What Qualifies as Acquisition Debt for Your Mortgage?

Acquisition debt is a mortgage secured by a qualified home, where the funds are used specifically to buy, build, or substantially improve that home. This classification is the basis for the home mortgage interest deduction, one of the most significant tax benefits available to individuals. The amount of interest you can deduct is tied directly to the amount of your acquisition debt, subject to specific federal limits. Correctly identifying what portion of a mortgage qualifies as acquisition debt is a necessary step for any taxpayer looking to accurately calculate their itemized deductions.

What Qualifies as Acquisition Debt

For a loan to be considered acquisition debt, its proceeds must be used for one of three specific purposes: buying, building, or substantially improving a qualified home. The “buy” and “build” components refer to the funds used to either purchase an existing home or to finance the construction of a new one. This includes the costs of land, materials, and labor associated with the construction project. The loan must be secured by the home it is being used to acquire or build.

A substantial improvement is a change 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, a major kitchen renovation, installing a new heating and air-conditioning system, or replacing the entire roof. These are distinct from routine repairs and maintenance, which do not qualify. Painting a room or fixing a leak are considered maintenance.

A qualified home is a taxpayer’s main home or one other secondary residence. To be considered a qualified home, a second property must meet personal use requirements. You must use it for more than 14 days or more than 10% of the days it is rented out, whichever is longer. A taxpayer can only have one main home and one second home that qualifies for the mortgage interest deduction.

The primary difference between acquisition debt and a home equity loan is the use of the funds. If a homeowner borrows against their property for personal expenses like consolidating credit card debt, that loan is considered home equity debt. Interest on home equity debt is not deductible unless the proceeds are used to buy, build, or substantially improve the home, in which case it can be treated as acquisition debt.

Deductible Loan Limits

The amount of acquisition debt on which you can deduct interest is subject to dollar limitations based on when the mortgage was secured. For mortgages taken out after December 15, 2017, a taxpayer can deduct the interest on a total of $750,000 of acquisition debt. This limit is halved to $375,000 for married taxpayers filing separately. For mortgages secured on or before December 15, 2017, homeowners can deduct interest on up to $1 million in acquisition debt, or $500,000 for married couples filing separately. The date the mortgage was secured determines which limit applies.

These limits are a total for each taxpayer, not per property. If you have acquisition debt on both a main home and a second home, the combined total of the loans cannot exceed the applicable limit ($750,000 or $1 million) to fully deduct the interest. For example, if a taxpayer has a $500,000 mortgage on their main home and a $300,000 mortgage on a vacation home, both taken out in 2019, their total acquisition debt is $800,000. Since this exceeds the $750,000 limit, they will not be able to deduct all of the interest paid.

The Tax Cuts and Jobs Act’s changes to these limits are set to expire at the end of 2025. If no new legislation is passed, the limits are scheduled to revert to the pre-TCJA levels of $1 million for most filers and $500,000 for married individuals filing separately.

How Refinancing Affects Acquisition Debt

Refinancing a mortgage has specific implications for how acquisition debt is treated. When you refinance an existing mortgage, the new loan maintains its status as acquisition debt up to the principal balance of the old mortgage at the time of the refinancing.

The situation is more complex with a “cash-out” refinance, where the new mortgage is for a larger amount than the old one. The portion of the new loan that equals the old mortgage’s balance remains acquisition debt, but the extra cash received is treated as home equity debt. An exception exists if the cash-out proceeds are used to substantially improve the qualified home. In that case, that portion of the funds can be added to the acquisition debt balance, subject to the overall deduction limits.

Consider a numerical example for clarity. A homeowner has a remaining mortgage balance of $250,000, which is all acquisition debt. They refinance for $300,000, taking $50,000 in cash to pay off student loans. After the refinance, only $250,000 of the new mortgage is treated as acquisition debt. The remaining $50,000 is home equity debt, and the interest paid on that portion is not deductible because the funds were not used to improve the home.

Calculating Your Deductible Interest

To calculate your deductible mortgage interest, first determine if your total mortgage debt is below the legal limit. For most homeowners in this situation, the process is straightforward. Your lender will send you Form 1098, Mortgage Interest Statement, which reports the total interest you paid, and this figure is fully deductible.

If your total mortgage balance exceeds the applicable limit, you must calculate the deductible portion. First, determine your average mortgage balance for the year, which may be provided by your lender. Then, divide the applicable debt limit ($750,000 or $1 million) by your average mortgage balance to find the deductible percentage. Multiply this percentage by the total interest you paid for the year. For example, with a $900,000 average balance subject to the $750,000 limit, you would divide $750,000 by $900,000 to get 0.833. If you paid $30,000 in interest, your deductible interest is $24,990.

After calculating the correct amount, you report it on Schedule A (Form 1040), Itemized Deductions. The mortgage interest deduction is claimed on line 8a of this form. Claiming this deduction requires you to itemize rather than taking the standard deduction.