What is Acquisition Indebtedness?
So, lets start at the beginning. Mortgage interest is tax deductible. The first type of mortgage interest defined under the tax code is called “acquisition indebtedness”. As you might expect, this includes the cost of borrowing to acquire your home, but also includes debt incurred to build or substantially improve a residence, as long as the debt is secured by the same residence.
What qualifies as a residence? In fact, it includes your principal residence as well as a second residence, like a vacation home. But heres where you have to be careful. If your vacation home is used and reported as a rental property, you cant treat it as a residence (although you may be able to deduct interest as a rental expense). A tax professional can tell you which approach will best benefit you on a second residence.
Assuming that your residences apply, how much interest can you deduct? Well, the interest is deductible on the first $1 million of principal, for your first residence. Whatever is left over from that first $1 million can be applied to a qualifying second residence. What does this mean? It means that if your principal on your first home is $500,000, then you have $500,000 of debt limit remaining. This remaining debt limit is available to claim for your second home. Now, keep in mind that the restriction applies to the amount of principle borrowed and does not relate to the amount of interest paid. In other words, no matter the interest rate on your mortgage, if your debt qualifies and falls within the $1 Million limit, you can claim the full amount of your interest costs.
So, in short, acquisition indebtedness includes all the money you borrow to buy your home, plus any money borrowed to substantially improve your home. Of course, youll have to be able to document it.
You can also deduct home equity indebtedness, but the rules will be different than acquisition indebtedness.