What Is Acquisition Debt and How Does It Work?

Acquisition debt is a specific type of loan used to buy, build, or substantially improve a home. This classification is important for homeowners because the interest paid on this debt can often be deducted on a tax return, potentially lowering their overall tax liability.

Defining Qualified Acquisition Debt

A loan qualifies as acquisition debt if its proceeds are used to purchase, construct, or substantially improve a property, and the loan is secured by that home. While buying or building a home is straightforward, the concept of “substantially improving” a home requires more specific definition from the Internal Revenue Service (IRS).

A substantial improvement is a project that adds to the home’s value, prolongs its useful life, or adapts it to new uses. Examples include adding a new bedroom or bathroom, finishing a basement, a complete kitchen remodel, or installing a new HVAC system. These are distinct from basic repairs and maintenance, such as painting a room, fixing a leaky faucet, or replacing a broken window pane, which do not qualify.

The debt must be for a “qualified home,” which the IRS defines as a main home and one additional second home. A main home is the one where the owner lives most of the time. For a property to be considered a second home for tax purposes, the owner must use it for personal purposes for more than 14 days or more than 10% of the days it was rented out, whichever is longer.

The timing of the loan is also a factor. If a home is purchased with cash, the homeowner has a 90-day window from the purchase date to take out a mortgage that can be treated as acquisition debt. A mortgage secured after this 90-day period does not qualify.

Acquisition Debt Limits and Grandfathered Debt

The amount of acquisition debt on which you can deduct interest is capped. Following the Tax Cuts and Jobs Act of 2017 (TCJA), for mortgages taken out after December 15, 2017, the total acquisition debt cannot exceed $750,000 for individuals and married couples filing jointly, or $375,000 for those who are married and filing separately.

Debt incurred on or before December 15, 2017, is considered “grandfathered debt” and is subject to higher limits. Under these rules, homeowners can treat up to $1 million of mortgage debt as acquisition debt, or $500,000 for those married filing separately.

These limits apply to the total acquisition debt across a main and second home combined, not per property. For example, if a married couple filing jointly has a $600,000 mortgage on their main home and a $200,000 mortgage on a vacation home, they can only deduct the interest on the first $750,000 of their combined $800,000 debt.

An exception exists for homeowners who entered a binding written contract before December 15, 2017, to buy a home. If the purchase was completed before April 1, 2018, the mortgage is treated as grandfathered debt and is subject to the higher $1 million limit.

The Impact of Refinancing and Home Equity Loans

Refinancing an existing mortgage can affect its status as acquisition debt. When a homeowner refinances, the new loan is considered acquisition debt only up to the outstanding balance of the original mortgage. Any additional cash-out amount is not automatically acquisition debt; its tax treatment depends on how the funds are used.

If the cash-out portion is used for substantial home improvements, it can be added to the acquisition debt balance, subject to the overall limits. For example, if a homeowner with a $300,000 balance refinances for $350,000 and uses the extra $50,000 to remodel a bathroom, that $50,000 also becomes acquisition debt. If the money is used to pay off credit cards, it does not qualify.

The interest on home equity loans and home equity lines of credit (HELOCs) is deductible only if the funds are used to buy, build, or substantially improve the home securing the loan. The TCJA eliminated the previous rule that allowed a deduction for home equity debt regardless of its use, making the purpose of the funds the determining factor.

For example, a homeowner who uses a HELOC to consolidate student loan debt cannot deduct the interest. However, one who uses a HELOC for a major kitchen renovation can treat that loan as acquisition debt and deduct the interest, provided their total debt remains within the applicable limit.

Documenting Your Acquisition Debt

Maintaining thorough records is a necessary practice for any homeowner who plans to claim the mortgage interest deduction. In the event of an IRS audit, the burden of proof falls on the taxpayer to substantiate the amount of their acquisition debt and demonstrate how loan proceeds were used.

For the initial purchase of a home, the most important document is the settlement statement, often called a Closing Disclosure. This document provides a detailed breakdown of the transaction, including the loan amount that establishes the original acquisition debt. These closing documents should be kept for as long as you own the home and have the mortgage.

When using loan funds for substantial improvements, homeowners must keep all related records. This includes contracts with builders that outline the scope and cost of the work, as well as invoices, canceled checks, or bank statements showing payment.

If a homeowner performs the improvement work themselves, they must keep detailed receipts for all materials purchased. These receipts for items like lumber, drywall, and plumbing fixtures serve as proof of the costs incurred for the substantial improvement.