Real Estate-Related Items You Cannot Deduct

Payments for the following items generally are not deductible as real estate taxes.

• Taxes for local benefits.
• Itemized charges for services (such as trash and garbage pickup fees).
• Transfer taxes (or stamp taxes).
• Rent increases due to higher real estate taxes.
• Homeowners' association charges.

Taxes for local benefits.   Deductible real estate taxes generally do not include taxes charged for local benefits and improvements that increase the value of your property. These include assessments for streets, sidewalks, water mains, sewer lines, public parking facilities, and similar improvements. You should increase the basis of your property by the amount of the assessment.

Local benefit taxes are deductible only if they are for maintenance, repair, or interest charges related to those benefits. If only a part of the taxes is for maintenance, repair, or interest, you must be able to show the amount of that part to claim the deduction. If you cannot determine what part of the tax is for maintenance, repair, or interest, none of it is deductible.

Taxes for local benefits may be included in your real estate tax bill. If your taxing authority (or mortgage lender) does not furnish you a copy of your real estate tax bill, ask for it. You should use the rules above to determine if the local benefit tax is deductible.

Itemized charges for services.   An itemized charge for services to specific property or people is not a tax, even if the charge is paid to the taxing authority. For example, you cannot deduct the charge as a real estate tax if it is:

• A unit fee for the delivery of a service (such as a $5 fee charged for every 1,000 gallons of water you use),
• A periodic charge for a residential service (such as a $20 per month or $240 annual fee charged to each homeowner for trash collection), or
• A flat fee charged for a single service provided by your government (such as a $30 charge for mowing your lawn because it was allowed to grow higher than permitted under your local ordinance).

You must look at your real estate tax bill to determine if any nondeductible itemized charges, such as those just listed, are included in the bill. If your taxing authority (or mortgage lender) does not furnish you a copy of your real estate tax bill, ask for it.

Exception.   Service charges used to maintain or improve services (such as trash collection or police and fire protection) are deductible as real estate taxes if:

1. The fees or charges are imposed at a like rate against all property in the taxing jurisdiction,
2. The funds collected are not earmarked; instead, they are commingled with general revenue funds, and
3. Funds used to maintain or improve services are not limited to or determined by the amount of these fees or charges collected.

Transfer taxes (or stamp taxes).   Transfer taxes and similar taxes and charges on the sale of a personal home are not deductible. If they are paid by the seller, they are expenses of the sale and reduce the amount realized on the sale. If paid by the buyer, they are included in the cost basis of the property.

Rent increase due to higher real estate taxes.   If your landlord increases your rent in the form of a tax surcharge because of increased real estate taxes, you cannot deduct the increase as taxes.

Homeowners' association charges.   These charges are not deductible because they are imposed by the homeowners' association, rather than the state or local government.

Personal Property Taxes

Personal property tax is deductible if it is a state or local tax that is:

1. Charged on personal property,
2. Based only on the value of the personal property, and
3. Charged on a yearly basis, even if it is collected more than once a year, or less than once a year.

A tax that meets the above requirements can be considered charged on personal property even if it is for the exercise of a privilege. For example, a yearly tax based on value qualifies as a personal property tax even if it is called a registration fee and is for the privilege of registering motor vehicles or using them on the highways.

Example.   Your state charges a yearly motor vehicle registration tax of 1% of value plus 50 cents per hundredweight. You paid $32 based on the value ($1,500) and weight (3,400 lbs.) of your car. You can deduct $15 (1% × $1,500) as a personal property tax, since it is based on the value. The remaining $17 ($.50 × 34), based on the weight, is not deductible.

Taxes and Fees You Cannot Deduct

Many federal, state, and local government taxes are not deductible because they do not fall within the categories discussed earlier. Other taxes and fees, such as federal income taxes, are not deductible because the tax law specifically prohibits a deduction for them.

Taxes and fees that are generally not deductible include the following items.

