However, many taxpayers and their advisers fail to realize that there are actually several limitations to the ability to deduct mortgage interest and that the rules are not nearly as simple as they might think. Failure to comply with the applicable guidelines and restrictions can result in a partial or complete loss of deductibility. This is because under the IRC, there are actually two different kinds of "mortgage interest" for tax purposes. Different rules, restrictions, and deductibility limitations apply to each type of mortgage interest. In addition, as more taxpayers find themselves affected by the alternative minimum tax (AMT), the picture gets more complicated.

Acquisition indebtedness. The first type of mortgage interest defined under the tax code is called "acquisition indebtedness." This refers to any kind of borrowing that is incurred to acquire, build, or substantially improve a taxpayer's residence and is secured by that residence.

The tax code further clarifies that "residence" actually means not only the individual's principal residence, but also a second residence (i.e., vacation home) that's used by the taxpayer as a residence. Unfortunately, if the vacation home is used and reported as rental property, it is not eligible for treatment as a residence (although interest may still be deductible as a rental expense).

The interest on loans that are treated as acquisition indebtedness is deductible for the first $1 million of debt principal (assuming the taxpayer itemizes deductions on Schedule A of the tax return). This total debt limit is aggregated if the taxpayer has acquisition indebtedness attributable to two residences; thus, if a taxpayer already has $600,000 of acquisition indebtedness against one residence, he or she can treat up to an additional $400,000 of borrowing to purchase a second residence as acquisition indebtedness and still stay within the $1 million debt limit. Note that this debt limit restriction applies to the amount of debt principal borrowed, not the amount of interest payments made.

Thus, if an individual has a mortgage of $1 million, the interest payments will be deductible, whether they are $60,000 (approximately 6% interest rate) or $120,000 (approximately 12% interest rate). However, if the taxpayer borrows more than $1 million, the excess cannot be treated as acquisition indebtedness, even if the loan is at a 4% interest rate and the total interest payments are much less than $120,000 or $60,000.

Home equity indebtedness. Any mortgage debt secured by a residence that does not qualify as acquisition indebtedness is instead treated as "home equity indebtedness." Home equity indebtedness is the second kind of mortgage interest defined under the tax code. It includes any and every kind of borrowing against (secured by) your residence that is not used to acquire, build, or substantially improve that residence.

The determination between acquisition indebtedness and home equity indebtedness is a use-based test; the determination is made by evaluating what the funds borrowed were used for. Consequently, home equity indebtedness includes the typical home equity line of credit, as well as the cash-out portion of a cash-out refinance, to the extent that the additional borrowing isn't used to improve the home substantially.

The difference between acquisition indebtedness and home equity indebtedness is critical, because interest on home equity indebtedness is deductible for only $100,000 of debt principal. Fortunately, this is in addition to acquisition indebtedness limits, for a total of $1.1 million of acquisition plus home equity indebtedness. However, home equity indebtedness, when added to acquisition indebtedness, cannot exceed the total value of the home when the loan is incurred--excess interest above the value of the residence would be non-deductible personal interest.

AMT issues. Unfortunately, one significant additional restriction is that home equity indebtedness deductions must be added back to income for AMT purposes as an adjustment item. Therefore, home equity indebtedness interest is not deductible at all for taxpayers subject to the AMT.

According to research by the Tax Policy Center, more than three million taxpayers will be affected by AMT in 2005, and nearly 15 million may be affected in 2006 when the temporary AMT exemption increase (as established by the Jobs and Growth Tax Relief Reconciliation Act of 2003) expires. Given the combination of rapidly increasing AMT exposure for all taxpayers and extensive mortgage borrowing due to several years of record-low interest rates, the impact of AMT on mortgage debt classified as home equity indebtedness could indeed be severe. In addition, with the changing landscape of tax planning shifting inexorably toward a world where the AMT will be the norm, in guiding their clients on future transactions advisers must be cognizant of various mortgage borrowing structures.

In the context of mortgage planning, the AMT makes it critical that clients structure their mortgage borrowing so it qualifies as acquisition indebtedness (subject to higher debt limits and no AMT adjustment), rather than as home equity indebtedness (subject to lower debt limits and non-deductibility for AMT purposes). Since the determination between acquisition and home equity indebtedness is a use-based test, advisers must clearly understand which situations create acquisition indebtedness and which do not.

