AMERICA’S FAVORITE LOOPHOLE: MORTGAGE INTEREST

If you’re a homeowner, you know you can deduct the interest on your mortgage. But the mortgage deduction can generate additional tax breaks. Here’s what I mean.

Interest is the fee you pay for the use of someone else’s money. But you can, in effect, lower that fee if you can write it off as a deduction on your taxes. Generally, that means finding a way to turn the interest into mortgage debt.

Deducting the interest on mortgage debt is our favorite tax loophole. Some 36 million taxpayers claimed the deduction in 2001, writing off $330.7 billion — or about $9,100 per taxpayer. It represented 37% or so of itemized deductions and generated slightly more in deductions than itemized deductions for deductible state and local taxes and twice as much in deductions as charitable donations. The amount deducted has been growing at an 8.5% rate since 1980 — a reflection of rising property values in this country.

And, as with anything else involving taxes, there are rules and stipulations you must know in order to claim the deduction.

You Must Be Truly Liable for the Debt

To start, just to be able to deduct interest on a debt, you must be legally liable for that debt. For example, assume you make a loan to your son, hoping he will repay you when he can. If no true debtor-creditor relationship is created, your son is not legally obligated to repay the loan and he will not be able to deduct any of the so called “interest” he pays you.

Alternatively, if you co-sign a note for a loan made by a bank to your son, and if both of you are jointly liable on the note, you may deduct any interest you pay and he may deduct any interest he pays — depending on what the money is borrowed for. Business interest is always deductible. Investment interest is allowed to the extent of investment income. But there is no deduction for personal or consumer interest.

The key here is if you have a loan with a family member, make sure there is a note to back it up. Then, make sure the terms of the note are kept. (If the money were to be used for personal reasons, the interest would not be deductible. In that case, you might want to use a home equity loan — i.e. a second mortgage on your house, to secure the debt.)

With a mortgage, there’s no question about the liability. Surely, you remember signing all those papers.

It’s the Real Estate That Counts

Mortgage and related debt — but little else — generates big tax breaks for taxpayers because it is always secured by the property. And you can buy a second home and deduct the mortgage interest (in addition to the real estate taxes on both properties) on it as well.

As good as the mortgage deduction is, there is a limit to how much you can borrow and still be able to deduct the interest. It’s the smaller of:

Remember, the cost of your house includes more than the amount paid to the seller. It also includes appraisal fees, title search, title insurance, transfer taxes, broker's commissions paid by the buyer, survey fees, bank or lender fees, legal fees, mortgage taxes, and any other nondeductible closing costs such as postage. It could also include the purchase of additional land adjacent to your home. It also includes your own costs of construction — including rehabilitation, refurbishing, new construction, additions, improvements, remodeling costs, etc.

Home Equity Loans — Seize the Opportunity

Since you can’t deduct interest on credit card loans and personal loans (consumer debt), home equity loans have become increasingly popular. That is because the interest on these loans, too, is deductible. Home equity indebtedness is any amount owed (other than the original acquisition mortgage debt and post-acquisition construction loans) secured by a qualified residence. Interest on home equity debt is deductible to the extent the debt does not exceed $100,000 (or $50,000 for a married individual filing separately). (Technically, the limit is the home’s fair market value in excess of any outstanding home acquisition or construction debt, with a $100,000 maximum. But, you’re rarely going to get a bank to lend more than the equity you have in the property.)

The beauty of home equity interest is that how you use the money is irrelevant. Money can be borrowed for vacations, parties or to pay off other debt.

The deductibility of home equity interest provides substantial opportunity for sophisticated tax planning. The interest rate on home equity debt is usually calculated based on the current prime rate, plus one or two percentage points. If you own a home and owe several thousand dollars in credit card debt at rates of 18% to 21%, it would be a financial slam dunk to pay off that debt with a home equity loan. Not only would you pay a lower rate, but you could also write off the interest as a tax deduction.

Getting to the Points

A mortgage — and the related real estate transaction — generates a few additional tax breaks, to wit:

Many people routinely miss potential tax savings from the points they pay to borrow money. Banks often charge fees, or points, for the privilege of borrowing money. The term “points” is sometimes used to describe the charges paid by a borrower. They are also called loan origination fees, maximum loan charges or premium charges. If the payment of any of these charges is solely for the use of money, then it is considered interest.

A point is equal to 1% of the loan amount. Thus, on a $100,000 mortgage, each point costs you $1,000. If you pay off a mortgage over 30 years, each point on a 6% loan adds 0.22 percentage points to the interest rate. Thus, a 6% loan that includes four points has an effective interest rate of 6.88%.

Deductible Points — If You Do the Right Things

The amount you pay in points is deductible in full in the year of payment — but only if the loan is to buy or improve your main home.

Points paid to refinance your home mortgage are NOT deductible in the current year. They must be deducted on a pro-rated basis over the life of the loan. For example, assume $2,400 in points is paid on a 20-year refinancing loan. You would deduct $10 per month for each month of each year the loan remains due ($2,400 divided by 240 months). If you refinance again, or sell the property, all non-deducted points would be deductible in that year.

Pay careful attention to the emphasized sentence above. The most common error in claiming the deduction for points is forgetting to deduct the rest of the points on an old refi when you refi again. SAVE YOUR OLD CLOSING PAPERS, FOLKS!

Staying on Top of the Law

The key in all of these explanations is making sure you know the tax laws.

As a final note, for instance, you can cut your tax bill by paying legitimate interest to another family member in a lower tax bracket.

Assume you are in the 28% tax bracket in (down from 30% in 2002) and you borrow money from your daughter’s custodial account and pay $1,500 in interest secured by your home (home equity interest). Regardless of what you do with the money, you have created a $420 tax savings ($1,500 x 0.28) because the loan can be deducted from your tax bill. Assuming she has no other income, your daughter will pay no tax on the first $750 of interest paid and, thanks to some nifty maneuvering by Congress in the fall of 2001, only 10% on the balance for a total tax bill of $75 ($750 x 0.10). By merely reshuffling the paper, you saved the family $345 ($420-$75).