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More than 86 million American households live in homes that they own, according to U.S. Census Bureau figures, and most of those homes have outstanding mortgages. Mortgage debt is often a household's biggest expense, but it also has some tax benefits. Let's look more closely at some key tax points concerning mortgages in 2016.
2 kinds of deductible mortgage debt
The key tax break that homeowners get is that they're typically allowed to deduct the interest that they pay on their mortgages. The IRS recognizes two different types of mortgages in determining limits on deducting mortgage interest.
Home acquisition debt is mortgage debt that you take out to buy, build, or substantially improve either your main home or a second home such as a vacation property. The limit on the principal balance of home acquisition debt is $1 million for all taxpayers except those who are married and file separately, who have a $500,000 limit. Interest on outstanding debt up to that amount is deductible.
Home equity debt, on the other hand, is mortgage debt used for any other purpose. If you take out a mortgage to consolidate other debt or for spending on things other than substantial improvements on your home, then the IRS will treat it as home equity debt. The limits on home equity debt are much lower, with an absolute limit of $100,000. More importantly for most people, the amount of home equity debt can't exceed the difference between the fair market value of your home and the amount of home acquisition debt that's outstanding.
One key point to realize is that refinancing a mortgage doesn't change its nature for tax purposes. In particular, a refinanced mortgage will still be treated as home acquisition debt up to the outstanding principal balance at the time of the refinancing transaction.
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What counts as interest?
The other important element in determining deductible mortgage interest is figuring out what counts as interest. The portion of monthly payments that goes toward interest rather than paying down principal is deductible, but some other things are well.
For example, you can often deduct points that you pay when you first get a mortgage. If you qualify, they're deductible in the year in which you pay them. In the worst case, you'll have to prorate them over the lifetime of your mortgage, taking a fraction every year.
In addition, homeowners are allowed to treat any private mortgage insurance premiums that their lender requires them to pay as deductible mortgage interest. This special provision is currently slated to expire at the end of 2016, but homeowners can count on being able to use the provision both for the 2015 tax returns that they're filing now and for the current 2016 tax year.
Finally, it's important to remember that many mortgage lenders require borrowers to make additional payments to cover property taxes associated with their homes. State and local taxes paid on real estate are eligible for taxpayers to deduct using a different provision of the tax laws, and so that portion of a monthly payment can also help reduce your taxes. If your mortgage lender collects those taxes on your behalf, then you just need to be prepared to get information on them. Many lenders will put the information in a separate box on your Form 1098 along with your reportable interest payments.
Home ownership is something to which millions of Americans aspire, and the tax benefits of mortgage financing help make the American Dream possible for many homeowners. Knowing the ins and outs of mortgages and taxes is important if you want to take full advantage of the incentives the federal government gives to own your own home.
The article What You Need to Know About Mortgage Taxes in 2016 originally appeared on Fool.com.
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