IRS Publication 936

1. Mortgages you took out on or before October 13, 1987 (called grandfathered debt).

2. Mortgages you took out after October 13, 1987, to buy, build, or improve your home (called home acquisition debt), but only if throughout 2004 these mortgages plus any grandfathered debt totaled $1 million or less ($500,000 or less if married filing separately).

3. Mortgages you took out after October 13, 1987, other than to buy, build, or improve your home (called home equity debt), but only if throughout 2004 these mortgages totaled $100,000 or less ($50,000 or less if married filing separately) and totaled no more than the fair market value of your home reduced by (1) and (2).

• Makes your ownership in a qualified home security for payment of the debt,

• Provides, in case of default, that your home could satisfy the debt, and

• Is recorded or is otherwise perfected under any state or local law that applies.

Debt not secured by home.   A debt is not secured by your home if it is secured solely because of a lien on your general assets or if it is a security interest that attaches to the property without your consent (such as a mechanic's lien or judgment lien).   A debt is not secured by your home if it once was, but is no longer secured by your home.

Choice to treat the debt as not secured by your home.   You can choose to treat any debt secured by your qualified home as not secured by the home. This treatment begins with the tax year for which you make the choice and continues for all later tax years. You may revoke your choice only with the consent of the Internal Revenue Service (IRS).   You may want to treat a debt as not secured by your home if the interest on that debt is fully deductible (for example, as a business expense) whether or not it qualifies as home mortgage interest. This may allow you, if the limits in Part II apply to you, more of a deduction for interest on other debts that are deductible only as home mortgage interest.

Cooperative apartment owner.   If you own stock in a cooperative housing corporation, see the Special Rule for Tenant-Stockholders in Cooperative Housing Corporations, near the end of this Part I.

Main home.   You can have only one main home at any one time. This is the home where you ordinarily live most of the time.

Second home.   A second home is a home that you choose to treat as your second home.

Second home not rented out.   If you have a second home that you do not hold out for rent or resale to others at any time during the year, you can treat it as a qualified home. You do not have to use the home during the year.

Second home rented out.   If you have a second home and rent it out part of the year, you also must use it as a home during the year for it to be a qualified home. You must use this home more than 14 days or more than 10% of the number of days during the year that the home is rented at a fair rental, whichever is longer. If you do not use the home long enough, it is considered rental property and not a second home. For information on residential rental property, see Publication 527.

Divided use of your home.   The only part of your home that is considered a qualified home is the part you use for residential living. If you use part of your home for other than residential living, such as a home office, you must allocate the use of your home. You must then divide both the cost and fair market value of your home between the part that is a qualified home and the part that is not. Dividing the cost may affect the amount of your home acquisition debt, which is limited to the cost of your home plus the cost of any improvements. (See Home Acquisition Debt in Part II.) Dividing the fair market value may affect your home equity debt limit, also explained in Part II.

Office in home.   If you have an office in your home that you use in your business, see Publication 587, Business Use of Your Home. It explains how to figure your deduction for the business use of your home, which includes the business part of your home mortgage interest.

Home under construction.   You can treat a home under construction as a qualified home for a period of up to 24 months, but only if it becomes your qualified home at the time it is ready for occupancy.   The 24-month period can start any time on or after the day construction begins.

Home destroyed.   You may be able to continue treating your home as a qualified home even after it is destroyed in a fire, storm, tornado, earthquake, or other casualty. This means you can continue to deduct the interest you pay on your home mortgage, subject to the limits described in this publication.   You can continue treating a destroyed home as a qualified home if, within a reasonable period of time after the home is destroyed, you:

Rebuild the destroyed home and move into it, or

Sell the land on which the home was located.

This rule applies to your main home and to a second home that you treat as a qualified home.

Time-sharing arrangements.   You can treat a home you own under a time-sharing plan as a qualified home if it meets all the requirements. A time-sharing plan is an arrangement between two or more people that limits each person's interest in the home or right to use it to a certain part of the year.

