This excerpt from the forthcoming edition of Tax Benefits of Ownership covers the basics of the mortgage interest deduction, from reporting methods to economic effects.
Two residences, alternative deductions
A long-standing policy of the federal government has been to encourage residential tenants to favor mortgaged homeownership, not renting, for their monthly expenditures on shelter.
The homebuyer receives this mortgage subsidy as an annual reduction in their income taxes implemented through the mortgage interest deduction (MID).
Taxpayers process the MID as an itemized deduction subtracted from the homeowner’s adjusted gross income (AGI).
When preparing their tax return, a taxpayer has two alternatives to consider for reporting personal deductions:
- itemize all their deductible expenditures — charitable gifts, medical expenditures, state income taxes, property taxes and home mortgage interest; or
- take the standard deduction (a fixed amount set at $12,000 for individuals, $18,000 for heads of household and $24,000 for married individuals filing jointly). [Internal Revenue Code §63(c)(7)(A)]
When the amount of permissible itemized expenditures exceeds the amount of the standard deduction, it is more beneficial for a taxpayer to itemize their deductions.
With the MID, interest accrued and paid on a mortgage, called qualified interest, is deductible from income as an itemized expenditure when the mortgage:
- funded the purchase price or paid for the cost of improvements for 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)(3)(B)]
The MID reduces 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. The AMT is a supplemental income tax analysis targeting high-income earners.
Interest paid on money mortgages and carryback credit sales originated to purchase or substantially improve an owner’s first or second home when the mortgage is secured by either home is deductible on combined mortgage balances of up to $750,000 for an individual, and for couples filing a joint return. The mortgage balance is limited to $375,000 for married persons filing separately.
To qualify home improvement mortgages for the MID, the new improvements need to:
- add to the property’s market value;
- prolong the property’s useful life; or
- adapt the property for residential use.
Mortgage funds spent on repairing and maintaining property to keep it in good condition do not qualify as funding for substantial improvements. [IRC §163(h)(3); Internal Revenue Service Publication 936]
When an owner refinances a purchase-assist/improvement mortgage, the portion of the refinancing used to fund the payoff qualifies as a purchase/improvement mortgage for future interest deductions. However, interest may only be written off as a purchase/improvement mortgage on the amount of refinancing funds used to pay off the principal balance on the existing purchase/improvement mortgage.
Qualifying the principal residence and second home
To qualify for the MID, mortgages need to be secured by a principal residence or second home.
A principal residence is an individual’s home when:
- 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 from time to time, the mortgage interest paid qualifies for the MID when 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 MID whether or not the owner occupies it. [IRC §163(h)(4)(A)(iii)]
The rental income on the second home is reported as investment/portfolio income when the home qualifies for the MID due to the owner’s days in occupancy exceeding the 14-day/10% rule.
However, when the residence is rented out and the owner’s family occupies the property for more than 14 days or 10% of the days rented (thus qualifying the home for the MID), the owner may not report the property as an investment. The second home is not an investment, and thus the owner may not depreciate it. [IRC §§163(h)(4)(A)(i)(II); 280a(d)(1)]
Economic effects of the MID
While purportedly created to encourage of low- to middle-income households to become owners and benefit financially, the MID disproportionately increases the wealth of high-income homeowners. High-income earners— who are more likely to own a home and have greater sums of personal expenditures — will itemize their deductions instead of claiming the standard deduction.
Additionally, the size of the subsidy is directly proportional to the amount of the mortgage, and thus the associated property value. The wealthier the homeowner, the bigger the tax savings – up to the mortgage debt ceiling of $750,000.
However, consider that the ultimate beneficiaries of the MID are homebuilders, sellers and lenders. Without the promised MID tax reduction, homebuyers have generally overextended their finances. Thus the MID operates to artificially inflate home prices; mathematically, buyers taking out purchase-assist mortgages have more money to spend due to the MID reduction in their income taxes — the subsidy for mortgaged homeownership. Theoretically, buyers are reimbursed through the MID — but most do not have the financial posture to benefit by itemizing their deductions. Thus, they do not receive the subsidy.
Based on the 2018 increase in the standard deduction, homeowners are more likely to take the standard deduction, as opposed to itemizing their deductions. This shift will decrease the availability of MID benefits for low- to middle-income households.