July 25, 2023

The Complex Rules Surrounding Mortgages and Taxes

The Complex Rules Surrounding Mortgages and Taxes

The home mortgage interest deduction is as American as apple pie, but since 2017 when the tax law for this deduction was passed, there have been some changes. For starters, and most notably, the maximum mortgage principal that made homeowners eligible for the interest deduction has been lowered. It was originally $1 million and is now $750,000.

The reality of the home mortgage interest deduction

Now, the home mortgage interest deduction is widely misunderstood yet applauded as a result of many aspiring homeowners being drawn in by the benefits of the deduction without any awareness of its drawbacks or what the implications of the benefits are in the first place. 

In line with the home mortgage interest deduction is the idea that being able to deduct interest that you pay toward your home mortgage is an incentive when it comes to buying a home. But is it really?

Before you can qualify for the home mortgage interest deduction, you have to itemize a number of things, including your mortgage interest, your property taxes and your partial medical expenses. As an example, let’s say you take the time to itemize your taxes and after doing so find that you qualify for the home mortgage interest deduction.

The amount of the deduction you qualify for will be a percentage of the interest you have already paid. This is important to note because you will not receive a dollar-for-dollar tax break for every single dollar you have already put toward your interest balance. Instead, you will receive pennies on the dollar.

As you can see, unlike tax credits, the home mortgage interest deduction simply lowers the total amount of your income that will be taxed come tax time. Also, the amount of your home mortgage interest that will be deducted is going to be based on your tax bracket for the year.

Who benefits most from the deduction?

But even taxpayers who are in higher tax brackets receive little to no benefits from the home mortgage interest deduction. The only time this deduction is significantly beneficial seems to be when homeowners also have various other deductions to make — those that would be of high-dollar value.

As a tax deduction that was thought to be put into effect for the sake of encouraging homeowners and increasing the number of home purchases seems to be more useful for those in high-income households. This is typically true even with the limitation regarding the amount of your home mortgage interest that can be deducted.

How the home mortgage interest deduction works

There are other home loans that qualify for the home mortgage interest deduction, such as home improvement loans, home equity loans, lines of credit and secondary mortgages. Remember that when you take out a mortgage, the option to buy mortgage points might be available to you. This can be beneficial because mortgage points serve the purpose of paying off a percentage of your loan’s interest right away.

Each mortgage point costs the equivalent of approximately 1% of your total mortgage amount. Plus, mortgage points can usually cover about 0.25% of your mortgage rate.

You must pay for your mortgage points at closing, and the payment will be made to your lender. In some situations, mortgage points can instead be deducted during the year in which they are paid. Otherwise, you have to deduct them over the life of the loan.

While you have the option to take charges accrued as the result of late payments and deduct them as part of your home mortgage interest, doing so can cause damage to your credit score. This could also result in you taking on various mean penalties.

For instance, prepayment penalties resulting from you paying off your mortgage in full too early can be deducted as mortgage interest. However, the penalty must result from you paying off your loan too early, not from a service that you benefited from or an additional cost that was incurred from the loan.

If you choose to sell your home, deducting any interest that you paid prior to the home being sold is still a possibility for you. That said, homeowners’ insurance, closing costs, nonmilitary moving expenses, deposits, down payments and/or interest that have been accrued on a reverse mortgage are examples of payments that are not tax-deductible.

The overall deductibility of interest paid toward your mortgage is going to be dependent on whether your loan is secured by collateral in the form of your mortgaged property. Interest on a home equity loan that is being used for a purpose other than buying or renovating the home is also not deductible.

Now, would paying cash for your new home make sense? After all, it would save you tens of thousands of dollars’ worth of interest. However, some argue that far more money could be made if you choose to pay the interest yourself and invest the rest of your money into other ventures, but this is only viable during favorable conditions.

In times when the stock market is down and the value of your home decreases as a result, you might be in a position where you owe more on your mortgage than what your home is worth. To combat this, either choosing to avoid the interest payments or paying off your home as quickly as possible could be the best option for you.

The bottom line? Take measures to maximize your mortgage interest tax deduction by making use of all your itemized deductions. That way, they stand the chance of exceeding the standard income tax deduction set forth by the IRS.

On the bright side, the home mortgage interest deduction can make it easier to borrow money for the sake of buying a home, though this is particularly true more for those who rake in a high income and pay a decently large mortgage. Of course, this is just a summary of a complex situation. Homeowners should work closely with qualified tax advisors to see what tax deductions are beneficial, and legal, in their situation.

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