Questions About the Mortgage Deduction Limits

Mortgage interest is tax-deductible within certain limits. The limitations are $1,000,000 of acquisition debt and $100,000 of home equity debt. Combined, this means that loans of up to $1.1 million in loan principal could be tax-deductible. Once the loan principal goes over this threshold, we need to look at what the loan proceeds were used for to determine how much interest can be deducted.

This is exactly the scenario that one reader emailed me to ask about:

Mr. Perez, I just read your article “Limitations on the Mortgage Interest Deduction”, (very informative) and had a question related to this....

The question is: If you have over $1,000,000 in a primary mortgage for a primary residence, and the amount over $1,000,000 is limited, can you still take an interest deduction on a second mortgage if the second was used in either of these situations? 1. Purchased a new car or 2. Improvements to your primary residence.

If I understand correctly, the interest deduction is limited in normal situations on a second to 50%, but can any deduction be used in the above scenario?

There's a single $1 million limit on all home acquisition debt, covering both the primary or secondary residences. There's an additional $100,000 limit on home equity debt (also covers both primary and secondary residences). These limits are set by law under Code section 163(h)(3).

There is no "50%" limit. Instead, we prorate the amount of interest claimed as a deduction so that the amount claimed as a deduction falls within $1m and $100k limits on loan principal. For example, you have a $1.2m loan and the proceeds were used entirely to buy, build, or improve your home, then the prorated amount would be roughly 1/1.2 or 83.3% of the mortgage interest. The prorated amount will be different every year, since the loan principal will be decreasing as you make payments. The IRS provides worksheets you can use to figure the deductible portion of mortgage interest on pages 9 through 12 of Publication 936 (pdf).

So for the second loan, we would need to analyze what the proceeds were used for and the principal amount of the loan.

In the case where the proceeds are used to substantially improve the residence, that portion of the interest will be non-deductible, since the you are already over the $1m limit for acquisition indebtedness.

In the case where the proceeds are used to buy a car, the interest may be deductible. That portion of the loan principal is home equity debt, and interest on home equity debt of up to $100k is deductible; the remainder is non-deductible. Making the further assumption that your first mortgage was used entirely to buy, build, or improve the residence, then the portion relating to the car would be deductible, up to the $100,000 limit on loan principal.