How the Mortgage Interest Tax Deduction Works

The mortgage tax deduction can potentially save you thousands of dollars, which could help furnish your home.
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Compared to renting, owning a home gives you the benefit of an investment. There's another benefit that you can't get from renting comes around every year during tax time, too: the mortgage tax deduction, which can potentially save you thousands of dollars.

When you have a mortgage on your home, you can deduct the interest from that mortgage on your taxes. It also applies if you pay interest on a condo, co-op, mobile home, boat, or recreational vehicle -- as long as the property is used as a residence.

The mortgage interest tax deduction is designed to make help make buying and owning homes more affordable for typical Americans. Although this deduction has been around for decades, it's also currently a topic of controversy with financial experts and government officials. Keep reading to find out why.

What Is the Mortgage Tax Deduction?

Established in 1913 along with the income tax, the mortgage tax deduction is one of the biggest tax deductions among Americans [source: McWhinney]. A deduction is just what it sounds like -- a sum of money you can subtract from your taxable income, therefore reducing the amount of taxes you have to pay to the IRS.

Mortgage interest is any interest on a loan secured by your home. (A loan is "secured" if the lender can sell the property if you don't pay back the loan.) Examples include:

  • A mortgage used to buy your home
  • A line of credit with your home as collateral
  • A second mortgage
  • A home equity loan

Personal loans don't count, because they're not secured by your home.

So, if you borrow money to buy, improve, or build your home, the mortgage tax deduction allows you to avoid paying taxes on the interest on that loan. Laura Adams of Money Girl provides a real-life example to make it easier to understand:

You purchase a home for $200,000 with a fixed-rate mortgage for 30 years at a 4.5 percent interest rate. Your payment for principal and interest on the home would be about $1,000 per month, or $12,000 per year. In the first year, the interest you pay on the mortgage would total $8,900. However, if you claim the mortgage interest tax deduction, $8,900 of your income won't be taxed. So that deduction can reduce the amount you owe, or, increase your tax refund

To learn how to claim the mortgage tax deduction on your taxes, keep reading.

How to Claim a Mortgage Interest Tax Deduction

The IRS has lots of rules and guidelines to claiming the mortgage interest tax deduction. We'll outline the basics here. You can deduct the interest on your mortgage on up to 1 million dollars of your home mortgage debt (or up to $500,000 if you're married and filing separately). Additionally, you can deduct the interest on up to $100,000 of home equity debt. To take the mortgage tax deduction, you must meet the following conditions:

  1. File your taxes on IRS Form 1040, and itemize your deductions on Schedule A (Itemized Deductions).
  2. Have a secured loan with an ownership interest on a qualified home.
  3. Be legally liable for the home -- you cannot claim a tax deduction if, for example, you are making payments for someone else's home loan.

The IRS provides a workbook to help you figure out if you are qualified for a mortgage tax deduction.

Each year there's a standard deduction amount (which varies depending on whether you're married or single, filing jointly, or filing as head of household). So you'll need to decide whether itemizing your deductions or taking the standard deduction saves you the most money.

If you do decide to itemize, ensure you don't make some common mistakes when claiming your mortgage tax deduction.

If there are multiple borrowers on your loan, sometimes only one borrower receives Form 1098, the mortgage interest statement sent out by your mortgage lender. You are both eligible to claim the deduction on your taxes, but only the amount you each paid during the year.

If you are married, ensure you claim the mortgage tax deduction correctly. If you and your spouse own your home together and file taxes jointly, you can claim the total amount of the mortgage tax deduction on the return. But if you're married and file separately -- or own the home with someone you're not married to -- you can only claim the portion of the mortgage you paid during the year.

The mortgage tax deduction is not without controversy. Read on to find out the debate among lawmakers and financial experts about this deduction.

Controversies About the Mortgage Tax Deduction

The government originally created the mortgage tax deduction to help middle-class Americans buy homes. It's a popular and almost sacred policy, having been around for decades. However, many academics and policymakers believe the mortgage tax deduction is outdated and ripe for reform.

They point to research that says the deduction benefits the rich more than the poor, as the rich receive more back on their taxes. Most benefits go to households making six figures or more and middle-class families usually receive only about $51 per month off their mortgage. The deduction does appear to give middle-class families more purchasing power, but they only bought houses about 3 percent higher than they would've otherwise [source: Randazzo & Stansel].

Other opponents of the mortgage tax deduction say that 22 percent of tax filers claimed the deduction in 2012, costing the federal government $68 million in revenue. And, as previously stated, more than three-quarters of the benefit went to households with more than $100,000 in annual income [source: Rubin].

Some ideas for reform suggested by bipartisan groups, economists, and President Barack Obama include:

  • Lowering the $1 million cap
  • Eliminating the tax break on second homes
  • Converting the deduction to a credit, which could equalize treatment across income groups

Experts agree any changes would have to be phased in order to prevent major effects on the real estate market. Real estate industry representatives oppose making any tax changes for fear it would bring down housing prices, destabilize the economy, and make it more difficult for the middle class to buy homes [source: Blumberg]. This is a debate that likely won't end anytime soon, so for now, the mortgage interest tax deduction is here to stay.

For more about taxes and deductions, check out the links on the next page.

Related Articles

Sources

  • Adams, Laura, MBA. "Deduction Dangers, Part 1: Mortgage Interest." March 27, 2012. (Oct. 11, 2014) http://www.quickanddirtytips.com/money-finance/credit/deduction-dangers-part-1-mortgage-interest
  • Blumberg, Alex. "Why Does The Mortgage-Interest Tax Deduction Still Exist?" NPR. June 6, 2012. (Oct. 11, 2014) http://www.npr.org/blogs/money/2012/06/14/154344781/why-does-the-mortgage-interest-tax-deduction-still-exist
  • McWhinney, James E. "Tax Deductions On Mortgage Interest." Investopedia. 2014. (Oct. 11, 2014) http://www.investopedia.com/articles/pf/06/mortinttaxdeduct.asp
  • Randazzo, Anthony and Stansel, Dean. "Mortgage Interest Deduction Saves Middle Class Taxpayers All Of $51/Month." Forbes. Dec. 18, 2013. (Oct. 11, 2014) http://www.forbes.com/sites/realspin/2013/12/18/mortgage-interest-deduction-saves-middle-class-taxpayers-all-of-51month/
  • Rubin, Richard. "Lawmakers Weigh How to Curb Mortgage Interest Tax Break." Bloomberg. Apr. 26, 2013. (Oct. 11, 2014) http://www.bloomberg.com/news/2013-04-26/lawmakers-weigh-how-to-curb-mortgage-interest-tax-break.html
  • TurboTax. "Deducting Mortgage Interest FAQs." 2013. (Oct. 11, 2014) https://turbotax.intuit.com/tax-tools/tax-tips/Home-Ownership/Deducting-Mortgage-Interest-FAQs/INF12051.html