Part II. Limits on Home Mortgage Interest Deduction

This part of the publication discusses the limits on deductible home mortgage interest. These limits apply to your home mortgage interest expense if you have a home mortgage that does not fit into any of the three categories listed at the beginning of Part I under Fully deductible interest.

Your home mortgage interest deduction is limited to the interest on the part of your home mortgage debt that is not more than your qualified loan limit. This is the part of your home mortgage debt that is grandfathered debt or that is not more than the limits for home acquisition debt and home equity debt. Table 1 can help you figure your qualified loan limit and your deductible home mortgage interest.

Home Acquisition Debt

Home acquisition debt is a mortgage you took out after October 13, 1987, to buy, build, or substantially improve a qualified home (your main or second home). It also must be secured by that home.

If the amount of your mortgage is more than the cost of the home plus the cost of any substantial improvements, only the debt that is not more than the cost of the home plus improvements qualifies as home acquisition debt. The additional debt may qualify as home equity debt (discussed later).

Home acquisition debt limit. The total amount you can treat as home acquisition debt at any time on your main home and second home cannot be more than $1 million ($500,000 if married filing separately). This limit is reduced (but not below zero) by the amount of your grandfathered debt (discussed later). Debt over this limit may qualify as home equity debt (also discussed later).

Refinanced home acquisition debt. Any secured debt you use to refinance home acquisition debt is treated as home acquisition debt. However, the new debt will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing. Any additional debt is not home acquisition debt, but may qualify as home equity debt (discussed later).

Mortgage that qualifies later. A mortgage that does not qualify as home acquisition debt because it does not meet all the requirements may qualify at a later time. For example, a debt that you use to buy your home may not qualify as home acquisition debt because it is not secured by the home. However, if the debt is later secured by the home, it may qualify as home acquisition debt after that time. Similarly, a debt that you use to buy property may not qualify because the property is not a qualified home. However, if the property later becomes a qualified home, the debt may qualify after that time.

Mortgage treated as used to buy, build, or improve home. A mortgage secured by a qualified home may be treated as home acquisition debt, even if you do not actually use the proceeds to buy, build, or substantially improve the home. This applies in the following situations.

1. You buy your home within 90 days before or after the date you take out the mortgage. The home acquisition debt is limited to the home's cost, plus the cost of any substantial improvements within the limit described below in (2) or (3). (See Example 1.)
2. You build or improve your home and take out the mortgage before the work is completed. The home acquisition debt is limited to the amount of the expenses incurred within 24 months before the date of the mortgage.
3. You build or improve your home and take out the mortgage within 90 days after the work is completed. The home acquisition debt is limited to the amount of the expenses incurred within the period beginning 24 months before the work is completed and ending on the date of the mortgage. (See Example 2.)

Example 1. You bought your main home on June 3 for $175,000. You paid for the home with cash you got from the sale of your old home. On July 15, you took out a mortgage of $150,000 secured by your main home. You used the $150,000 to invest in stocks. You can treat the mortgage as taken out to buy your home because you bought the home within 90 days before you took out the mortgage. The entire mortgage qualifies as home acquisition debt because it was not more than the home's cost.

Example 2. On January 31, John began building a home on the lot that he owned. He used $45,000 of his personal funds to build the home. The home was completed on October 31. On November 21, John took out a $36,000 mortgage that was secured by the home. The mortgage can be treated as used to build the home because it was taken out within 90 days after the home was completed. The entire mortgage qualifies as home acquisition debt because it was not more than the expenses incurred within the period beginning 24 months before the home was completed. This is illustrated by Figure C.

Date of the mortgage. The date you take out your mortgage is the day you receive the loan proceeds. This is generally the closing date. You can treat the day you apply in writing for your mortgage as the date you take it out. However, this applies only if you receive the loan proceeds within a reasonable time (such as within 30 days) after your application is approved. If a timely application you make is rejected, a reasonable additional time will be allowed to make a new application.

Cost of home or improvements. To determine your cost, include amounts paid to acquire any interest in a qualified home or to substantially improve the home.

The cost of building or substantially improving a qualified home includes the costs to acquire real property and building materials, fees for architects and design plans, and required building permits.

Substantial improvement. An improvement is substantial if it:

1. Adds to the value of your home,
2. Prolongs your home's useful life, or
3. Adapts your home to new uses.

Repairs that maintain your home in good condition, such as repainting your home, are not substantial improvements. However, if you paint your home as part of a renovation that substantially improves your qualified home, you can include the painting costs in the cost of the improvements.

Acquiring an interest in a home because of a divorce. If you incur debt to acquire the interest of a spouse or former spouse in a home, because of a divorce or legal separation, you can treat that debt as home acquisition debt.

