Your home is a tax shelter, too

November 5, 2004

If you think all you can deduct are mortgage interest and property taxes, you may be missing some significant savings.

Which of the following best describes your home?

A. A bottomless pit that swallows all your spare cash.

B. The inspiration for Murphy's Law: Whatever can go wrong, will.

All right, maybe C wasn't your first choice. But if you don't think of your home fondly at tax time, read on. The taxman still takes pity on homeowners. Here are nine ways you may be able to take advantage of his sympathy.

1. Deduct all the mortgage interest you can. Mortgage interest remains the sacred cow of income tax deductions. You can deduct interest you'll pay this year on up to $1 million of mortgage loans used to buy, build, or substantially improve your principal home and one other residence (or up to $500,000 if you're married filing separately).

Got a home equity loan? You can deduct interest on up to $100,000 of that debt as well, no matter how you spend the cash. Generally, mortgages and home equity loans you took out before Oct. 14, 1987, don't count toward the limit on how much you can deduct, although they reduce the limits on what you can deduct on money you borrow after that date. But if you refinanced a mortgage for more than the remaining principal balance amount, you can deduct the interest on the additional principal if it is home equity debt or home acquisition debt, used to build or improve the first or second home.

Suppose you took a home equity loan that pushed you over the $100,000 limit. One notable exception could preserve your interest deduction, says Joseph Unger, CPA, a partner with Weiser, an accounting firm in New York City. If you use the proceeds for a business purpose-to buy equipment for your practice, for example-you can treat the loan as business debt. You can use your home as collateral to borrow money, and that interest would be deductible as business interest.

2. Build up construction-interest deductions. Uncle Sam smiles less broadly on pioneering types who erect their own dwellings. "Interest on a construction loan becomes deductible only after construction begins," says Unger. "So if you took the loan before you started building, you can't deduct any interest you paid before the builders broke ground."

Also, the home must be your main or secondary residence when it's finished. Another limitation: You can deduct only interest you paid during a 24-month period beginning no earlier than the day construction started. If you've already started building but haven't applied for a loan yet, consider holding off on the loan until you finish the house. As long as you apply for the loan within 90 days after construction is completed, the clock starts ticking backward from the completion date. You can deduct interest on any amount borrowed (up to the $1 million mortgage-debt ceiling) to reimburse construction expenses you racked up within the prior 24 months.

No matter how good your timing, though, you can't take a deduction if the loan wasn't secured by the land you built the house on. Also, you can deduct interest only on principal you can link to construction costs.

3. Make the most of points you can deduct. If a lender charged you points for use of the money rather than for services (such as an appraisal or preparing the loan documents), you can deduct them as interest-generally, in equal amounts over the loan's life. But the tax code mucks up that simple rule with lots of exceptions and stipulations. Here's what they boil down to:

Deduct in full any points you'll pay this year for the mortgage you used to buy or build the home you live in, or for a home equity loan used to improve the dwelling. If you used only part of the equity loan proceeds to improve your home, you can deduct a proportionate share of the points now and claim the remainder in equal amounts over the rest of the loan's life. Divide your deductions for points on your second home's mortgage and those on a refinanced mortgage similarly.