Mortgage Interest Deduction – Not as Simple as it Seems

The mortgage interest deduction is one of the most popular in the whole tax code; however, it is more complicated than it first appears.

Generally, you need to satisfy five factors before you can deduct mortgage interest. These factors are:

1. Who paid the mortgage?
2. Who is listed as the borrower?
3. Is the property secured by the residence?
4. Are there limits to deducting personal mortgage interest?

As simple as these questions may appear, the details of your living arrangement can easily complicate matters. Below we look at three scenarios where the mortgage interest deduction is anything but straightforward.

Case #1: Your parents buy the house for you, but you pay the mortgage.

Young people sometimes lack sufficient down payment or an adequate credit score necessary to purchase a home. In the face of such circumstances, some families have found the solution to be that the parents purchase the house while their son or daughter residing in the home pays the mortgage, taxes, etc.

If you refer to the five factors listed above, you’ll notice that in this scenario the answer to each question is not the same taxpayer. The son or daughter does not own the mortgage debt they are paying, so they cannot deduct the mortgage interest. Similarly, factor #3 provides no relief as only the parents are on the deed. At the same time, the parents are not entitled to the deduction since they never paid the mortgage under factor #1. It’s starting to look like nobody can take the deduction!

The answer lies in whoever the tax regulations deem an equitable owner. An equitable owner is allowed to deduct the mortgage interest they paid even if they are not listed on the mortgage as a borrower. An equitable owner is the person who possesses, uses, improves, maintains, insures and pays property taxes and assessments. They also must be able to obtain legal title by paying the balance of the purchase price.

Qualifying as an equitable owner is not easy. Make sure you pay all mortgage costs, real estate taxes, repairs, maintenance and insurance expense. It also helps if you pay at least part of the down payment. Essentially, act like the owner in every financial respect possible. 

Case #2: You and your roommate own a house together and pay the mortgage out of joint or separate bank accounts.

In this case, since both you and your roommate are on the deed and own the debt, the determining factor is who paid the interest. If payments are made from separate bank accounts, then the situation is straightforward as you and your roommate’s portion of interest paid is assignable to one or the other. The real issue comes when the payments are made from a joint bank account.

In the eyes of the IRS, monies paid from joint accounts are presumed to be paid equally from both account holders unless proven otherwise. In our example, since there are two account holders, you and your roommate each get 50 percent of the mortgage interest deduction.

Case #3: You own a home with your spouse, but you file Married Filing Separately

In situations where married taxpayers pay the interest expense jointly but choose to file separate returns under married filing separately status, each spouse is allowed to take 50 percent of the interest deduction.

Assume the same facts as above, except this time you pay the full interest expense on the loan and your spouse pays nothing, then you get the entire interest expense deduction and your spouse who paid nothing gets no deduction. The complication that arises here is when the mortgage debt exceeds $500,000, as explored in the next paragraph.

Married filing jointly taxpayers are allowed to deduct mortgage interest expense on mortgage debt of up to $1 million; however, when they file married filing separately, each spouse is limited to the interest paid on only up to $500,000 of debt. Therefore, if the couple had a mortgage of $750,000 and only one spouse paid the mortgage interest, that spouse gets a deduction limited to the interest on $500,000 of the debt but loses out on the interest paid on the remaining $250,000.

In the end, tax law and regulations are almost never as simple as they seem. Any time taxpayers engage in non-traditional forms of homeownership and lending arrangements, they are best advised to consult a professional tax advisor.