• Estate, inheritance, legacy, or succession taxes. These taxes are generally not deductible. However, you can deduct the estate tax attributable to income in respect of a decedent if you, as a beneficiary, must include that income in your gross income. In that case, deduct the estate tax as a miscellaneous deduction that is not subject to the 2%-of-adjusted-gross-income limit. For more information, see chapter 4.
• Federal income taxes. This includes taxes withheld from your pay.
• Fines. You cannot deduct penalties for violation of any law, including forfeiture of related collateral deposits.
• Gift taxes.
• License fees. You cannot deduct license fees for personal purposes (such as marriage, driver's, and dog license fees).
• Social security. This includes social security, Medicare, or railroad retirement taxes withheld from your pay.
• Social security and other employment taxes for household workers. You generally cannot deduct the social security or other employment taxes you pay on the wages of a household worker. However, you may be able to include them in medical or child care expenses. For more information, see chapters 23 and 33.

Many taxes and fees other than those listed above are also nondeductible, unless they are ordinary and necessary expenses of a business or income producing activity. For other nondeductible items, see Real Estate-Related Items You Cannot Deduct, earlier.

Where To Deduct

You deduct taxes on the following schedules.

State and local income taxes.   These taxes are deducted on line 5 of Schedule A (Form 1040), even if your only source of income is from business, rents, or royalties.

Foreign income taxes.   Generally, income taxes you pay to a foreign country or U.S. possession can be claimed as an itemized deduction on line 8 of Schedule A (Form 1040), or as a credit against your U.S. income tax on line 45 of Form 1040. To claim the credit, you may have to complete and attach Form 1116. For more information, see chapter 38 or the instructions for Form 1040 or get Publication 514.

Real estate taxes and personal property taxes.   These taxes are deducted on lines 6 and 7 of Schedule A (Form 1040), unless they are paid on property used in your business in which case they are deducted on Schedule C or Schedule F (Form 1040). Taxes on property that produces rent or royalty income are deducted on Schedule E (Form 1040).

Self-employment tax.   Deduct one-half of your self-employment tax on line 29, Form 1040.

Other taxes.   All other deductible taxes are deducted on line 8 of Schedule A (Form 1040).

Interest Expense

Important Reminders

Personal interest.   Personal interest is not deductible. Examples of personal interest include interest on a loan to purchase an automobile for personal use and credit card and installment interest incurred for personal expenses. But you may be able to deduct interest you pay on a qualified student loan. For details, see Publication 970, Tax Benefits for Education.

Limit on itemized deductions.   Certain itemized deductions (including home mortgage interest) are limited if your adjusted gross income is more than $137,300 ($68,650 if you are married filing a separate return). For more information, see chapter 22.

Introduction

This chapter discusses interest. Interest is the amount you pay for the use of borrowed money.

The types of interest you can deduct as itemized deductions on Schedule A (Form 1040) are:

• Home mortgage interest, including certain points, and
• Investment interest.

This chapter explains these deductions. It also explains where to deduct other types of interest and lists some types of interest you cannot deduct.

Use Table 25-1 to find out where to get more information on various types of interest, including investment interest.

Useful Items You may want to see:

Publication

• 936   Home Mortgage Interest Deduction

Home Mortgage Interest

Generally, home mortgage interest is any interest you pay on a loan secured by your home (main home or a second home). The loan may be a mortgage to buy your home, a second mortgage, a line of credit, or a home equity loan.

You can deduct home mortgage interest only if you meet all the following conditions.

• You must file Form 1040 and itemize deductions on Schedule A (Form 1040).
• You must be legally liable for the loan. You cannot deduct payments you make for someone else if you are not legally liable to make them. Both you and the lender must intend that the loan be repaid. In addition, there must be a true debtor-creditor relationship between you and the lender.
• The mortgage must be a secured debt on a qualified home. (Generally, your mortgage is a secured debt if you put your home up as collateral to protect the interests of the lender. The term qualified home means your main home or second home. For details, see Publication 936.)

Amount Deductible

In most cases, you will be able to deduct all of your home mortgage interest. Whether you can deduct all of it depends on the date you took out the mortgage, the amount of the mortgage, and your use of its proceeds.