Part of home not a qualified home. To figure your home acquisition debt, you must divide the cost of your home and improvements between the part of your home that is a qualified home and any part that is not a qualified home. See Divided use of your home under Qualified Home in Part I.

Home Equity Debt

If you took out a loan for reasons other than to buy, build, or substantially improve your home, it may qualify as home equity debt. In addition, debt you incurred to buy, build, or substantially improve your home, to the extent it is more than the home acquisition debt limit (discussed earlier), may qualify as home equity debt.

Home equity debt is a mortgage you took out after October 13, 1987, that:

1. Does not qualify as home acquisition debt or as grandfathered debt, and
2. Is secured by your qualified home.

Example. You bought your home for cash 10 years ago. You did not have a mortgage on your home until last year, when you took out a $20,000 loan, secured by your home, to pay for your daughter's college tuition and your father's medical bills. This loan is home equity debt.

Home equity debt limit. There is a limit on the amount of debt that can be treated as home equity debt. The total home equity debt on your main home and second home is limited to the smaller of:

1. $100,000 ($50,000 if married filing separately), or
2. The total of each home's fair market value (FMV) reduced (but not below zero) by the amount of its home acquisition debt and grandfathered debt. Determine the FMV and the outstanding home acquisition and grandfathered debt for each home on the date that the last debt was secured by the home.

Example. You own one home that you bought in 1998. Its FMV now is $110,000, and the current balance on your original mortgage (home acquisition debt) is $95,000. Bank M offers you a home mortgage loan of 125% of the FMV of the home less any outstanding mortgages or other liens. To consolidate some of your other debts, you take out a $42,500 home mortgage loan [(125% × $110,000) - $95,000] with Bank M.

Your home equity debt is limited to $15,000. This is the smaller of:

1. $100,000, the maximum limit, or
2. $15,000, the amount that the FMV of $110,000 exceeds the amount of home acquisition debt of $95,000.

Debt higher than limit. Interest on amounts over the home equity debt limit (such as the interest on $27,500 [$42,500 - $15,000] in the preceding example) generally is treated as personal interest and is not deductible. But if the proceeds of the loan were used for investment, business, or other deductible purposes, the interest may be deductible. If it is, see the Table 1 Instructions for line 13 for an explanation of how to allocate the excess interest.

Part of home not a qualified home. To figure the limit on your home equity debt, you must divide the FMV of your home between the part that is a qualified home and any part that is not a qualified home. See Divided use of your home under Qualified Home in Part I.

Fair market value (FMV). This is the price at which the home would change hands between you and a buyer, neither having to sell or buy, and both having reasonable knowledge of all relevant facts. Sales of similar homes in your area, on about the same date your last debt was secured by the home, may be helpful in figuring the FMV.

Grandfathered Debt

If you took out a mortgage on your home before October 14, 1987, or you refinanced such a mortgage, it may qualify as grandfathered debt. To qualify, it must have been secured by your qualified home on October 13, 1987, and at all times after that date. How you used the proceeds does not matter.

Grandfathered debt is not limited. All of the interest you paid on grandfathered debt is fully deductible home mortgage interest. However, the amount of your grandfathered debt reduces the $1 million limit for home acquisition debt and the limit based on your home's fair market value for home equity debt.

Refinanced grandfathered debt. If you refinanced grandfathered debt after October 13, 1987, for an amount that was not more than the mortgage principal left on the debt, then you still treat it as grandfathered debt. To the extent the new debt is more than that mortgage principal, it is treated as home acquisition or home equity debt, and the mortgage is a mixed-use mortgage (discussed later under Average Mortgage Balance in the Table 1 Instructions). The debt must be secured by the qualified home.

You treat grandfathered debt that was refinanced after October 13, 1987, as grandfathered debt only for the term left on the debt that was refinanced. After that, you treat it as home acquisition debt or home equity debt, depending on how you used the proceeds.

Exception. If the debt before refinancing was like a balloon note (the principal on the debt was not amortized over the term of the debt), then you treat the refinanced debt as grandfathered debt for the term of the first refinancing. This term cannot be more than 30 years.

Example. Chester took out a $200,000 first mortgage on his home in 1985. The mortgage was a five-year balloon note and the entire balance on the note was due in 1990. Chester refinanced the debt in 1990 with a new 20-year mortgage. The refinanced debt is treated as grandfathered debt for its entire term (20 years).

Line-of-credit mortgage. If you had a line-of-credit mortgage on October 13, 1987, and borrowed additional amounts against it after that date, then the additional amounts are either home acquisition debt or home equity debt depending on how you used the proceeds. The balance on the mortgage before you borrowed the additional amounts is grandfathered debt. The newly borrowed amounts are not grandfathered debt because the funds were borrowed after October 13, 1987. See Mixed-use mortgages under Average Mortgage Balance in the Table 1 Instructions that follow.

