With federal interest rates slowly on the decline, it may be a good opportunity to consider whether you should refinance your mortgage or purchase a home.
During the pandemic, interest rates were at their lowest; many took advantage of these rates to purchase homes. Later, with the impending recession, the housing market took a hit as interest rates rose significantly in hopes of preventing a recession. With the economy rebounding, Federal interest rates are slowly decreasing again, and it may be time to start thinking about whether you should refinance a mortgage with a high interest rate or wait to see if they continue to decrease and whether mortgage interest rates will follow. We have yet to see any actual significant decrease in mortgage interest rates, but they may be on the horizon. Let us discuss the basics of mortgage interest so you can make an informed decision.
Understanding Mortgage Interest and Its Tax Benefits
Mortgage interest is the cost you pay to borrow money from a lender to purchase a property. It is calculated as a percentage of the total loan amount and is paid in addition to the principal balance of the mortgage. The mortgage interest deduction is a valuable tax incentive for homeowners, allowing them to reduce their taxable income by the amount of interest paid on their home loans during the year. This deduction can significantly lower the overall tax burden for many homeowners, making it an important aspect of homeownership and financial planning. The mortgage interest deduction allows homeowners to deduct the interest paid on loans used to buy, build, or improve their primary or secondary residences. This deduction is available only to those who itemize their deductions on their tax returns rather than taking the standard deduction.
There are several conditions that must be met for the interest to be deductible:
- Secured Debt: The mortgage must be a secured debt on a qualified home, meaning the home is collateral for the loan.
- Qualified Home: The home must be your primary or secondary residence. This can include houses, condominiums, cooperative apartments, mobile homes, house trailers, boats, or comparable properties with sleeping, cooking, and toilet facilities.
- Loan Amount Limits: For mortgages taken out after December 15, 2017, you can deduct interest on the first $750,000 of mortgage debt ($375,000 if married filing separately). For mortgages taken out before this date, the limit is $1 million ($500,000 if married filing separately).
Mortgage interest is reported to you on Form 1098, which reports the interest you paid during the year, as well as any points paid. Points are fees paid to the lender in exchange for a reduced interest rate. Points may be deducted in full or may need to be deducted over the life of the mortgage, depending on when they were purchased. If points are paid on the purchase of your primary residence, the points are deductible in full in the year paid. Points paid on a refinancing of your mortgage would be deductible over the life of the mortgage. Refinancing a mortgage involves replacing your existing mortgage with a new mortgage, primarily with different terms. Your decision to refinance could involve obtaining a lower interest rate (and subsequently lower mortgage payments), changing the loan term (extending or shortening the length of the mortgage), or increasing your mortgage and being able to “cash out” on your equity. This additional cash can be used for home improvements or other expenses.
If cashing out is your intent, you may choose to take out a home equity loan – essentially separate and apart from your mortgage. A home equity loan is a loan that allows you to borrow on the equity of your property. The interest on a home equity loan would be deductible only if the funds were used to buy, build, or improve your home. If you chose to consolidate credit cards, student loans, or personal loans, the interest would not be deductible.
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The mortgage limits provided by the Tax Cuts and Jobs Act of 2017 allow interest to be deductible if the mortgage balance is less than $750,000 for a married couple or single filer and $375,000 for married filing separate filers. This applies to mortgages taken out after December 16, 2017. Mortgages with originating dates prior to December 16, 2017, allow for deductible interest on mortgages up to $1 million for a married couple and $500,000 for those filing separately.
Understanding Complex Mortgage Interest Deduction Scenarios
Since the law allows you to deduct the interest on mortgages for your primary and second home, there are unique situations that may cause the calculation to be a bit more complex:
- More than two eligible homes: Taxpayers with more than two homes should consider keeping a mortgage on their principal residence and one other residence selected as a qualified residence and paying off debt on any house(s) for which interest will not be deductible.
- Home under construction: If you take out a construction loan to build your new home, and construction starts on January 1, 2025, and the home is completed and ready for occupancy on December 31, 2025, you can deduct the interest paid on the construction loan during this period, provided the home becomes your primary or secondary residence when it is ready for occupancy. Interest on a construction loan is deductible provided the home is completed within 24 months and is secured by the home.
- Special 90-day rule for qualified residence acquisition debt: On August 1, 2024, you pay $200,000 cash for a vacation home. The vacation home is now your second residence. On October 1, 2024, you take out a $150,000 personal loan for personal expenditures. Since the debt was incurred within 90 days before or after you purchased the home, you can treat the loan as used to acquire the vacation home even though the funds were spent on personal expenditures (see IRS Notice 88-74). Make sure the lender secures the loan with the home.
- Subject to both the $1 million and $750,000 limitations:
- Primary residence purchased pre-December 15, 2017: $600,000 mortgage balance (subject to $1 million limitation).
- Second home purchased after December 16, 2017: $300,000 (subject to $750,000 limitation).
- Primary residence: Mortgage interest is fully deductible as the balance is under the $1 million limitation.
- Second home: Since this home is subject to the $750,000 limitation, first reduce the $750,000 limitation by the mortgage balance of the first home ($600,000). This provides you with $150,000 left of mortgage balance. Interest on the second home is deductible only to the extent it is related to $150,000 of the $300,000 mortgage balance. You would need to allocate the interest only to the remaining allowable mortgage.
With the possible expiration of the Tax Cuts and Jobs Act of 2017 at the end of 2025, if Congress does not act, the calculation of mortgage interest is set to change. If allowed to expire, the mortgage balance on which deductible mortgage interest is allowed will increase to $1 million (reverting to 2017) and the deductibility of home equity mortgage interest will be reinstated (assuming proceeds were used to buy, build, or improve the home). Many are looking forward to seeing the evolution of deductible mortgage interest.
As you can see, mortgage interest limitations can involve simple or intricate calculations.