The Internal Revenue Service offers two broad categories of items that reduce your taxes: deductions and credits. Deductions reduce the amount of income on which you pay taxes, which in turn reduces the amount of tax you pay, while credits directly reduce your tax liability. For example, a $500 deduction just lowers your taxable income, while a $500 credit directly lowers your income taxes by $500. Mortgage interest can lower your taxable income.
Home Mortgage Interest
The mortgage interest deduction counts as an itemized deduction, which means that it reduces your taxable income, but only if you give up your standard deduction. If your mortgage interest deduction plus your other itemized deductions does not exceed your standard deduction, it won't lower your tax bill at all because you're better off claiming the standard deduction. Other itemized deductions include medical expenses, state and local income taxes and charitable donations.
Investment Property Mortgage Interest
Mortgage interest paid on investment property loans, on the other hand, is deductible regardless of whether or not you itemize. When you have rental income and expenses, you must file Schedule E to document your income and expenses, which include mortgage interest. Once you've figured your net income from rental properties, the total goes on line 17 of Form 1040. Since the deduction is already included, you don't report the investment property mortgage interest separately.
Effect On Taxes
The effect of your mortgage interest deduction is to reduce your adjusted gross income, which in turn reduces your tax liability. The amount of the reduction of your tax liability depends on your tax bracket: the higher your bracket, the greater the savings. For example, if you deduct $10,000 of mortgage interest and you fall in the 35 percent tax bracket, your tax liability drops by $3,500. If you're only in the 20 percent bracket, you only save $2,000.
The amount you receive as a tax refund is affected by the size of your mortgage interest deduction, but also how much you've had withheld during the year for federal taxes. If your tax liability equals your withholding without accounting for your mortgage interest deduction, the reduction of your tax liability will come back to you as a tax refund. For example, if your withholding is equal to your tax liability without your mortgage interest deduction and your mortgage interest deduction reduces your tax liability by $2,000, you receive a $2,000 refund.