Rental of time-share.   If you rent out your time-share, it qualifies as a second home only if you also use it as a home during the year. See Second home rented out, earlier, for the use requirement. To know whether you meet that requirement, count your days of use and rental of the home only during the time you have a right to use it or to receive any benefits from the rental of it.

Married taxpayers.   If you are married and file a joint return, your qualified home(s) can be owned either jointly or by only one spouse.

Separate returns.   If you are married filing separately and you and your spouse own more than one home, you can each take into account only one home as a qualified home. However, if you both consent in writing, then one spouse can take both the main home and a second home into account.

Late payment charge on mortgage payment.   You can deduct as home mortgage interest a late payment charge if it was not for a specific service in connection with your mortgage loan.

Mortgage prepayment penalty.   If you pay off your home mortgage early, you may have to pay a penalty. You can deduct that penalty as home mortgage interest provided the penalty is not for a specific service performed or cost incurred in connection with your mortgage loan.

Prepaid interest.   If you pay interest in advance for a period that goes beyond the end of the tax year, you must spread this interest over the tax years to which it applies. You can deduct in each year only the interest that qualifies as home mortgage interest for that year. However, there is an exception that applies to points, discussed later.

Mortgage interest credit.    You may be able to claim a mortgage interest credit if you were issued a mortgage credit certificate (MCC) by a state or local government. Figure the credit on Form 8396, Mortgage Interest Credit. If you take this credit, you must reduce your mortgage interest deduction by the amount of the credit.   See Form 8396 and Publication 530 for more information on the mortgage interest credit.

Ministers' and military housing allowance.   If you are a minister or a member of the uniformed services and receive a housing allowance that is not taxable, you can still deduct your home mortgage interest.

Mortgage assistance payments.   If you qualify for mortgage assistance payments for lower-income families under section 235 of the National Housing Act, part or all of the interest on your mortgage may be paid for you. You cannot deduct the interest that is paid for you.

No other effect on taxes.   Do not include these mortgage assistance payments in your income. Also, do not use these payments to reduce other deductions, such as real estate taxes.

Divorced or separated individuals.   If a divorce or separation agreement requires you or your spouse or former spouse to pay home mortgage interest on a home owned by both of you, the payment of interest may be alimony. See the discussion of Payments for jointly-owned home under Alimony in Publication 504, Divorced or Separated Individuals.

Redeemable ground rents.   In some states (such as Maryland), you may buy your home subject to a ground rent. A ground rent is an obligation you assume to pay a fixed amount per year on the property. Under this arrangement, you are leasing (rather than buying) the land on which your home is located.   If you make annual or periodic rental payments on a redeemable ground rent, you can deduct them as mortgage interest.   A ground rent is a redeemable ground rent if all of the following are true.

• Your lease, including renewal periods, is for more than 15 years.

• You can freely assign the lease.

• You have a present or future right (under state or local law) to end the lease and buy the lessor's entire interest in the land by paying a specific amount.

• The lessor's interest in the land is primarily a security interest to protect the rental payments to which he or she is entitled.

Payments made to end the lease and to buy the lessor's entire interest in the land are not ground rents. You cannot deduct them.

Nonredeemable ground rent.   Payments on a nonredeemable ground rent are not mortgage interest. You can deduct them as rent if they are a business expense or if they are for rental property.

Rental payments.   If you live in a house before final settlement on the purchase, any payments you make for that period are rent and not interest. This is true even if the settlement papers call them interest. You cannot deduct these payments as home mortgage interest.

Mortgage proceeds invested in tax-exempt securities.   You cannot deduct the home mortgage interest on grandfathered debt or home equity debt if you used the proceeds of the mortgage to buy securities or certificates that produce tax-free income. “Grandfathered debt” and “home equity debt” are defined in Part II of this publication.