Fully deductible interest.   If all of your mortgages fit into one or more of the following three categories at all times during the year, you can deduct all of the interest on those mortgages. (If any one mortgage fits into more than one category, add the debt that fits in each category to your other debt in the same category.)

The three categories are:

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 2002 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 2002 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).

The dollar limits for the second and third categories apply to the combined mortgages on your main home and second home.

See Part II of Publication 936 for more detailed definitions of grandfathered, home acquisition, and home equity debt.

You can use Figure 25-A to check whether your home mortgage interest is fully deductible.

Figure 25-A. Is My Interest Fully Deductible?

Limits on deduction.   You cannot fully deduct interest on a mortgage that does not fit into any of the three categories listed above. If this applies to you, see Part II of Publication 936 to figure the amount of interest you can deduct.

Special Situations

This section describes certain items that can be included as home mortgage interest and others that cannot. It also describes certain special situations that may affect your deduction.

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 performed 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.

Sale of home.   If you sell your home, you can deduct your home mortgage interest (subject to any limits that apply) paid up to, but not including, the date of sale.

Example.   John and Peggy Harris sold their home on May 7. Through April 30, they made home mortgage interest payments of $1,220. The settlement sheet for the sale of the home showed $50 interest for the 6-day period in May up to, but not including, the date of sale. Their mortgage interest deduction is $1,270 ($1,220 + $50).

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, see Points, 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.

For more information on the credit, see chapter 38.

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 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 in chapter 20.

Redeemable ground rent.   If you make annual or periodic rental payments on a redeemable ground rent, you can deduct them as mortgage interest.

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. For more information, see Publication 936.

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 earlier under Amount Deductible.

Refunds of interest.   If you receive a refund of interest in the same tax 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 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 chapter 13.

Points

The term points is used to describe certain charges paid, or treated as paid, by a borrower to obtain a home mortgage. Points may also be called loan origination fees, maximum loan charges, loan discount, or discount points.

A borrower is treated as paying any points that a home seller pays for the borrower's mortgage. See Points paid by the seller, later.

General rule.   You generally cannot deduct the full amount of points in the year paid. Because they are prepaid interest, you generally must deduct them over the life (term) of the mortgage.

Exception.   You can fully deduct points in the year paid if you meet all the following tests. (You can use Figure 25-B as a quick guide to see whether your points are fully deductible in the year paid.)

1. Your loan is secured by your main home.
2. Paying points is an established business practice in the area where the loan was made.
3. The points paid were not more than the points generally charged in that area.
4. You use the cash method of accounting. This means you report income in the year you receive it and deduct expenses in the year you pay them. (If you want more information about this method, see Accounting Methods in chapter 1.)
5. The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.
6. The funds you provided at or before closing, plus any points the seller paid, were at least as much as the points charged. The funds you provided do not have to have been applied to the points. They can include a down payment, an escrow deposit, earnest money, and other funds you paid at or before closing for any purpose. You cannot have borrowed these funds from your lender or mortgage broker.
7. You use your loan to buy or build your main home.
8. The points were computed as a percentage of the principal amount of the mortgage.
9. The amount is clearly shown on the settlement statement (such as the Uniform Settlement Statement, Form HUD-1) as points charged for the mortgage. The points may be shown as paid from either your funds or the seller's.

Figure 25–B. Are My Points Fully Deductible This Year?

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.

Home improvement loan.   You can also fully deduct in the year paid points paid on a loan to improve your main home, if tests (1) through (6) are met.

Second home. The Exception does not apply to points you pay on loans secured by your second home. You can deduct these points only over the life of the loan.

Exception does not apply.   If you do not qualify under the exception, or choose not to deduct the full amount of points in the year paid, see Points in chapter 5 of Publication 535, Business Expenses, for the rules on when and how much you can deduct. However, if the points relate to refinancing a home mortgage, see Refinancing, later.

Amounts charged for services.   Amounts charged by the lender for specific services connected to the loan are not interest. Examples of these charges are:

1. Appraisal fees,
2. Notary fees,
3. Preparation costs for the mortgage note or deed of trust,
4. Mortgage insurance premiums, and
5. VA funding fees.

