One of the most important benefits of buying a home and having a mortgage is the mortgage interest expense income tax deduction. For most borrowers, the mortgage tax deduction provides a significant, positive financial impact and is an important factor in determining how much home they can afford. The mortgage tax deduction benefit helps to offset property taxes, homeowners insurance and other monthly housing expenses you pay when you own a home.
According to federal tax code, mortgage interest, mortgage insurance, property taxes as well as lender origination fees and discount points are deductible against a borrowerâ€™s gross income. The lower your reported gross income, the less tax you pay. To be clear, your mortgage interest expense is not directly deducted from the federal taxes you owe on a dollar-for-dollar basis, but rather reduces the gross income figure that is used to determine the amount of tax that you owe (see the bottom of the page for a helpful example). Additionally, you do not receive any money directly from the federal government as the result of the mortgage tax deduction benefit but you do pay less in federal taxes, which offsets your total monthly housing expense. So instead of receiving a check from the government for your mortgage interest tax benefit, you pay the government less taxes.
The tax deduction benefit applies to interest expense from mortgages on on first, second and vacation homes defined as qualified residences such as a house, condominium, cooperative, mobile home, house trailer or boat.
There is a limit on the loan amount that the tax deduction applies to and in December 2017 a major tax law -- the Tax Cuts and Jobs Act -- was passed that changed the maximum loan amount that is eligible for the mortgage tax deduction.
For most mortgages that closed on or after December 15, 2017 you can only deduct interest expense on up to $750,000 in mortgages ($375,000 if married filing separately) on a primary and second homes. Interest expense on any mortgage amount above $750,000 ($375,000 if married filing separately) is not tax deductible. For example, if you take out a $950,000 mortgage to buy a home in 2018, you can only deduct the interest expense on $750,000 of the loan amount while the interest expense for the remaining $200,000 of the mortgage is not deductible.
For mortgages that closed before December 15, 2017 you can deduct interest expense on up to $1,000,000 in mortgages ($500,000 if married filing separately) on your primary and second homes. Interest expense on any mortgage amount above $1,000,000 ($500,000 if married filing separately) is not tax deductible. For example, if a borrower took out a $1,250,000 mortgage to buy a home in 2016, the interest expense for $1,000,000 of the mortgage is deductible while the interest expense for the remaining $250,000 of the mortgage is not deductible.
Please note that there are certain exceptions to the December 15, 2017 mortgage closing deadline. Rate and term refinances of mortgages that closed prior to December 15, 2017 and purchase mortgages on homes that were under written contract prior to December 15, 2017 and closed before April 1, 2018 are eligible for the higher mortgage tax deduction loan cap of $1,000,000 instead of the $750,000 loan cap. We always recommend that borrowers check with their tax advisor or an accountant to understand how the mortgage tax deduction applies to them. The mortgage tax deduction rules are effective for the 2018 through 2025 tax years.
It is also important to highlight that the mortgage tax deduction only applies to interest expense, and not your entire mortgage payment. For example, if your monthly payment is $2,500 comprised of $500 in principal and $2,000 in interest, then only $2,000 of your payment is tax deductible. This is important to keep in mind because the split between principal and interest payments changes over the course of your mortgage, which means your tax benefit also changes every year.
Given the mechanics of amortization, for most loans the tax deduction benefit is the greatest at the beginning of the mortgage and gradually declines over time. This is because over the life of most mortgages, the portion of your monthly mortgage payment that goes to interest decreases while the portion of your payment that goes to paying down principal increases.
The interest expense on second mortgages, home equity loans and home equity lines of credit (HELOC) is tax deductible as long as the loan is used to buy, build or substantially improve the property that secures the loan. Additionally, second mortgage, home equity loan and HELOC interest is tax deductible as long as the total amount of loans secured by the property does not exceed the value of the property and the total amount of the loans, including the first mortgage, does not exceed $750,000 (in most cases). For example, if you take out a second mortgage to purchase your primary residence, then the interest expense on the second mortgage is tax deductible. If you take out a second mortgage, home equity loan or HELOC and do not use the proceeds to buy, build or substantially improve your home, such to pay for a vacation, college tuition or to payoff credit card debt, then the interest expense on the loan is not tax deductible.
