Filing Your Income Taxes

Mortgages & Taxes: What You Need to Know

Mortgages & Taxes: What You Need to Know
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If you take out a loan to buy a home, the interest you pay is deductible on your federal income tax as a home mortgage interest deduction. But there is a limit to the amount of interest you can take. A mortgage can be a great way to get a tax deduction, but with the standard deduction being so high in recent years, some homeowners are finding that a mortgage doesn’t bring the tax benefits it once did.

What Is a Mortgage?

Unless you have hundreds of thousands of dollars in cash lying around, you’ll need to get a loan if you want to buy a house. Ideally, you’ll be pre-approved before you start shopping for a home and, once you commit to buy a house, the process of preparing the loan begins. On a date that’s typically a month or so after you put the contract on the house, you’ll have a closing meeting where you finalize the paperwork and pay closing costs.

In addition to closing costs, homeowners typically are required to make a down payment toward the loan they’re taking. You’ll make a monthly payment on that loan until you either sell the home or pay off the loan. Your mortgage payment will usually include the month’s portion of the overall amount you borrowed, called “the principal,” interest and your homeowner’s insurance and property taxes.

Mortgage Interest Deductions

The good news is, homeownership can get you some tax deductions, assuming you itemize. The mortgage interest deduction is the largest deduction available to homeowners, but there are other deductions you can take, as well, including:

  • Mortgage interest:​ If your mortgage was finalized after ​Dec. 15, 2017​, you can deduct the interest on ​up to $375,000​ if you’re single or ​$750,000​ if you’re married filing jointly. For those with mortgages dated before that, the limit increases to ​$500,000​ for single filers and ​$1 million​ for joint filers. For mortgages finalized before ​Oct. 14, 1987​, you should be able to deduct all interest.
  • Refinance interest​: At some point in your mortgage’s life, you may refinance it to lower your payment or increase the speed at which you’ll pay it off. No matter when you refinanced, the limit on how much interest you can claim is based on your original loan’s date.
  • Home equity loan interest:​ You can also claim the interest on any home equity loans you took out for home improvements. This includes a home equity line of credit. However, this additional debt will count toward your total interest deduction limit. If you and your spouse paid interest on a $700,000 home loan and your loan is $100,000, you can only claim interest on $50,000 of that $100,000.
  • Discount points:​ You can reduce the interest you’ll pay over the life of the mortgage by paying “discount points” when you close on the house. You’ll get a ​1 percent​ discount on interest for every point you pay. Discount points are deductible, but it’s important to separate them from the loan origination points you pay at closing, which are actually lender fees and aren’t deductible.

Other Homeowner Deductions

Interest isn’t the only thing that’s potentially an itemized deductible on your federal income tax. There are some other expenses you pay on your mortgage each year that may be tax-deductible, including:

  • Property taxes:​ Unless you’ve paid your house off, you’re probably paying your annual property taxes through your mortgage. Homeowners may be able to deduct up to ​$10,000​ in property taxes, or ​$5,000​ if filing separately, along with other state and local taxes, also known as SALT.
  • Home office expenses:​ If you work from home, you can claim the portion of your home that’s used for an office. The easiest way to do this is by using the simplified option, which issues a rate per square foot that you just multiply by your square footage. The regular method has you figuring the percentage of your home used for business, then claiming the portion toward your utilities, mortgage interest, insurance, repairs and depreciation.
  • Private mortgage insurance:​ If you didn’t make a down payment of at least ​20 percent​, you were required to buy private mortgage insurance to protect the lender if you default. The deductibility of PMI has come and gone in recent years, but it’s back. You can not only claim PMI paid in ​2020​, but you can also retroactively claim any amounts you paid toward PMI in ​2018 and 2019​, when it wasn’t deductible.

Your mortgage payment will usually include the month’s portion of the overall amount you borrowed, called “the principal,” interest and your homeowner’s insurance and property taxes.

Itemizing Versus Standard Deduction

In many cases, homeowners never take a mortgage interest deduction. This is because itemizing isn’t always the best option. In fact, since the standard deduction increased from ​$6,500 to $12,000​ per taxpayer, fewer people than ever are itemizing.

For ​2020​, that increase is even higher. Single taxpayers have a standard deduction of ​$12,400​, bumping up to ​$24,800​ for married couples. Heads of households will get a standard deduction of ​$18,650​.

Some taxpayers will find that taking the standard deduction is easier. If you own a home, it’s usually a good idea to crunch the numbers to see whether itemizing will put you over ​$12,400​, or ​$24,800​ if you’re married. Using Schedule A, you can pull everything together and see how much itemizing your deduction will reduce your tax liability.

