Mortgage interest for up to two residences is deductible on Federal Schedule A. If you have a third home, the interest might be deductible as business or investment interest, depending upon the use of the proceeds, which we’ll discuss later. A loan that is used to buy, improve or construct a first or second home is called acquisition debt. The current loan limit is $750,000 for loans originated after December 15, 2017. The same limit applies to married taxpayers (joint filing), single and head of household. For loans originated on or prior to December 15^th, 2017, the limit is $1M. The IRS has worksheets to calculate the allowable interest deduction if mortgage debt exceeds the limitation.

To qualify as mortgage interest, the debt must be secured by your residence (or second home).  Secured means the lender records the mortgage on the property.  So, if you decide to lend money to a child or relative on a residence, the note needs to be properly recorded for them to secure the deduction.

Lenders may charge points or origination fees. In general, if the points are charged to buy, build or improve your primary residence and paid directly to the lender, they are deductible in the year paid. Points paid to refinance a current residence or purchase a second residence are amortized over the life of the loan.

Planning Tip:

If you have cash and want to help children or another relative, consider being their lender. The loans must be properly documented, and the IRS mandates a minimum interest rate. You can set up the note as interest-only or interest and principle. This might also present a gifting opportunity, as the loan could be forgiven over time subject to annual gifting limits.

For a more in-depth analysis, read our previous blog: How to Assist A Child Buying a Home – Dent Moses, LLP

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Investment Interest

Interest paid on debts to acquire investment assets is deductible but limited to net investment income. What is considered investment income? Interest, dividends (qualified dividends are not), royalties, annuities, as well as nonpassive investments such as working interests in oil and gas properties. Tax-exempt interest and dividends do not qualify. Passive activities like rentals and passive interests in partnerships are not considered investment income.

Investment income is reduced by qualifying expenses to arrive at net investment income, and then the remainder is deducted against income to arrive at net investment income. As an example, if you have $5,000 in interest income and $1,000 in expenses net investment income would be $4,000. You would be able to deduct up to $4,000 in investment interest, provided you have $4,000 of investment income.

Any disallowed investment interest is carried forward until used.

Planning Tip:

Investment income does not include qualified dividends or capital gains.  However, you can elect to treat those income items as investment income if you forgo favorable capital gains treatment. Sometimes, making this election and getting the deduction can produce a beneficial outcome.  This is especially true if you have a large carryover, which might take several years to use.

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Complete Itemized Dedication Series

This series is intended to cover the most common deductions. Please keep in mind that there are always exceptions; what’s more, your situation or facts may be different from someone else. We recommend that you consult with your tax advisor before taking any action.

Part 1: The Basics

Part 2: Deductions and Medical Expenses

Part 3: Deduction for Taxes

Part 4: Deducting Morgage Interest & Investment Interest

Part 5: Contributions & Charitable Giving

Part 6: Casualty & Theft Losses

Part 7: Job Expenses and Miscellaneous Deductions