total $100,000. If you are married but file separately, the limits are split in half.

For debt to qualify as an acquisition loan, you must buy or substantially improve your home with that money. If you apply for a home loan refinancing for more than the outstanding indebtedness, the excess amount does not qualify as an acquisition loan unless you use it to improve your home.

For example, let’s say your current home mortgage balance is down to $200,000, but because of the tremendous appreciation over the past few years, your house is now worth $600,000. You want to refinance and get some money.

Based on your credit and the equity in your house, your lender is prepared to lend you $450,000. That sounds great, but unless you use the money to improve the house, you will be able to deduct interest on only $300,000 - acquisition debt of $200,000 plus $100,000 in home equity.

Points: When you shop for a mortgage - which is something every potential home buyer should do - you get a lot of data thrown at you. One of the most important items you should understand is the concept of “points.”

Each point is 1 percent of the amount of your mortgage loan; you pay points upfront when you borrow. Points sometimes go by other names, such as loan discounts or origination fees. But for tax purposes, they’re points.

If you were to borrow $450,000, each point would cost you $4,500. Lenders can charge as many points as they want, but at some level, a loan becomes usurious, potentially illegal, and may represent what is commonly known as “loan sharking.”

Typically, for every point you pay a mortgage company, you should be able to reduce your interest rate by 1/8 of a percent. Because rates were extremely low in the past few years, borrowers generally have not wanted to pay extra cash just to get an even lower rate.

Points paid to obtain a new mortgage are fully deductible in the year they are paid by the borrower. The IRS used to require that the borrower write a separate check to the lender for these points; in recent years, the IRS seems to have backed off this position.

If you pay points to obtain a loan for conventional mortgage or home equity loan refinancing, in most circumstances those points are not deductible in full in the year they are paid. Rather, the IRS requires that you allocate the points by the number of years of your loan.

For example, you refinance and obtain a loan for $450,000. To get this new loan at a reduced interest rate, you opt to pay one point, or $4,500. If your loan is for 30 years, you can deduct one-thirtieth of the point each year, or $150.

However, should you pay off this loan early, either by selling the house or refinancing again, the balance of the unallocated (non-deducted) points can then be deducted on your income tax return for that year.