home mortgage interest
Assume when purchasing an $800,000 home I obtain a $640,000 first
mortgage and a $120,000 second mortgage. The interest on the entire
$120,000 is tax deductible since it was used to purchase the property.
Now I want to refinance the second for $150,000. Will the IRS view
the entire $150,000 as an equity loan (subject to the $100,000 limit
for interest deduction), or will it consider $760,000 of first lien
debt ($640,000 + $120,000) and $30,000 of home equity debt?
The general rule is that an individual can deduct the interest on
a loan, or loans, not exceeding $1 million in debt secured by their
first and/or second home(s). This is referred to as home acquisition
debt. You can also borrow up to $100,000 for any purpose you want,
such as buying a car or consolidating debt, and deduct the interest
as home mortgage interest. This is referred to as home equity debt.
If you use the $100,000 to buy, build or substantially improve your
first or second home, it falls back into the category of home acquisition
debt, which is to your benefit. Then you would still have the deduction
on the $100,000 available to you, as long as you don't go over the
combined debt limit of $1.1 million.
When you refinance existing debt that was used to buy, build or
substantially improve your home, the refinanced debt is considered
home acquisition debt up to the balance that was refinanced. For
example, in your case that would be the $120,000. However, if you
had amortized the loan down to $115,000 when refinancing, then only
$115,000 would qualify as home acquisition debt. Continuing with
your example, the $30,000 additional that you borrowed would be
home equity debt, unless you use it to substantially improve your
home, by adding a pool, for example. See IRS
Publication 936 for more information on home mortgage interest.