Mortgage Interest Deduction: Acquisition Indebtedness v. Home Equity Indebtedness
As most taxpayers are aware, most mortgage interest is deductible. However, not all mortgage interest is the same for purposes of the deduction. There are two types of mortgage interest, each with different limitations placed on them by the Internal Revenue Code. The first and most common type of interest is acquisition indebtedness. The second type is called home equity indebtedness. In this article, we’ll answer how to tell the difference between these two types of mortgage interest. We’ll also discuss what happens when you have both types of indebtedness, and what happens when you re-finance your mortgage debt.
What is Acquisition Indebtedness?
The deduction for mortgage interest is granted by Section 163 of the Internal Revenue Code. In this same Code section, we also find the definitions for both acquisition and home equity indebtedness. In IRC §163(h)(3)(B), it states that acquisition indebtedness is “any indebtedness which … is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and … is secured by such residence.”
So, there are two basic criteria here: 1) how were the proceeds of the loans used? and 2) is the loan secured by the residence? Basically, acquisition indebtedness can really be any type of loan so long as the loan was used to purchase, build, or “substantially improve” any qualified residence of the taxpayer. To the second issue, the loan must also be secured by the residence that you used the loan proceeds to purchase, build or improve. In case you’re wondering what it means for the loan to be secured by the residence, it basically means that the residence serves as collateral for the loan: if the person who takes out the loan fails to repay the loan (i.e. the debtor “defaults” on the loan), then the person who took out the loan can lose the house to the creditor to help satisfy the debt.
The interest accrued and paid by a taxpayer is fully deductible on Schedule A of a taxpayer’s return–however, you cannot deduction interest from acquisition indebtedness of more than $1,000,000. You can take a deduction for the interest on the first million of debt, but any debt you incur above that amount is non-deductible.
What is Home Equity Indebtedness?
Most people think of a home equity loan as a loan that is used for home improvement. But, as you’ve read, a mortgage used to improve a house could actually count as “acquisition indebtedness.” Home equity indebtedness under Section 163, rather, is any indebtedness that does not already count as acquisition indebtedness so long as it’s secured by a qualified residence. So, just like before, the debt must be secured by the residence. However, this time taxpayers are given complete freedom on how the funds from the loan are used. Taxpayers may use the loan to pay for an education, to pay down credit cards, or even to purchase a new car–it doesn’t matter, the interest will still be deductible.
Unfortunately, there is a cost that comes with the freedom of deducting interest from home equity indebtedness: the overall limitation on deducting the interest is much more stringent for home equity indebtedness than it is for acquisition indebtedness. Taxpayers may only deduct the interest from home equity indebtedness for up to $100,000 of home equity indebtedness. If you incur more than $100,000 of home equity indebtedness, you may only deduct the interest from the first $100,000 of indebtedness. Also, you cannot have home equity indebtedness that exceeds the fair market value of the residence. So, for example, if you have a principal residence that is worth $75,000 on the market, and you get a mortgage on the home for $100,000, you can only deduct the interest from the first $75,000 of the mortgage loan. The interest on the remaining $25,000 of the mortgage is non-deductible.
May I deduct interest from both Acquisition and Home Equity Indebtedness?
Yes, you can deduct interest from both acquisition and home equity indebtedness, so long as the value of the combined home equity and acquisition indebtedness does not exceed the fair market value of the home. The $1,000,000 and $100,000 limitations on acquisition and home equity indebtedness also still apply. So, for example, a taxpayer with a home worth $500,000 who has a $400,000 mortgage on the home that counts as acquisition indebtedness and a $100,000 mortgage on the home that counts as home equity indebtedness may deduct the interest from both mortgages. However, if the same taxpayer had the same mortgages on a home worth only $450,000, then only interest on the first $450,000 of the mortgages is deductible.
May I deduct interest from re-financed mortgages?
Yes, interest from re-financed mortgages is deductible. If you re-finance a mortgage, you can continue deducting the interest from the re-financed mortgage using the same limitations used for the original loan. So, if you re-finance a mortgage that counted as acquisition indebtedness, you can treat interest on the re-financed loan as acquisition indebtedness as well. However, there is an important restriction that applies here. You cannot deduct interest from a re-finance mortgage that is more than the original loan you are re-financing. The following example may help make this clear:
Example: Natalie incurs a mortgage for $400,000 to purchase her home (worth $400,000). The home Natalie purchased is security for the mortgage. After a few years of making payments on the loan, the balance on Natalie’s mortgage is now $300,000. However, Natalie’s home has also increased in value to $500,000, and Natalie decides to re-finance her loan based on the new value of her home. Therefore, the new loan balance for Natalie’s mortgage is $500,000. Even though the re-financed mortgage can count as acquisition indebtedness, Natalie may only deduct interest for the first $400,000 of the re-financed loan, because the original mortgage Natalie used to purchase the home was $400,000. The remaining $100,000 of Natalie’s refinanced loan is non-deductible.
Hopefully, with the previous explanations and examples, you better understand the difference between acquisition indebtedness and home equity indebtedness and how they play into whether or not interest is deductible by taxpayers. By understanding the concepts and rules discussed in this article, you can more effectively make sound financial decisions related to the purchase and improvement of your home by knowing the tax implications and opportunities that come from these types of decisions throughout your life.
- 26 U.S.C. §163.↵
- 26 U.S.C. §163(h)(3)(B).↵
- Qualified residence under Section 163 basically is the principal residence of the taxpayer, but it can also be one other home that the taxpayer uses as a residence. For more information on what constitutes the principal residence of a taxpayer, see Section 121 of the Code.↵
- This process, commonly known as foreclosure, involves the creditor taking over ownership of the home and typically ends with the creditor selling the home and using the proceeds of the sale to satisfy the unpaid debts of the debtor under the loan.↵
- 26 U.S.C. §163(h)(3)(B)(ii).↵
- 26 U.S.C. §163(h)(3)(C).↵
- 26 U.S.C. §163(h)(3)(C)(ii).↵
- 26 U.S.C. §163(h)(3)(C)(i)(II).↵
- See Rev. Rul. 2010-25.↵
- 26 U.S.C. §163(h)(3)(B).↵