Please note that the interest expense on a second mortgage, home equity loan or HELOC for a second or vacation home is tax deductible as long as the loan is secured by the second or vacation home and the the total amount of the loans on your primary, second or vacation homes does not exceed $750,000. If you take out a home equity loan or HELOC on your primary residence to buy a second or vacation home, the interest expense on the home equity loan or HELOC is not tax deductible because the loan is not secured by the property it was used to purchase. We advise you to consult a tax professional to understand how the home equity loan interest tax deduction applies to you.
You can also deduct the cost of mortgage points such as lender origination points (also called origination fees) and discount points that you may incur when you get a mortgage. For both origination and discount points, one point equals 1% of the mortgage amount. So for a $300,000 mortgage, one mortgage point equals $3,000 in fees paid by the borrower. Origination points are the fees lenders charge borrowers to process and close your mortgage. A discount point is an optional fee that borrowers choose to pay to obtain a lower mortgage rate. Because origination and discount points effectively enable lenders to collect interest from borrowers upfront, the government allows you to deduct these mortgage point fees on your taxes. Other closing costs such as appraisal, title and escrow fees are not tax deductible.
Please note that for home purchase loans you can deduct mortgage point fees in the year in which you incurred the cost. For example, if you paid $15,000 in mortgage points on a home purchase loan, you can take the full $15,000 tax deduction in the year you obtained the mortgage. For refinance loans, the mortgage point fees are deductible over the term of the loan. For example, if you paid $15,000 in mortgage points when you refinanced into a 30 year loan, you can take a $500 tax deduction annually for 30 years ($15,000 / 30 years = $500).
Expenses for mortgage insurance including private mortgage insurance (PMI), FHA Mortgage Insurance Premium (MIP), USDA Mortgage Insurance and the VA Funding Fee are also tax deductible as long as your adjusted gross income is less than $100,000 per year (or $50,000 for married filing separately). If your adjusted gross income is between $100,000 and $109,000 (or $54,500 if married filing separately) per year, you are eligible for a partial deduction of your mortgage insurance fees while the mortgage insurance tax deduction does not apply to borrowers that earn more than $109,000 in annual adjusted gross income.
The tax code permits a total of $10,000 in combined state and local tax (SALT) deductions, including property, income and sales taxes. Please note that the the deduction for property taxes also includes state and local income and sales taxes and not only property taxes, which you could previously itemize and deduct separately. For example, if you pay $4,000 in property tax and $9,000 in state income tax, you are only able to deduct a total of $10,000 in combined property and state income taxes instead of the $13,000 in total state and local property and income taxes you pay. The $10,000 cap on state and local property, income and sales tax deductions was implemented as part of the 2017 tax reform law. Borrowers who itemize their deductions and who pay higher state and local property, income and sales taxes may experience a significant reduction in their property tax deduction benefit as compared to the prior tax code.
The example below illustrates how the mortgage tax deduction works. The example shows the impact of the deduction on a borrower who makes $75,000 per year, or $6,250 per month, in gross income. The borrower has a $380,000 mortgage with a 4.000% mortgage rate and pays $4,700 per year in property taxes. The example demonstrates how the tax deduction reduces your taxable income which lowers your tax bill. The mortgage tax deduction benefit results in a tax savings of $3,915 per year, or $325 per month, reducing the borrower's monthly housing expense from $2,300 to $1,975 and making home ownership more affordable.
Please note that this example presents one scenario and the mortgage tax deduction benefit you actually receive depends on your personal circumstances. For example, if you pay a higher mortgage rate or are in a higher federal tax bracket, your tax benefit increases. We should also highlight that the tax benefit usually decreases over time as you pay down your loan.
Deductions reduce gross income for calculating taxes
Watch our mortgage tax deduction video tutorial to learn more about how this benefit applies to you.
Mortgage Tax Benefit Instructional Video
Mortgage Tax Deduction IRS Update: https://www.irs.gov/newsroom/interest-on-home-equity-loans-often-still-deductible-under-new-law
IRS Guidelines: https://www.irs.gov/publications/p936