I recently prepared a memo to
explain how mortgage interest and investment interest are deducted on Schedule
A for a client who was considering taking out a mortgage on his home, which
currently has no mortgage, to either buy a vacation home or to invest in the
stock market. I have adapted it slightly
for posting here.
MORTGAGE INTEREST
There are two types of deductible
mortgage interest – acquisition debt interest and home equity debt interest.
Acquisition debt is debt that is used
to buy, build, or substantially improve a residence, and it is “secured” by
that residence. You can deduct interest
on up to $1,000,000 of acquisition debt.
Once acquisition debt on a residence is paid off, or if the residence
was purchased with all cash, it can never be “reinstated” (except for moneys
borrowed to pay for subsequent substantial improvement to the property) for
that property. You can deduct allowable
acquisition debt interest on up to two residences – usually your principal
residence and one vacation or other residence.
Acquisition debt interest is deductible for calculating both the
“regular” tax and the dreaded Alternative Minimum Tax (AMT)
Home equity debt is debt that is used
for any other purpose – to pay down credit cards, pay for college expenses, purchase
a car, etc, etc. You can deduct interest
on up to $100,000 of home equity debt.
While home equity debt interest is fully deductible in calculating the
“regular” tax, it is NOT deductible in calculating AMT.
If you took out a mortgage secured
by your current primary principal residence to purchase a personal-use vacation
residence it would be treated as home equity debt and you would only be able to
deduct the interest on up to $100,000 on Schedule A. You would get no actual federal tax benefit
for this interest if you are a victim of AMT.
But you could probably deduct the interest on this debt on your state
return (depending on your state or residence – not deductible in NJ or PA, for
example).
If you purchased a vacation
residence with a mortgage secured by that new vacation residence you could
deduct interest on up to $1,000,000 (if you are not already deducting mortgage
interest on two properties).
For more detailed information on
deducting mortgage interest consult my MORTGAGE INTEREST GUIDE – available for
only $1.00 (check out My Dollar Store)!
INVESTMENT INTEREST
If you take out a mortgage on your primary
personal residence and use the money to purchase taxable investments you can
elect to deduct the interest as investment interest instead of home equity
interest. Investment interest is
deductible to the extent of current taxable net investment income. Unused investment interest can be carried
forward.
Because qualified dividends and
long-term capital gains are taxed at a lower capital gain rate - 0%, 15%, or
20% instead of at your “regular” marginal tax rate - your net investment income
for purposes of deducting investment interest is reduced by qualified dividends and long-term capital gains.
If you use part of the money to
purchase tax-exempt municipal investments you must pro-rate the deductible
interest (investment interest is not deductible on money used to purchase
tax-exempt investments such as municipal bonds).
If you take out a mortgage for $100,000
to invest in taxable stocks, bonds, mutual funds, etc, and your total mortgage
interest treated as investment interest is $5,000, and you earn $7,000 in
taxable income on the investments, but $3,000 of this is qualified dividends
and long-term capital gain, you can only deduct $4,000 currently ($7,000 - $3,000). $1,000 of the investment interest is carried
forward.
However you could deduct the full
$5,000 of interest if you elect to treat $1,000 of the qualified dividends and
long term capital gain as “ordinary income” and be taxed at your “regular”
marginal tax rate.
The IRS uses tracking rules to
determine how to treat interest. To be
safe you would need to deposit the $100,000 check from the mortgage directly into your brokerage account
(not into a checking or savings account first, and then into the brokerage
account) and purchase the investments.
Any questions?
TTFN
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