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, Tax Information for First-Time Homeowners.

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 chapter 16 for information on the sale of 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 the Exception, earlier, are met, the buyer can deduct the points in the year paid. If any of those tests is not met, the buyer deducts the points over the life of the loan.

For information about basis, see chapter 14.

Funds provided are less than points.   If you meet all the tests in the Exception, earlier, except that the funds you provided were less than the points charged to you (test 6), you can deduct the points in the year paid, up to the amount of funds you provided. In addition, you can deduct any points paid by the seller.

Example 1.   When you took out a $100,000 mortgage loan to buy your home in December, you were charged one point ($1,000). You meet all the tests for deducting points in the year paid, except the only funds you provided were a $750 down payment. Of the $1,000 charged for points, you can deduct $750 in the year paid. You spread the remaining $250 over the life of the mortgage.

Example 2.   The facts are the same as in Example 1, except that the person who sold you your home also paid one point ($1,000) to help you get your mortgage. In the year paid, you can deduct $1,750 ($750 of the amount you were charged plus the $1,000 paid by the seller). You spread the remaining $250 over the life of the mortgage. You must reduce the basis of your home by the $1,000 paid by the seller.

Excess points.   If you meet all the tests in the Exception, earlier, except that the points paid were more than are 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.

Mortgage ending early.   If you spread your deduction for points over the life of the mortgage, you can deduct any remaining balance in the year the mortgage ends. However, if you refinance the mortgage with the same lender, you cannot deduct any remaining balance of spread points. Instead, deduct the remaining balance over the term of the new loan.

A mortgage may end early due to a prepayment, refinancing, foreclosure, or similar event.

Example.   Dan paid $3,000 in points in 1993 that he had to spread out over the 15-year life of the mortgage. He had deducted $1,800 of these points through 2001.

Dan prepaid his mortgage in full in 2002. He can deduct the remaining $1,200 of points in 2002.

Refinancing.   Generally, points you pay to refinance a mortgage are not deductible in full in the year you pay them. This is true even if the new mortgage is secured by your main home.

However, if you use part of the refinanced mortgage proceeds to improve your main home and you meet the first six tests listed under Exception, earlier, you can fully deduct the part of the points related to the improvement in the year you paid them with your own funds. You can deduct the rest of the points over the life of the loan.

Example 1.   In 1991, Bill Fields got a mortgage to buy a home. In 2002, Bill refinanced that mortgage with a 15-year $100,000 mortgage loan. The mortgage is secured by his home. To get the new loan, he had to pay three points ($3,000). Two points ($2,000) were for prepaid interest, and one point ($1,000) was charged for services, in place of amounts that ordinarily are stated separately on the settlement statement. Bill paid the points out of his private funds, rather than out of the proceeds of the new loan. The payment of points is an established practice in the area, and the points charged are not more than the amount generally charged there. Bill's first payment on the new loan was due July 1. He made six payments on the loan in 2002 and is a cash basis taxpayer.

Bill used the funds from the new mortgage to repay his existing mortgage. Although the new mortgage loan was for Bill's continued ownership of his main home, it was not for the purchase or improvement of that home. He cannot deduct all of the points in 2002. He can deduct two points ($2,000) ratably over the life of the loan. He deducts $67 [($2,000 ÷ 180 months) × 6 payments] of the points in 2002. The other point ($1,000) was a fee for services and is not deductible.

Example 2.   The facts are the same as in Example 1, except that Bill used $25,000 of the loan proceeds to improve his home and $75,000 to repay his existing mortgage. Bill deducts 25% ($25,000 ÷ $100,000) of the points ($2,000) in 2002. His deduction is $500 ($2,000 × 25%).

Bill also deducts the ratable part of the remaining $1,500 ($2,000 - $500) that must be spread over the life of the loan. This is $50 [($1,500 ÷ 180 months) × 6 payments] in 2002. The total amount Bill deducts in 2002 is $550 ($500 + $50).

Limits on deduction.   You cannot fully deduct points on a mortgage unless the mortgage fits into one of the categories listed earlier under Fully deductible interest. See Publication 936 for details.

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