Everyone loves to hate income taxes. So one aspect of the U.S. tax code that's enormously popular is the mortgage interest deduction, which provides sizeable tax breaks on first and second mortgages.
Mortgage deduction basics
The IRS recognizes two types of mortgage debt-home acquisition and home equity. A second mortgage could be either one, depending on how you use the money. If you buy, construct or remodel a home, it's considered home acquisition debt. If you pay for anything else, such as college tuition or a new car purchase, it's considered home equity debt.
Tax law allows you to deduct mortgage interest on up to $1 million of home acquisition debt, and up to $100,000 of home equity debt. But there are limitations:
- You can't deduct interest on home equity debt that exceeds the home's market value.
- Both limits are halved for married taxpayers who file separately.
- Home acquisition debt in excess of $1 million qualifies as home equity debt.
- Limits apply to total mortgage debt, no matter how many mortgages or homes you have.
Second mortgage scenarios
If you fund a second mortgage when you already owe more than $1.1 million in mortgage debt, the new loan would not be tax-deductible. If you owe less than $1.1 million in mortgage debt, the second mortgage could be tax-deductible as either home acquisition or home equity debt.
Consider these scenarios:
- Bob wants to buy a vacation home with a $300,000 first mortgage, and a $75,000 second mortgage. He owes $700,000 on his primary residence. Bob will reach the $1 million cap on home acquisition debt with his primary home's $700,000 loan and the vacation home's $300,000 first mortgage. The $75,000 second mortgage is technically home acquisition debt, but Bob has already reached this cap. Therefore, since up to $100,000 of excess home acquisition debt is deductible under the home equity debt cap, the interest on Bob's $75,000 second mortgage would be tax-deductible.
- Two years ago, Molly borrowed $90,000 on her home equity line of credit (HELOC) to remodel her home. Now she wants to borrow $30,000 to buy a car. The balance on her first mortgage is $325,000. Molly's home acquisition debt total is $415,000 ($325,000 on the first mortgage and $90,000 on the HELOC). Since she has no existing home equity debt, the interest on the $30,000 would be tax-deductible under the $100,000 limitation, as long as she doesn't owe more than the home is worth.
- Sam owes $100,000 on a first mortgage that he obtained to pay for his daughter's college tuition. Now he wants to take out a second mortgage for $50,000 and travel around the world. The interest on the second mortgage would not be tax-deductible, because he's already reached the $100,000 home equity debt cap.
If your mortgage is deductible, estimate your savings. Calculate the difference in your deductions, pre- and post-second mortgage. Then apply your marginal tax rate to that difference to determine your tax break in that first year. That'll give you something to love.