Refunds of interest.   If you receive a refund of interest in the same year you paid it, you must reduce your interest expense by the amount refunded to you. If you receive a refund of interest you deducted in an earlier year, you generally must include the refund in income in the year you receive it. However, you need to include it only up to the amount of the deduction that reduced your tax in the earlier year. This is true whether the interest overcharge was refunded to you or was used to reduce the outstanding principal on your mortgage. If you need to include the refund in income, report it on Form 1040, line 21.   If you received a refund of interest you overpaid in an earlier year, you generally will receive a Form 1098, Mortgage Interest Statement, showing the refund in box 3. For information about Form 1098, see Mortgage Interest Statement, later.   For more information on how to treat refunds of interest deducted in earlier years, see Recoveries in Publication 525, Taxable and Nontaxable Income.

Cooperative apartment owner.   If you own a cooperative apartment, you must reduce your home mortgage interest deduction by your share of any cash portion of a patronage dividend that the cooperative receives. The patronage dividend is a partial refund to the cooperative housing corporation of mortgage interest it paid in a prior year.   If you receive a Form 1098 from the cooperative housing corporation, the form should show only the amount you can deduct.

General rule.   You generally cannot deduct the full amount of points in the year paid. Because they are prepaid interest, you generally deduct them ratably over the life (term) of the mortgage. However, see Deduction allowed in year paid, and Home improvement loan.

Note.

If you meet all of these tests, you can choose to either fully deduct the points in the year paid, or deduct them over the life of the loan.

Original issue discount.   If you do not qualify to either deduct the points in the year paid or deduct them ratably over the life of the loan, or if you choose not to use either of these methods, the points reduce the issue price of the loan. This reduction results in original issue discount, which is discussed in chapter 5 of Publication 535.

You cannot deduct these amounts as points either in the year paid or over the life of the mortgage. For information about the tax treatment of these amounts and other settlement fees and closing costs, get Publication 530.

Points paid by the seller.   The term “points” includes loan placement fees that the seller pays to the lender to arrange financing for the buyer.

Treatment by seller.   The seller cannot deduct these fees as interest. But they are a selling expense that reduces the amount realized by the seller. See Publication 523 for information on selling your home.

Treatment by buyer.   The buyer reduces the basis of the home by the amount of the seller-paid points and treats the points as if he or she had paid them. If all the tests under Deduction allowed in year paid, earlier, are met, the buyer can deduct the points in the year paid. If any of those tests are not met, the buyer deducts the points over the life of the loan.   If you need information about the basis of your home, see Publication 523 or Publication 530.

Excess points.   If you meet all the tests in Deduction in year paid, earlier, except that the points paid were more than generally paid in your area ( test (3)), you deduct in the year paid only the points that are generally charged. You must spread any additional points over the life of the mortgage.

Limits on deduction.   You cannot fully deduct points paid on a mortgage that exceeds the limits discussed in Part II. See the Table 1 Instructions for line 10.

Form 1098.    The mortgage interest statement you receive should show not only the total interest paid during the year, but also your deductible points paid during the year. See Mortgage Interest Statement, next.

Prepaid interest on Form 1098.   If you prepaid interest in 2004 that accrued in full by January 15, 2005, this prepaid interest may be included in box 1 of Form 1098. However, you cannot deduct the prepaid amount for January 2005 in 2004. (See Prepaid interest, earlier.) You will have to figure the interest that accrued for 2005 and subtract it from the amount in box 1. You will include the interest for January 2005 with other interest you pay for 2005.

Refunded interest.   If you received a refund of mortgage interest you overpaid in an earlier year, you generally will receive a Form 1098 showing the refund in box 3. See Refunds of interest under Special Situations, earlier.

More than one borrower.   If you and at least one other person (other than your spouse if you file a joint return) were liable for and paid interest on a mortgage that was for your home, and the other person received a Form 1098 showing the interest that was paid during the year, attach a statement to your return explaining this. Show how much of the interest each of you paid, and give the name and address of the person who received the form. Deduct your share of the interest on Schedule A (Form 1040), line 11, and print “See attached” next to the line.   Similarly, if you are the payer of record on a mortgage on which there are other borrowers entitled to a deduction for the interest shown on the Form 1098 you received, deduct only your share of the interest on Schedule A (Form 1040), line 10. You should let each of the other borrowers know what his or her share is.

