California Mortgage Interest Deduction Limit: What You Need to Know

California’s mortgage interest deduction limit is a critical factor for homeowners and prospective buyers, influencing financial planning and tax obligations. With rising real estate prices, understanding these limits is essential for maximizing tax benefits.

This article examines various aspects of California’s mortgage interest deduction limit, including current thresholds, eligible loan types, and other important considerations.

Current Loan Limit Threshold

The Tax Cuts and Jobs Act (TCJA) caps the mortgage interest deduction at $750,000 for married couples filing jointly and $375,000 for married individuals filing separately as of 2024. This applies to loans used to buy, build, or substantially improve a primary or secondary residence taken out after December 15, 2017. Loans from before this date have a higher limit of $1 million ($500,000 for married individuals filing separately).

In high-cost areas like California, where property values often exceed national averages, these thresholds can significantly impact homeowners. If a mortgage principal exceeds $750,000, only the interest on the first $750,000 is deductible. This limitation can influence tax strategies, especially for those with substantial mortgage debt.

Eligible Loan Types

The Internal Revenue Code (IRC) Section 163(h) defines the types of loans eligible for the mortgage interest deduction. These include acquisition indebtedness, which refers to loans used to purchase, construct, or improve a qualified residence. This category includes traditional mortgages, home equity loans, and refinanced loans, provided the refinanced amount does not exceed the original mortgage’s principal balance.

Home equity loans are eligible for interest deduction only if the borrowed funds are used for significant home improvements. If the funds are used for unrelated purposes, such as paying off personal debt, the interest is not deductible.

Refinanced loans also require attention. The interest on the new loan remains deductible only if it does not exceed the balance of the original acquisition indebtedness. Careful documentation of fund allocation is essential to ensure compliance with IRS guidelines.

When Loans Exceed the Threshold

For loans exceeding $750,000, only the interest on the first $750,000 is deductible. Homeowners may restructure their loans to align with deductible limits. Refinancing to reduce the principal below the threshold or making additional principal payments can bring more of the interest into deductible territory over time.

Homeowners unable to restructure their loans should evaluate the impact on their tax liability and consult a tax professional. Exploring alternative deductions or credits may help offset the non-deductible interest. Maintaining accurate records of interest payments is essential for compliance and audits.

Special Handling for Second Homes

Mortgage interest deductions for second homes differ from primary residences. A second home qualifies for deductions if it is used as a personal residence for part of the year. If rented out, the homeowner must occupy it for at least 14 days or 10% of the rental period, whichever is greater, to maintain its status as a second home.

For those who rent their second homes, rental income must be reported, and expenses, including a portion of the mortgage interest, property taxes, and maintenance costs, can be deducted proportionately based on the rental period versus personal use. Accurate record-keeping is critical. If personal use exceeds the limits, the property may be classified as a rental, changing how mortgage interest is deducted under passive activity loss rules.

Mortgage Points and Prepaid Interest

Mortgage points and prepaid interest provide additional ways to manage mortgage interest deductions. Mortgage points, or discount points, are fees paid upfront to lower the loan’s interest rate. Each point typically costs 1% of the loan amount and reduces the interest rate by about 0.25%. Points are deductible in the year they are paid if they meet IRS criteria outlined in Publication 936.

Prepaid interest, paid at closing to cover the period between the closing date and month’s end, can also be deducted, but only for the portion applicable to the tax year in question. Points on refinanced loans are generally amortized over the loan’s life rather than being deducted in full the year they are paid. Accurate documentation, such as the HUD-1 Settlement Statement or Closing Disclosure, is necessary to support these deductions.

Documentation Requirements

Maintaining proper documentation is vital for claiming mortgage interest deductions. Homeowners should retain Form 1098, issued annually by lenders, summarizing total interest paid during the year. This form is key for reconciling deductions on tax returns.

Closing documents, such as the Closing Disclosure or HUD-1 Settlement Statement, detail points paid and prepaid interest and should also be kept. For refinanced or home equity loans, records demonstrating fund use, especially for home improvements, are essential.

For those with loans exceeding the threshold or second homes, documentation requirements are more stringent. Taxpayers must provide detailed calculations showing deductible interest and records of personal versus rental use for second homes. Organized record-keeping simplifies compliance and assists in responding to IRS inquiries.