Surprised that it is better to not deduct mortgage of second home!

[rainbowdragon62]

Last year, I purchased a second home.  I was surprised to learn that including the second home's mortgage in my itemized deduction Schedule A worksheet was actually worse for the overall interest I could deduct.  After some close examination of the math behind the deduction worksheet, I think I understand why.  The balance of my first mortgage exceeds the $1M cap (purchased prior to 2017) and the balance of my second mortgage exceeds the $750k cap.  Therefore, my overall mortgage balance went up.  However, the rules only allow for deducting the interest paid -- and the important part -- multiplied by $1M as a percentage of the total mortgage balance.  Some numbers representative of my case:

First home:

$1.1 mortgage balance

$35k interest paid

Second home:

 $1.2 mortgage balance

$10k interest paid

If only deducting the first home’s interest, I get to deduct:

$35k * ($1M / $1.1M) = $31,818

If deducting both home’s interest, I get to deduct:

($35k + 10k) * ($1M / ($1.1M + $1.2M)) = $19,565

Therefore, the clear conclusion is that it is better not to include the second home for the purpose of deductions.

My question to the tax experts is whether it is permissible to exclude the second home from my taxes so that I can increase my deductions?  Or is there a rule that I have to include all mortgages for which I receive a 1098 in the deduction calculation?  Thank you for your help!

[RaifH · Accepted solution]

Yes, it is permissible, although I do not necessarily recommend it. The IRS allows you to not consider the debt as secured by your home. This is usually done if the interest can be used somewhere else on your tax return, like as a valid business expense.

While you can make this election, reversing it may be a little harder in the future. It requires consent from the IRS. 

However, it may not be in your best interest. While your math is correct, judging by the fact that you only paid $10,000 in interest on the second home, I'm guessing you purchased it later in the year. 

The $1.2 million of outstanding principal does not accurately reflect your average mortgage balance throughout the year, since you did not have the home for the majority of the year. You can determine the average loan balance by taking the reported outstanding mortgage principal in Box 2 of Form 1098, multiplying it by the number of months you had the loan, and dividing by 12. When you use that as the loan balance, your deduction will be much closer to your original deduction, depending on whether the interest rate is better on the first loan or the second loan. When TurboTax asks for the outstanding loan balance as of January 1, 2022, you will use the same calculated amount. 

[rainbowdragon62]

That's a very helpful explanation, and you are indeed correct, I only had the 2nd loan for 1/3 of the year.  Thank you for pointing out the multiple options that I can consider, and the super fast reply.  I really appreciate it!