The IRS allows you to deduct the interest on loans that qualify as home acquisition debt. Home acquisition debt includes any amount you borrow to substantially improve a qualified home. However, you must pledge your ownership interest in the home to the bank that issues the loan as security for repayment of the loan. The loan document must expressly state that in the event you default on payments, ownership of the home transfers to the lender and will satisfy a portion of the debt. The interest you pay on a home equity loan also qualifies if the same loan requirements are met.
Only loans you obtain on a qualified home are eligible for the annual interest deduction. Qualified homes include the main home you use as the primary residence, plus one additional home. You must use the additional home as a second residence; investment and income-producing properties do not qualify. A home can include a boat, motor home or trailer provided they have sleeping, cooking and toilet facilities.
The interest is deductible for loan funds you use to pay the actual costs of substantial improvements to the home. A substantial improvement must add value to the home, prolong its useful life or adapt it to new uses. Expenses you incur for maintenance and repairs do not qualify for the interest deduction if you pay for them with loan funds. For example, adding square footage or building a garage on the property qualifies as substantial home improvements. In contrast, painting walls, cleaning, and carpet shampooing are non-deductible maintenance expenses. However, the cost you incur to paint the home when part of a larger and substantial home improvement project qualifies for the interest deduction.
The federal tax law limits the amount of interest-accruing loan principal that qualifies for the deduction. You can deduct the interest that accrues on a maximum of $1 million in total outstanding principal loan balances for two qualified homes. For example, if you finance the purchase of two homes that cost $1.2 million and obtain a mortgage for $1.3 million, you cannot deduct the interest on the excess $100,000 even if you use the funds to substantially improve one of the homes. However, as the outstanding balance of the mortgages decreases over time, you can begin to deduct the interest on the other non-deductible portion of the loan.