Over the years, taxpayers have become accustomed to deducting mortgage interest on Schedule A. But many do not understand that although you can deduct home mortgage interest on Schedule A, you may have to include a portion of that deduction on Form 6251, Alternative Minimum Tax.

You can deduct interest on home mortgages and home equity on Schedule A, if you are legally liable for the debt. But there are limits on the amount of the mortgage and home equity debt.

For home mortgages, the debt limit is $1 million ($500,000 if married filing separately). This includes buying, building, or substantially improving a first or second home, so that any interest paid is deductible as qualified residence interest.

For home equity debt, the limit is $100,000 ($50,000 if married filing separately). Home equity debt is secured by the borrower's first or second home. You don't have to use the borrowed amount for home improvements—or for anything related to your home. However, if you do use the borrowed funds for substantially improving your first or second home, the debt is considered home mortgage debt rather than home equity debt.

If your home mortgage or home equity debt is above these limits, the interest you paid on the amount above the limits is not tax-deductible.

If John Doe borrows $350,000 to purchase his primary residence and itemizes his deductions for the tax year, he may deduct the interest paid on his mortgage for that year. His loan would be considered home mortgage debt and would fall within the $1 million limit.

Fast-forward a couple of years. Using the equity he has accrued in his residence, John has borrowed $135,000. That loan could be considered a home equity loan, depending on how John uses the proceeds. Imagine he uses the loan for the following:

• $25,000 to add a bathroom
• $60,000 to buy a boat
• $30,000 to buy a new car
• $20,000 to travel

The $25,000 used for the bathroom would not be considered home equity debt, as John used it to substantially improve his residence. Instead, that $25,000 would be considered home mortgage debt and must fall within the home mortgage limit for the interest to be tax-deductible. The portion of the home equity loan used for boat, car, and travel would be considered home equity debt and would be subject to the $100,000 limit, as well as the possible effects of the alternative minimum tax (AMT).

Of the $135,000 that John borrowed, subtract the portion considered home mortgage debt ($25,000). What remains is the portion of the loan that is considered home equity debt: $110,000. The interest on this debt is subject to the $100,000 limit, so John would not be allowed to deduct the interest paid on $10,000 of his home equity debt. 

To determine this, first determine whether AMT is applicable. Interest paid on home equity debt is considered an AMT adjustment, which means that the interest paid on the debt, if deducted on Schedule A, might be added back when determining taxable income for the AMT.

To determine the AMT adjustment amount, see the instructions for IRS Form 6251, Alternative Minimum Tax – Individuals. On page 2 of the instructions is this worksheet:

Remember, if the home equity debt is related to buying, building, or substantially improving your first or second home, it is considered eligible mortgage debt and will not be considered in figuring AMT.

For tax year 2007, Mark and Cindy paid $15,000 in interest on a home mortgage acquisition loan. During the same year, they refinanced that mortgage and paid an additional $11,000 in interest. Remember, even though they refinanced their mortgage, the balance of the old mortgage does not change.

Later in the same year, Mark and Cindy got a home equity loan and used it to go on a vacation. They paid $2,500 in interest on the loan for the year.

The amount to enter on the Home Mortgage Interest Adjustment Worksheet line 1 is $28,500—the sum of all interest paid ($15,000 + $11,000 + $2,500). Mark and Cindy would enter $15,000 on line 2 because this amount was paid on an eligible mortgage, and they would enter $11,000 on line 3 for the amount due to refinancing an eligible mortgage. Line 5, then, would reflect a total of $26,000.

On line 6, Mark and Cindy would enter the remaining difference between the total interest paid ($28,500) minus the amount excluded ($26,000) to equal $2,500—which is the adjustment amount for AMT. They would enter this amount on line 4 of Form 6251. 

If you have a second home, it's treated the same as a primary residence for figuring deductible home mortgage and home equity interest on Schedule A. According to IRS Publication 936, a qualified home is a main or second home and is defined as a “house, condominium, cooperative, mobile home, house trailer, boat, or similar property that has sleeping, cooking, and toilet facilities.” For AMT purposes, the instructions for Form 6251 define a second home as “any house, apartment, condominium, or mobile home not used on a transient basis.” This implies that a boat, trailer, or similar property would not be considered a qualified dwelling for AMT purposes; these would instead be considered home equity debt when determining the total amount of home mortgage and equity interest deducted on Schedule A.

If you rent your second home, you can still consider it a second home (and not entirely rental property) as long as at least one of the following is true:

• You used the second home for more than 14 days in a year.
• You used the second home more than 10% of the number of days you rented it during the year at a fair market value price.

You may only have one qualified second home during the year unless one of the following exceptions apply, causing you to change the home treated as a second home for tax purposes:

• If you acquire a new home during the year, you may choose to treat the new home as a second home starting on the day you acquire it.
• If your home no longer qualifies as the primary residence, you may choose to treat it as a second home starting on the day you no longer use it as your main home.
• If you sell your second home during the year, or it becomes your main home, you may use a new, second home starting on the day you sell the original second home or it became your main home