1. What is the mortgage interest deduction (MID)?

The mortgage interest deduction (MID) is a tax deduction on interest accrued and paid on mortgages. Mortgage interest is deductible from income as an itemized expense if the mortgage:

  • funded the purchase price or paid for the cost of improvements to the owner’s principal residence or second home; and
  • is secured by either the owner’s principal residence or second home. [Internal Revenue Code §163(h)]

The MID for the first and second home reduce the property owner’s taxable income as an itemized deduction under both the standard income tax (SIT) and the alternative minimum tax (AMT) reporting rules.

2. What types of mortgages qualify for the MID?

Two categories of mortgages on personal-use homes allow the homeowner to qualify interest related charges to reduce the homeowner’s income tax liability on:

  • purchase or improvement mortgages; and
  • home equity mortgages.

For mortgages originated after December 14, 2017, interest on the first $750,000 of mortgage qualifies for the MID. Mortgages originated prior to this point were allowed to take the MID on interest from mortgages up to $1 million, plus an additional $100,000 in home equity lines of credit (HELOCs), regardless of how the home equity funds were used. [IRC §163(h)(3)(f)]

Interest paid on lender and seller carryback mortgages secured by and originated to purchase or substantially improve either the owner’s first or second home is deductible, limited to combined principal balances of up to:

  • $750,000 for an individual or a couple filing a joint return; or
  • $375,000 for a married person filing separately.

Thus, if the mortgage funds are used to acquire, construct or further improve a principal residence or second home, and the mortgage funds collectively exceed $750,000, only the interest paid on $750,000 of the purchase and improvement mortgage balances is deductible under the purchase/improvement interest deduction rule.

Now, homeowners who wish to take the MID on the interest paid for HELOCs are severely limited. This includes homeowners who took out a HELOC in 2018 and even in previous years. Unlike for mortgages used to purchase a primary or secondary residence, old HELOCs are not grandfathered in for the MID in 2018.

In order to qualify to take the MID in 2018, the home equity mortgage needs to be used to substantially improve the residence securing the HELOC. When the HELOC is used for other purposes (e.g. to pay college tuition, go on vacation or buy a jet ski), the interest is no longer deductible.

To qualify home improvement mortgages for interest deductions, the new improvements funded by the mortgage need to:

  • add to the property’s market value;
  • prolong the property’s useful life; or
  • adapt the property to residential use.

Mortgage funds spent on repairing and maintaining the home to keep it in good condition do not qualify as funding for substantial improvements. [IRC §163(h)(3); Temporary Revenue Regulations §1.163-8T; Internal Revenue Service Publication 936]

The current rules sunset after 2025. Beginning in 2026 — and absent any further changes —the old rules which allowed mortgage interest to be deducted on mortgages up to $1 million and HELOCs up to $100,000, regardless of their use, will apply. [IRC §163(h)(3)(f)(ii)]

A principal residence is defined as an individual’s home if:

  • the homeowner’s immediate family resides in it a majority of the year;
  • the home is located close to the homeowner’s place of employment and banks which handle the homeowner’s accounts; and
  • the home’s address is used for tax returns. [IRC §§163(h)(4)(A)(i)(I), 121]

A second home is any residence selected by the owner from year to year, including mobile homes, recreational vehicles and boats.

When the second home is rented out for portions of the year, the interest qualifies for the home mortgage interest deduction if the owner occupies the property for the greater of:

  • more than 14 days; or
  • 10% of the number of days the residence is rented. [IRC §280A(d)(1)]

When the owner does not rent out their second home at any time during the year, the property qualifies for the home mortgage interest deduction – whether or not the owner occupies it. [IRC §163(h)(4)(A)(iii)]

3. What are the limitations for refinanced mortgages?

When an owner refinances a purchase/improvement mortgage, the principal portion of the refinancing used to fund the payoff qualifies as a purchase/improvement mortgage for future interest deductions.

However, interest on the refinancing may only be written off as a purchase/improvement mortgage on the future amortized amount of refinancing funds used to pay off the principal balance on the existing purchase/improvement mortgage.

For example, consider an owner who borrows $200,000 to fund the purchase of their principal residence. Years later the mortgage balance is paid down to $180,000. The owner refinances the residence, paying off the original purchase/improvement mortgage. However, the new mortgage is for a greater amount than the payoff demand on the old purchase-assist mortgage.

In this scenario, interest paid on only $180,000 of the refinancing, as reduced by amortization, is deductible as interest paid on a purchase or improvement mortgage, unless:

  • the excess funds generated by the refinance are used to improve the residence; or
  • the excess mortgage amount qualifies as a home equity mortgage under its separate ceiling of $100,000 in principal.
4. What are the limitations for home equity mortgages?

Interest paid on mortgage amounts secured by the first or second home might not qualify for the purchase/improvement home mortgage interest deduction, due either to:

  • a different use of the mortgage proceeds; or
  • the $750,000 mortgage limitation.

However, interest paid on mortgages which are secured by the first or second residence and do not qualify as a purchase/improvement mortgage, collectively called home equity mortgages, is deductible as interest paid on additional or other mortgage amounts up to:

  • $100,000 in principal for individuals and couples filing joint returns; and
  • $50,000 in principal for married persons filing separately. [IRC§163(h)(3)(C)(ii)]

Home equity mortgages are typically junior encumbrances. However, the category also includes:

  • excessive principal amounts on a refinance which do not qualify as purchase/improvement funds; and
  • principal amounts on purchase/improvement mortgages which exceed the $1,000,000 ceiling.

The proceeds from home equity mortgages may be used for any purpose, including personal or investment uses unrelated to the property.