Mortgage proceeds used for business or investment.   If your home mortgage interest deduction is limited under the rules explained in Part II, but all or part of the mortgage proceeds were used for business, investment, or other deductible activities, see Table 2 near the end of this publication. It shows where to deduct the part of your excess interest that is for those activities. The Table 1 Instructions for line 13 in Part II explain how to divide the excess interest among the activities for which the mortgage proceeds were used.

Figuring deductible home mortgage interest.   Generally, if you are a tenant-stockholder, you can deduct payments you make for your share of the interest paid or incurred by the cooperative. The interest must be on a debt to buy, build, change, improve, or maintain the cooperative's housing, or on a debt to buy the land.   Figure your share of this interest by multiplying the total by the following fraction.

Limits on deduction.   To figure how the limits discussed in Part II apply to you, treat your share of the cooperative's debt as debt incurred by you. The cooperative should determine your share of its grandfathered debt, its home acquisition debt, and its home equity debt. (Your share of each of these types of debt is equal to the average balance of each debt multiplied by the fraction just given.) After your share of the average balance of each type of debt is determined, you include it with the average balance of that type of debt secured by your stock.

Form 1098.    The cooperative should give you a Form 1098 showing your share of the interest. Use the rules in this publication to determine your deductible mortgage interest.

Home acquisition debt limit.   The total amount you can treat as home acquisition debt at any time on your main home and second home cannot be more than $1 million ($500,000 if married filing separately). This limit is reduced (but not below zero) by the amount of your grandfathered debt (discussed later). Debt over this limit may qualify as home equity debt (also discussed later).

Refinanced home acquisition debt.   Any secured debt you use to refinance home acquisition debt is treated as home acquisition debt. However, the new debt will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing. Any additional debt is not home acquisition debt, but may qualify as home equity debt (discussed later).

Mortgage that qualifies later.   A mortgage that does not qualify as home acquisition debt because it does not meet all the requirements may qualify at a later time. For example, a debt that you use to buy your home may not qualify as home acquisition debt because it is not secured by the home. However, if the debt is later secured by the home, it may qualify as home acquisition debt after that time. Similarly, a debt that you use to buy property may not qualify because the property is not a qualified home. However, if the property later becomes a qualified home, the debt may qualify after that time.

Date of the mortgage.   The date you take out your mortgage is the day the loan proceeds are disbursed. This is generally the closing date. You can treat the day you apply in writing for your mortgage as the date you take it out. However, this applies only if you receive the loan proceeds within a reasonable time (such as within 30 days) after your application is approved. If a timely application you make is rejected, a reasonable additional time will be allowed to make a new application.

Cost of home or improvements.   To determine your cost, include amounts paid to acquire any interest in a qualified home or to substantially improve the home.   The cost of building or substantially improving a qualified home includes the costs to acquire real property and building materials, fees for architects and design plans, and required building permits.

Substantial improvement.   An improvement is substantial if it:

• Adds to the value of your home,

• Prolongs your home's useful life, or

• Adapts your home to new uses.

Repairs that maintain your home in good condition, such as repainting your home, are not substantial improvements. However, if you paint your home as part of a renovation that substantially improves your qualified home, you can include the painting costs in the cost of the improvements.

Acquiring an interest in a home because of a divorce.   If you incur debt to acquire the interest of a spouse or former spouse in a home, because of a divorce or legal separation, you can treat that debt as home acquisition debt.

Part of home not a qualified home.    To figure your home acquisition debt, you must divide the cost of your home and improvements between the part of your home that is a qualified home and any part that is not a qualified home. See Divided use of your home under Qualified Home in Part I.