Table 1 Instructions

You can deduct all of the interest you paid during the year on mortgages secured by your main home or second home in either of the following two situations.

1. All the mortgages are grandfathered debt.
2. The total of the mortgage balances for the entire year is within the limits discussed earlier under Home Acquisition Debt and Home Equity Debt.

In either of those cases, you do not need Table 1. Otherwise, you may use Table 1 to determine your qualified loan limit and deductible home mortgage interest.

Fill out only one Table 1 for both your main and second home regardless of how many mortgages you have.

Table 1. Worksheet: qualified loan limit

Home equity debt only. If all of your mortgages are home equity debt, do not fill in lines 1 through 5. Enter zero on line 6 and complete the rest of Table 1.

Average Mortgage Balance

You have to figure the average balance of each mortgage to determine your qualified loan limit. You need these amounts to complete lines 1, 2, and 9 of Table 1. You can use the highest mortgage balances during the year, but you may benefit most by using the average balances. The following are methods you can use to figure your average mortgage balances. However, if a mortgage has more than one category of debt, see Mixed-use mortgages, later, in this section.

Average of first and last balance method. You can use this method if all the following apply.

1. You did not borrow any new amounts on the mortgage during the year. (This does not include borrowing the original mortgage amount.)
2. You did not prepay more than one month's principal during the year. (This includes prepayment by refinancing your home or by applying proceeds from its sale.)
3. You had to make level payments at fixed equal intervals on at least a semi-annual basis. You treat your payments as level even if they were adjusted from time to time because of changes in the interest rate.

To figure your average balance, complete the following worksheet.

Interest paid divided by interest rate method. You can use this method if at all times in 2001 the mortgage was secured by your qualified home and the interest was paid at least monthly.

Complete the following worksheet to figure your average balance.

Example. Mr. Blue had a line of credit secured by his main home all year. He paid interest of $2,500 on this loan. The interest rate on the loan was 9% (.09) all year. His average balance using this method is $27,778, figured as follows.

Statements provided by your lender. If you receive monthly statements showing the closing balance or the average balance for the month, you can use either to figure your average balance for the year. You can treat the balance as zero for any month the mortgage was not secured by your qualified home.

For each mortgage, figure your average balance by adding your monthly closing or average balances and dividing that total by the number of months the home secured by that mortgage was a qualified home during the year.

If your lender can give you your average balance for the year, you can use that amount.

Example. Ms. Brown had a home equity loan secured by her main home all year. She received monthly statements showing her average balance for each month. She may figure her average balance for the year by adding her monthly average balances and dividing the total by 12.

Mixed-use mortgages. A mixed-use mortgage is a loan that consists of more than one of the three categories of debt (grandfathered debt, home acquisition debt, and home equity debt). For example, a mortgage you took out during the year is a mixed-use mortgage if you used its proceeds partly to refinance a mortgage that you took out in an earlier year to buy your home (home acquisition debt) and partly to buy a car (home equity debt).

Complete lines 1 and 2 of Table 1 by including the separate average balances of any grandfathered debt and home acquisition debt in your mixed-use mortgage. Do not use the methods described earlier in this section to figure the average balance of either category. Instead, for each category, use the following method.

1. Figure the balance of that category of debt for each month. This is the amount of the loan proceeds allocated to that category, reduced by your principal payments on the mortgage previously applied to that category. Principal payments on a mixed-use mortgage are applied in full to each category of debt, until its balance is zero, in the following order:
   1. First, any home equity debt,
   2. Next, any grandfathered debt, and
   3. Finally, any home acquisition debt.
2. Add together the monthly balances figured in (1).
3. Divide the result in (2) by 12.

Complete line 9 of Table 1 by including the average balance of the entire mixed-use mortgage, figured under one of the methods described earlier in this section.

Example 1. In 1986, Sharon took out a $1,400,000 mortgage to buy her main home (grandfathered debt). On March 2, 2001, when the home had a fair market value of $1,700,000 and she owed $1,100,000 on the mortgage, Sharon took out a second mortgage for $200,000. She used $180,000 of the proceeds to make substantial improvements to her home (home acquisition debt) and the remaining $20,000 to buy a car (home equity debt). Under the loan agreement, Sharon must make principal payments of $1,000 at the end of each month. During 2001, her principal payments on the second mortgage totaled $10,000.

To complete line 2 of Table 1, Sharon must figure a separate average balance for the part of her second mortgage that is home acquisition debt. The January and February balances were zero. The March through December balances were all $180,000, because none of her principal payments are applied to the home acquisition debt. (They are all applied to the home equity debt, reducing it to $10,000 [$20,000 - $10,000].) The monthly balances of the home acquisition debt total $1,800,000 ($180,000 × 10). Therefore, the average balance of the home acquisition debt for 2001 was $150,000 ($1,800,000 ÷ 12).