5. Are mortgage insurance and points deductible under the MID rules?

Mortgage insurance premiums (MIPs) paid on government-backed mortgages and private mortgage insurance (PMI) paid on personal-use home mortgages are deductible in the same way as home mortgage interest. The mortgage insurance needs to have commenced after 2006.

Points are fees charged by a lender as prepaid interest when they originate a mortgage. As prepaid interest, the payment reduces the note rate on the mortgage. A point equals 1% of the amount of the mortgage and reduces the interest rate around 1/4%. To qualify to deduct points in the year they are paid, the purchase-assist or improvement mortgage is to be secured by the homebuyer’s principal residence, not a second home.

In contrast, points paid by a homebuyer to finance the purchase or improvement mortgage for a second home are deducted as they accrue over the life of the loan. For example, points paid on a purchase-assist mortgage for a vacation home, payable monthly with a 30-year term, will be deductible 1/360th for each month in the tax year as the prepaid interest accrues.

Lender costs reimbursed by the borrower are not considered prepaid interest and are not deductible either at the time paid or over the life of the mortgage. They are acquisition costs and become part of the cost basis for the property. [IRC §163; Rev. Proc. 94- 27]

6. What is the property value ceiling?

Interest paid on any portion of a mortgage balance which exceeds the fair market value of a residence is not deductible. However, the application of the rule is limited.

In practice, the fair market value rule applies almost exclusively to home equity mortgages and refinancing proceeds greater in amount than the balance paid off on a purchase/improvement mortgage. [IRC§163(h)(3)(C) (i)]

Here, the fair market value of each residence is presumed by the IRS to be the original purchase price paid plus any improvement costs. Thus, for underwater homeowners a drop in property value below the balance remaining on their purchase-assist mortgages does not affect their interest deductions. [Temp. Rev. Regs. §1.163-10T(k)(2)]

7. How does a homeowner take the deduction?

Interest deductions on home mortgages are only allowed for interest which has accrued and been paid, called qualified interest. [IRC §163(h)(3)(A)]

Interest paid on first and second home mortgages is deducted from an owner’s adjusted gross income (AGI) as an itemized deduction. Further, limitations restrict the total of all types of itemized deductions a homeowner can claim.

Unlike the homeowner’s mortgage interest deduction (MID), interest paid on business, rental or investment loans is an expense. It is accounted for as an adjustment that reduces the taxpayer’s AGI. Instead of reducing the AGI for a homeowner, the two types of home mortgage interest deductions reduce the amount of taxable income.

Personal deductions of home mortgage interest reduce only taxable income (not the homeowner’s AGI). This makes a substantial difference for high-income earners. The higher an owner’s AGI, the lesser the amounts allowed by itemized deduction phase-out calculations (starting at an AGI of $261,500 for individuals in 2017 and $313,800 for couples filing jointly), for rental loss deductions, and for any tax credits held by the owner. [IRC §163(a), (h)(2)(A)]

8. What is the controversy surrounding the MID?

Critics of the mortgage interest deduction (MID) point to data showing it primarily benefits (favors) the top 20% of income earners in the U.S. In fact, it gives the highest earners four times more housing subsidy than is provided to the poorest 20% of mortgaged homeowners – the most in need of subsidies among us.

This is partly because the size of the subsidy runs with the amount of the mortgage, which in turn relates to value of the owner’s home. So the rule evolving from the implicit benefit is: the wealthier the homeowner, the bigger the tax savings and vice-versa.

In California, roughly 25%-31% of taxpayers claim the MID each year, or about half of the state’s homeowners (which is around 2/3rds of homeowners with a mortgage). On average, each of these claims is an interest deduction of just under $14,000 as of 2012 – the highest of all the states – according to Pew Charitable Trusts.

From 2010-2015, the MID cost the U.S. about $380 billion in lost tax revenue, according to Pew. Tax revenue is used, via transfers, to provide services needed and used by everyone like quality schools, safe well-maintained roads, sufficient law enforcement, health care, etc. With all that lost tax revenue, services are less than they might be.

On the other hand, proponents of the MID argue it:

  • promotes the financial benefits of homeownership induced by the MID subsidy;
  • provides tax relief for homeowners (albeit in favor of wealthy homeowners);
  • maintains homeownership rates and in turn home values (which will drop in low- and mid-tier homes if the MID subsidy is eliminated); and
  • limits government intrusion into the wallets of homeowners.

For these reasons, it was a shock in late-2017 when the Republican’s 2018 tax plan introduced limitations on the MID for tax years 2018-2025. These changes reduce the number of households able to take the MID in 2018 and future years. The biggest impact is felt in California, with its high home values and standard of living.

9. Where can I read more?

To read more on the rules and exclusions of the mortgage interest deduction (MID), firsttuesday students see Realtipedia, Tax Benefits of Ownership (Chapter 1: Home mortgage interest deductions).

To read more on the 2018 MID changes, see: Mortgage interest deduction changes in 2018.

For more on the MID claim rates and amounts across the U.S., see the Pew Charitable Trusts articles: The Geographic Distribution of the Mortgage Interest Deduction and The Distribution of Select Federal Tax Deductions and Credits Across the States.

For more criticism of the MID, see firsttuesday articles: Mortgage interest tax deduction broken? and The MID truth test and The mortgage interest tax deduction: working class regression.

To read more about deduction limits, see the firsttuesday recent case decision: Joint tenants sharing ownership rights cannot exceed individual deduction limit.

For some examples on applying the MID, see IRS Publication 936.

For a flowchart to determine whether a homebuyer may deduct the full amount of points in the year paid, see IRS Publication 936 Figure B.

To read about other tax deductions for homeowners, see firsttuesday article: Last-minute tax reminders for homeowners.