What Is the Definition of Qualified Residence Interest?
The tax rules for deducting mortgage interest are nuanced. Learn how your eligibility is shaped by your property type, loan purpose, and debt origination date.
Qualified residence interest is the interest taxpayers pay on a loan secured by their primary home or a second home. This deduction can reduce a homeowner’s taxable income, but it is governed by a detailed set of rules and limitations. The Internal Revenue Service (IRS) provides specific guidance on what constitutes qualified residence interest, differentiating between debt used to acquire a home and other types of debt secured by the property.
Recent tax law changes have refined these definitions, impacting the deductibility of interest for many homeowners. To claim the deduction, taxpayers must meet requirements regarding the type of property, the use of the loan, and specific dollar thresholds.
Defining a Qualified Residence
A taxpayer can deduct mortgage interest on up to two qualified residences each tax year: a main home and a second home. A main home is the property where the taxpayer lives most of the time during the year, which is often determined by the address on legal documents like a driver’s license and voter registration.
A second home must also meet certain criteria. If the second home is rented out, the taxpayer must use it personally for more than 14 days or more than 10% of the days it is rented at fair market value, whichever is greater. If the second home is not rented out, it is automatically considered a qualified residence. A taxpayer with multiple other residences can choose which one to treat as the second qualified residence for the tax year, and this choice can be changed annually.
A qualified residence is not limited to a traditional house. It can also be a:
- Condominium
- Cooperative
- Mobile home
- House trailer
- Boat with sleeping, cooking, and toilet facilities
Types of Qualifying Debt
The deductibility of mortgage interest depends on how the loan proceeds were used. The tax code categorizes debt secured by a qualified residence into specific types, each with its own set of rules.
Acquisition Indebtedness
Acquisition indebtedness is debt incurred to buy, build, or substantially improve a qualified residence, and it must be secured by that home. A “substantial improvement” is one that adds to the value of the home, prolongs its useful life, or adapts it to new uses, such as adding a new room or remodeling a kitchen. Routine repairs and maintenance do not qualify.
Refinanced acquisition debt is also treated as acquisition indebtedness up to the outstanding balance of the original loan just before the refinancing. Any additional cash received from a refinancing that is not used for substantial improvements does not qualify as acquisition debt.
Home Equity Indebtedness
Home equity indebtedness is debt secured by a qualified residence but not used to buy, build, or substantially improve it. The Tax Cuts and Jobs Act of 2017 (TCJA) suspended the deduction for interest on home equity indebtedness for tax years 2018 through 2025.
There is an exception to this rule. If the proceeds of a home equity loan, line of credit, or second mortgage are used to buy, build, or substantially improve the taxpayer’s home, the interest can be deducted as home acquisition debt, subject to the overall debt limits.
Grandfathered Debt
A special category exists for mortgage debt taken out on or before October 13, 1987, which is referred to as “grandfathered debt.” This debt is treated as acquisition indebtedness regardless of how the loan proceeds were used.
Grandfathered debt is not subject to the same acquisition debt limits as newer mortgages, but it is included when determining if a taxpayer is within the overall limits. When a taxpayer refinances grandfathered debt, the new loan retains this status only up to the outstanding principal balance of the old mortgage at the time of refinancing.
Debt Limitation Rules
The amount of mortgage interest a taxpayer can deduct is limited by the total amount of their mortgage debt. These limits apply to the combined total of mortgage debt on both a main home and a second home, and the applicable threshold depends on when the mortgage was taken out.
For mortgage debt incurred after December 15, 2017, the rules established by the TCJA apply. Under these regulations, a taxpayer can deduct the interest on a maximum of $750,000 of acquisition indebtedness. For married taxpayers filing separately, this limit is $375,000. This provision is scheduled to expire at the end of 2025, at which point the limit will revert to $1 million unless Congress acts.
For mortgage debt incurred on or before December 15, 2017, the older limits still apply. Taxpayers can deduct the interest on up to $1 million of acquisition indebtedness. The limit for married taxpayers filing separately under these rules is $500,000. If a taxpayer refinances a mortgage from this period, they can continue to use the higher $1 million limit on the remaining balance of the original loan.
Calculating the Deductible Interest
If the total balance of all home acquisition debt throughout the year is below the applicable limit ($750,000 or $1 million), then all of the mortgage interest paid is generally deductible. This amount is reported by the lender on Form 1098, the Mortgage Interest Statement.
The calculation becomes more complex when the total mortgage balance exceeds the applicable debt limit. In this situation, the taxpayer must determine the portion of the interest that relates to the amount of debt within the limit. This requires a specific formula to allocate the interest between the deductible and non-deductible parts of the loan.
To calculate the deductible interest when the loan balance is over the limit, divide the deductible debt limit by the average balance of the mortgage for the year. Then, multiply this result by the total interest paid for the year. For example, if a taxpayer has a mortgage with an average balance of $900,000, is subject to the $750,000 limit, and paid $36,000 in interest, the deductible portion is $30,000. The calculation is: ($750,000 / $900,000) x $36,000 = $30,000.
Taxpayers with multiple mortgages on their qualified residences must combine the average balances of all loans to perform this calculation. The IRS provides worksheets in Publication 936 to help taxpayers accurately determine their qualified residence interest deduction.