As mentioned, the key points in qualifying for acquisition indebtedness treatment are that the debt be used to acquire, build, or substantially improve the residence and that the debt be secured by that residence. To be considered as "used to acquire or build," the loan proceeds must be directly traceable to expenditures used for the acquisition or construction of the residence, or the expenditures must be made (i.e., the house must be paid for) within 90 days before or after the loan is incurred. If the house is being constructed, a loan made within 90 days of its completion will be acquisition debt to the extent expenditures were made in the 24 months before completion.

Generally speaking, for debt to be considered as "used to substantially improve" the residence, the improvement to which the borrowing is attributable must be "substantial." Although no clear guidelines exist to delineate what is and is not a "substantial improvement," the guiding spirit of the law suggests that repairs would not be eligible for acquisition indebtedness treatment, while substantive changes or additions to the house would.

In addition, to be eligible for acquisition indebtedness treatment, the debt must be secured by the same residence that the proceeds are used to acquire or improve. If funds are borrowed against a primary residence and used to purchase a second residence, the debt will not be considered acquisition indebtedness. Although that loan was borrowed to acquire one residence and is secured by another, the debt is not secured by the residence that was acquired. Consequently, when purchasing a second residence, the debt must be against that residence at the time it is acquired--borrowing against the first to purchase the second will be considered home equity indebtedness. Exacerbating the mistake, a later loan against the second residence to pay off the debt on the first will then be considered home equity indebtedness against the second.

Refinancing issues. Fortunately, once mortgage debt is eligible for acquisition indebtedness treatment, this classification may remain even after refinancing. Under the tax code and associated regulations, if a mortgage was originally considered to be acquisition indebtedness, then any refinancing of that mortgage will continue to be considered acquisition indebtedness, but only to the extent of the original mortgage.

If there is any additional borrowing against the residence at the time of refinance above the remaining acquisition indebtedness balance, the additional borrowing will be treated like home equity indebtedness. This restriction will apply, regardless of what the additional borrowing was for, unless it was specifically attributable to a substantial improvement on the existing residence under the acquisition indebtedness guidelines. "The Refinancing Rules in Action" (below) illustrates the principles of mortgage deductibility on refinancing in light of these restrictions.

Reporting issues. Luckily for taxpayers, at this time the IRS has no real way to track acquisition versus home equity indebtedness. The mortgage-interest reporting document, Form 1098, does not differentiate between the two, due in no small part to the fact that, because the difference is based on how funds were used after borrowing, there is no easy way for mortgage lenders to know which type to report.

This oversight is largely due to an administrative lack of reporting capabilities and may eventually be fixed with new reporting requirements. Consequently, it behooves advisers to guide clients correctly about the treatment of mortgage deductibility, regardless of whether they are likely to be caught or audited. If the reporting rules change in the future, and a client's home equity indebtedness becomes more readily distinguishable from acquisition indebtedness, the client may suddenly find mortgage interest that was previously deducted cannot be any longer.

In any event, any failure to report acquisition or home equity indebtedness interest properly may result in penalties and interest. Just because the IRS doesn't have a good way to check up on mortgage-interest-related tax reporting doesn't mean the rules don't apply.

In order to guide their clients properly on the treatment of past and anticipated future transactions, advisers must understand the differences in treatment between acquisition indebtedness and home equity indebtedness, due not only to the limitations on deductible amounts but also the fact that, at a time when the ranks of AMT taxpayers are expanding rapidly, home equity indebtedness is non-deductible for those taxpayers. Although the rules seem simple, they are actually far more complex than most people think.

Because of the substantial focus of mortgage interest deductibility rules on classification as acquisition indebtedness at the time of purchase, it is particularly critical for financial advisers to consult with their clients before transactions occur to ensure that they are properly structured to preserve beneficial tax treatment. Failure to do so may cause irrevocable classification as home equity indebtedness, and clients may thus never be able to deduct their mortgage interest.

Michael E. Kitces, MSFS, CFP, CLU, ChFC, is director of financial planning for Pinnacle Advisory Group, a private wealth management firm in Columbia, Md. He welcomes your comments at michael@kitces.com.