A good place to check out what you can deduct before you borrow is the chart on page 3 of IRS Publication 936. It’ll walk you through the requirements you must meet to deduct all of your home loan interest. The first hurdle you'll run into is the total amount of your loan or loans. In general, individuals and couples filing jointly can deduct interest on loans up to $1 million ($500,000 if you're married and filing separately). The money must have been used for acquisition costs — that is the cost to buy, build, or substantially improve a home.
Spend loan proceeds wisely
The other limitation comes into play when you take out a home equity loan or HELOC, even if you don’t use the proceeds to buy, build, or improve your home. In that case, you can deduct interest on up to $100,000 ($50,000 if married filing separately) on outstanding home equity debt. This loan limit also applies in a cash-out refi, in which you refinance and take out part of the equity you’ve built up as cash. That means if you decide to take out a $115,000 home equity loan to buy that Porsche, you can deduct the interest on the first $100,000 but not on the $15,000 that exceeds the limit. Use the same $115,000 to add a new bedroom, however, and the full amount is allowable under the $1 million cap. Keep in mind, though, that the $115,000 gets added into the pot of whatever else you owe on your other home loans. In many cases, points and loan origination costs for HELOCs are deductible.
Consider this simplified scenario: You borrow $250,000 against your home at 8% interest. That means you’ll pay $20,000 in interest the first year. Spend the $250,000 on home improvements, and all of the interest is deductible. Spend $150,000 on improvements and $100,000 on your kids’ college tuition, and all the interest is still deductible.
Even if you've followed all the loan limit rules, you can still get stuck paying tax on mortgage interest. How come? It's all thanks to the Alternative Minimum Tax. Congress created the AMT, which limits or eliminates many deductions, as a way to keep the wealthy from dodging their fair share of taxes.
Calculating the AMT can be complex, but if you make more than $75,000 and have several kids or other deductions, you might well be subject to it. Problem is, if you fall into the AMT group, you may not be able to deduct interest on a home equity loan, even if the loan falls within the $1 million/$100,000 limit. If you're subject to the AMT and borrow money against the value of your home, you'll have to use it to buy, build, or improve your place, or you may not have a chance to deduct the interest.