Deducting mortgage interest payments you make can significantly reduce your federal income tax bill. The tax rules do allow you to take the deduction on up to two homes, but restrictions and limitations in the law may preclude you from deducting any or all of the interest on your second home’s mortgage. And regardless of whether you satisfy all of the Internal Revenue Service's requirements, you’ll have to itemize on Schedule A in order to take the deduction.
Secured Mortgage Loan
You are precluded from deducting any interest on a loan you obtain to purchase or improve a second home unless the lender has a security interest in that home – meaning the second home serves as collateral in case you stop making loan payments. Most mortgages satisfy this basic requirement, but it ultimately depends on the terms of your loan agreement.
Qualified Home Requirement
The second home must also be a “qualified home.” The IRS defines a qualified home as your main residence plus one additional home that is used for personal purposes. It isn’t necessary for you to actually use the second home, but it can’t be up for sale or made available to prospective renters during the tax year you deduct the interest. It is possible that your second home can still be treated as a qualified home if it’s rented for only part of the year. In this case, you’ll need to use it for personal purposes at least 15 days or more than 10 percent of the days the home is occupied by tenants, whichever is longer.
Maximum Annual Interest
There is also an annual limit on the amount of mortgage interest you can deduct. The limitation isn’t based on a fixed number; rather, the maximum interest you can deduct is that which accrues on up to $1 million of outstanding principal loan balances. This $1 million restriction applies to the combined total of loan balances on both of your homes – not just the mortgage balance on the second home. Moreover, this maximum mortgage balance only applies to funds you borrow that are used to buy, construct or make improvements to your home and that were obtained after Oct. 13, 1987. If any of your outstanding mortgage balances were used for other purposes, you may still be able to deduct them, but only as home equity loan interest.
Home Equity Limits
To deduct the excess as home equity loan interest, your lender must hold a security interest in the home just like your other mortgage lenders do. Provided you took the loan out after Oct. 13, 1987, the IRS lets you deduct the interest payments that accrue on a maximum of $100,000 in loan balances or the actual equity you have in both homes, whichever is smaller. Equity is calculated as the combined fair market values of both homes minus your outstanding mortgage balances. When you deduct home equity loan interest on Schedule A, you combine it with your other deductible mortgage interest and report a single figure.