Example 2. The facts are the same as in Example 1. In 2002, Sharon's January through October principal payments on her second mortgage are applied to the home equity debt, reducing it to zero. The balance of the home acquisition debt remains $180,000 for each of those months. Because her November and December principal payments are applied to the home acquisition debt, the November balance is $179,000 ($180,000 - $1,000) and the December balance is $178,000 ($180,000 - $2,000). The monthly balances total $2,157,000 [($180,000 × 10) + $179,000 + $178,000]. Therefore, the average balance of the home acquisition debt for 2002 is $179,750 ($2,157,000 ÷ 12).

Line 1

Figure the average balance for the current year of each mortgage you had on all qualified homes on October 13, 1987 (grandfathered debt). Add the results together and enter the total on line 1. Include the average balance for the current year for any grandfathered debt part of a mixed-use mortgage.

Line 2

Figure the average balance for the current year of each mortgage you took out on all qualified homes after October 13, 1987, to buy, build, or substantially improve the home (home acquisition debt). Add the results together and enter the total on line 2. Include the average balance for the current year for any home acquisition debt part of a mixed-use mortgage.

Line 7

The amount on line 7 cannot be more than the smaller of:

1. $100,000 ($50,000 if married filing separately), or
2. The total of each home's fair market value (FMV) reduced (but not below zero) by the amount of its home acquisition debt and grandfathered debt. Determine the FMV and the outstanding home acquisition and grandfathered debt for each home on the date that the last debt was secured by the home.

See Home equity debt limit under Home Equity Debt, earlier, for more information about fair market value.

Line 9

Figure the average balance for the current year of each outstanding home mortgage. Add the average balances together and enter the total on line 9. See Average Mortgage Balance, earlier.

Note. When figuring the average balance of a mixed-use mortgage, for line 9 determine the average balance of the entire mortgage.

Line 10

If you make payments to a financial institution, or to a person whose business is making loans, you should get Form 1098 or a similar statement from the lender. This form will show the amount of interest to enter on line 10. Also include on this line any other interest payments made on debts secured by a qualified home for which you did not receive a Form 1098. Do not include points on this line.

Claiming your deductible points. Figure your deductible points as follows.

1. Figure your deductible points for the current year using the rules explained under Points in Part I.
2. Multiply the amount in item (1) by the decimal amount on line 11. Enter the result on Schedule A (Form 1040), line 10 or 12, whichever applies. This amount is fully deductible.
3. Subtract the result in item (2) from the amount in item (1). This amount is not deductible as home mortgage interest. However, if you used any of the loan proceeds for business or investment activities, see the instructions for line 13, next.

Line 13

You cannot deduct the amount of interest on line 13 as home mortgage interest. If you did not use any of the proceeds of any mortgage included on line 9 of the worksheet for business, investment, or other deductible activities, then all the interest on line 13 is personal interest. Personal interest is not deductible.

If you did use all or part of any mortgage proceeds for business, investment, or other deductible activities, the part of the interest on line 13 that is allocable to those activities may be deducted as business, investment, or other deductible expense, subject to any limits that apply. Table 2 shows where to deduct that interest. See Allocation of Interest in chapter 5 of Publication 535 for an explanation of how to determine the use of loan proceeds.

The following two rules describe how to allocate the interest on line 13 to a business or investment activity.

1. If you used all of the proceeds of the mortgages on line 9 for one activity, then all the interest on line 13 is allocated to that activity. In this case, deduct the interest on the form or schedule to which it applies.
2. If you used the proceeds of the mortgages on line 9 for more than one activity, then you can allocate the interest on line 13 among the activities in any manner you select (up to the total amount of interest otherwise allocable to each activity, explained next).

You figure the "total amount of interest otherwise allocable to each activity" by multiplying the amount on line 10 by the following fraction.

Example. Don had two mortgages (A and B) on his main home during the entire year. Mortgage A had an average balance of $90,000, and mortgage B had an average balance of $110,000.

Don determines that the proceeds of mortgage A are allocable to personal expenses for the entire year. The proceeds of mortgage B are allocable to his business for the entire year. Don paid $14,000 of interest on mortgage A and $16,000 of interest on mortgage B. He figures the amount of home mortgage interest he can deduct by using Table 1. Since both mortgages are home equity debt, Don determines that $15,000 of the interest can be deducted as home mortgage interest.

The interest Don can allocate to his business is the smaller of:

1. The amount on line 13 of the Table 1 worksheet ($15,000), or
2. The total amount of interest allocable to the business ($16,500), figured by multiplying the amount on line 10 (the $30,000 total interest paid) by the following fraction.

Because $15,000 is the smaller of items (1) and (2), that is the amount of interest Don can allocate to his business. He deducts this amount on his Schedule C (Form 1040).