Acquisition Debt

• Acquisition debt is an original mortgage on a primary residence or second home secured by the property and taken after October 13, 1987. Loans taken before that date are called grandfathered debt. Only the principal amount of the mortgage equal to or less than the original purchase price of the property and the cost of any improvements qualify as home-acquisition debt. If a taxpayer pays down the principal and then refinances the loan, only the refinanced amount equal to or less than the remaining portion of original acquisition debt qualifies as refinanced acquisition debt.
  
  

Calculating Deductible Acquisition Interest on Refinanced Debt

• The interest on a refinanced loan equal to or less than the remaining portion of original acquisition debt is tax deductible. Interest on any refinanced principal above this amount may or may not be deductible as home mortgage interest unless substantially all of the excess amount is used for home improvements. For example, Edna purchased a home for $400,000 and took a mortgage of $300,000 on the property. After five years of payments, the mortgage principal balance is $260,000. Edna refinances the loan and takes an additional $40,000 to travel the world. The new loan balance is $300,000, but only the interest on $260,000, the amount equal to the remaining acquisition debt, is deductible as acquisition interest. If Edna used the additional $40,000 to remodel her home, the interest on the entire $300,000 of refinanced debt would be deductible as acquisition interest.
  
  

Home Equity Loan Interest

• The Internal Revenue Service allows a home mortgage interest deduction for interest on up to $100,000 ($50,000 if married filing separately) of additional home mortgage principal, depending on the difference between acquisition debt and the home's fair market value. Interest on refinance debt above acquisition debt may be deductible in this case. In the previous example, if the fair market value of Edna's home is $300,000 or more, the interest on the additional $40,000 she borrowed in the refinance is deductible as home equity interest if she uses the money for anything other than home improvements.
  
  

Points Charged in Refinancing

• Points paid to refinance a home mortgage as prepaid interest generally must be capitalized and amortized over the life of the loan. For example, Edna pays 2 points for her $300,000 refinanced loan with a 15-year term, using the additional amount over the original acquisition debt for her trip around the world. The $6,000 in points is prepaid interest and must be amortized over the 15-year life of the loan. Edna can take $400 (6,000/15 = 400) each year as an interest deduction during the life of the loan. If Edna used the additional $40,000 of loan proceeds to remodel her home, she would be able to take that percentage of the points, $780, as an interest deduction in the first year (40,000/300,000 = 13 percent; 6,000 X .13 = 780). The remaining $5,220 is capitalized.
  
  

Grandfathered Debt

• Taxpayers who had a mortgage or refinanced a mortgage secured by a primary or second home before October 13, 1987, have grandfathered mortgage debt. The debt must have been secured by the property at all times after that date. It does not matter how the proceeds were used. All the interest is deductible home mortgage interest. The principal balance cannot exceed $1 million of home acquisition debt, plus allowable home equity debt based on the property's fair market value. Any subsequent refinancing that exceeds the remaining grandfathered debt can qualify up to the limit on home equity debt based on the home's fair market value. Interest on debt that exceeds this amount is not deductible as home mortgage debt.