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Calculating home mortgage interest

Dear Tax Talk,
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?
-- Rob

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Dear Rob,
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.

Bankrate.com's corrections policy -- Posted: Dec. 29, 2005
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