If you deduct mortgage interest, be careful -- IRS may be ramping up audits

Recently a business owner asked TaxMama to review his personal tax return for 2007, which included income from several businesses. The return had just been targeted for audit. Despite several business-related red flags on the return, that wasn't what triggered the audit. The auditor said the return was pulled for audit specifically due to the high mortgage interest deduction. This taxpayer is not alone.

Did you know there are limits to the mortgage interest that you can take? Most people don't realize they may be deducting more than they're entitled to use.

Reports from tax professionals indicate that they are starting to see audits on tax returns with high mortgage interest deductions, specifically Schedule As with mortgage interest deductions of over $50,000. The IRS has not yet had time to respond to our specific questions about this audit program.

If your interest deduction is less than $50,000, can you breathe easy? Well, not exactly. If you're audited for any other reason, IRS will look at your mortgage interest deduction, too. So be sure to heed the rules.

Rules of the mortgage-deduction road

We're only going to talk about laws in effect right now. We're not getting into laws that might take effect later, such as President Obama's proposal to reduce the value of the mortgage deduction for those earning $250,000 or more.

The overall limit on the mortgage interest deduction is the interest paid on mortgages of up to $1 million used to buy or fix up the house, plus another $100,000 of debt used for any other purpose. In other words, the maximum limit is interest on up to $1,100,000 of mortgage debt. Your mortgage balance is higher than these numbers? Too bad.

• There is one exception. If your loan was originated before October 14, 1987 and it's higher than $1 million dollars, you can deduct all the interest. So, if you've never refinanced, be sure you have proof of the original note.
  
• If you have refinanced that loan, you may still deduct the interest on the balance of the original debt at the time of the refinance. In other words, let's say you had a pre-October 14, 1987 loan with a balance of $3,500,000 and you refinanced it in 2007 for $4 million and a lower interest rate. You may still fully deduct the interest on the $3,500,000 balance. In other words, you'll be able to deduct 87.5% of the interest (3.5 divided by 4 = 0.875).
  

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