taxes

Deduct mortgage interest on a second home?

Judy O'ConnorDear Tax Talk,
We are purchasing a home for my in-laws to live in rent-free for as long as they need it. The lending bank explained they needed to characterize the loan as an "investment property," requiring us to pay a higher interest rate since we won't be living in it ourselves. My question is, can we deduct the mortgage interest on a second home, as well as any expenses we pay for the property? We will not receive any income from the property, at least until we sell it at some future date. Thank you!
-- Gayle

Dear Gayle,
If you meet all the IRS requirements, you may be able to deduct the mortgage interest on the home you are purchasing for your in-laws to live in.

Toy house on tax form © karen roach/Shutterstock.com

You are allowed deductions for mortgage interest paid on your main home and a second home. Your main home is where you live most of the time and your second home can be the home that you are now purchasing for your in-laws. You can have only one "second home" for mortgage deduction purposes, so if you already have a vacation home and are deducting the interest for it, you will need to figure out which deduction is better for you.

There are a few more hurdles for you to get through, and they involve taking a look at when the mortgages for both homes were taken out and what the money was used for. So let's get started on the categories of mortgages:

  • The first is called "grandfathered debt," and it has nothing to do with your grandparents. It means the mortgage was taken out before Oct. 13, 1987.
  • The second category is called "home acquisition debt," and this means the mortgage was used to buy, build or improve your home.
  • The third category is known as "home equity debt." These are mortgages taken out after Oct. 13, 1987, and used for other purposes besides buying, building or improving your homes.

Generally, for the first and second categories you can deduct mortgage interest on up to $1 million ($500,000 for those married filing separately). For the third category, the interest is deductible if throughout 2014 the mortgage was $100,000 or less ($50,000 or less if married filing separately) and additionally did not total more than the fair market value of your homes reduced by mortgages in the first and second categories. If your mortgage interest does not fit into any of these categories, it may be limited. The IRS provides work sheets to help you figure out your deduction.

By the way, don't forget you will also be able to deduct the property taxes that you pay.

Thanks for the great question and all the best to you.

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