The Secured Debt Requirement

The IRS is quick to clarify that you can only take the mortgage interest deduction if your mortgage is classified as a secured debt. What’s a secured debt? In a mortgage loan, the house itself serves as the collateral, so if you don’t pay it, it eventually reverts to the bank. Your mortgage loan must have your home as the collateral.

When is a loan not eligible for a mortgage interest deduction? If the debt is no longer secured by your home, which happens if your home has a lien on it, you can’t claim the deduction. You also can’t claim the interest on it. Your home also must qualify. You can have only one main home in a given tax year, and the interest on any additional homes are only tax-deductible to the extent that they qualify.

Mortgage Interest on Second Home

Some homeowners are fortunate enough to have more than one house. This could be a vacation property you share with friends and relatives, or maybe it’s your winter home. If you use this for personal reasons and never rent it, you can take the mortgage interest deduction up to the ​$750,000/$375,000​ limit that applies to primary homes.

But even if you rent the home out part or all of the year, you may still qualify to claim the mortgage interest deduction on it as your residence. If you rent the house infrequently, as long as you use the property for more than ​14 days​ each year, you can take the income tax deduction on mortgage interest. If you rent it more than ​14 days​ each year and seldom use it, though, you’ll only be able to claim the portion of the interest that relates to the period of time each year you used it personally.

Mortgage Interest on Rental Property

If your second home is a rental property, you may be able to deduct the interest as a business expense. In fact, interest is often a landlord’s biggest deductible expense. You can also deduct mortgage interest on loans you take out to improve your rental activity, as well as credit card interest on purchases you make for rental property improvements.

There is a cap on the rental home mortgage interest you can take. This will likely only apply if you own multiple properties. The IRS limits rental property interest deductions to ​$25 million​, but you can get around this by depreciating your rental property over a ​30-year​ period versus the standard ​27.5 years​.

How to Deduct

Claiming your mortgage as a tax deduction should be fairly easy. If you paid ​$600 or more​ in mortgage interest during the year, you should receive Form 1098 in the mail at tax time. This will detail the mortgage interest you paid, the outstanding mortgage principal, any refunds on overpaid interest you received, any PMI premiums you paid and any points paid on your principal residence.

On Schedule A, you’ll insert the amount on ​Form 1098​, ​Line 8a​. If your records show that you paid more interest than the form shows, you can first try to ask your lender to reissue the form with the correct amount. But even if you don’t have the corrected form, you can input the correct amount on ​Line 8b​, write “see attached” next to it and attach a statement explaining the difference.

Advantages of a Mortgage

At one time, the mortgage interest deduction was a top reason for buying a home instead of renting. But with the standard deduction being so high, that argument isn’t quite as strong. However, assuming you don’t have cash in the bank to buy a house without a loan, the tax savings was only one of the reasons that a mortgage was a good idea.

Here are some of the other advantages of a mortgage:

  • Depending on rent costs where you live, monthly mortgage payments can come out cheaper than rent. In fact, a GoBankingRates survey pinpointed ​31​ U.S. cities where buying was cheaper than renting.
  • Even if your mortgage payment is higher than rent today, it will remain steady in the coming years as the cost of living increases. Rent costs will continue to rise.
  • If, at some point in the future, you need a lower mortgage payment, you can refinance and possibly save hundreds of dollars a month.
  • Interest rates on mortgages are notoriously low. Although it will vary depending on the market, you can often find rates as low as ​2 to 4 percent​.
  • With each month you pay your mortgage, you’ll make a small dent in the principal. This gives you equity in the loan, which is money that will be yours when you sell the house. Renters don’t have equity to show for the rent they’ve paid over the years.

Disadvantages of a Mortgage

For all those benefits, though, there are some pitfalls, as well. Since you’ll benefit from the standard deduction anyway, it’s worth considering whether a mortgage is the right idea.

  • By far, the most popular mortgage term is ​30 years​. If you take a 30-year loan on a $250,000 home with a 20 percent down payment at 4 percent interest, you’ll pay $143,738.80 in interest. You can use this calculator to determine the exact amount you’ll pay. Ideally, you could pay cash for your home, but you may find renting isn’t so bad, after all.
  • You’ll pay fees. These include loan processing fees that will be wrapped into your closing costs.
  • You’ll have to be approved. You’ll need an income, assets and good credit. The lender will likely verify your income and, once all of this is taken into account, you’ll only be approved for a certain mortgage amount.
  • If you don’t pay, you could lose your home. You should be given a grace period and plenty of warnings. In fact, you’ll probably be given far more leeway in getting caught up on payments than you would if you were answering to a landlord.

A mortgage interest deduction can help you reduce your taxable income. But before you claim it on your federal income taxes, check to make sure the standard deduction won’t give you more of a benefit. Itemizing can often put you at a lower total than what the standard deduction provides.