In the closing hours of the 109th Congress a long-time irritation was resolved: Fees for mortgage insurance will be tax-deductible for huge numbers of homeowners beginning in 2007.

Mortgage insurance has been the key to homeownership for millions of buyers. Unlike other forms of insurance, mortgage insurance does not protect against some future and improbable horror, instead it makes home purchases possible today.

Lenders have traditionally wanted homebuyers to purchase with 20 percent down. The logic for this requirement is fairly clear: If something goes wrong and the home must be foreclosed, the lender is still likely to get back most or all of its loan balance. (In practice, legitimate lenders hate foreclosures because they face big costs to acquire and market such properties. The result is that foreclosures routinely result in lender losses, even with mortgage insurance.)

Few people have enough cash to buy with 20 percent down. If only people with so much cash could buy, the real estate market would shrink and there would be far less demand for houses.

Mortgage insurance helps buyers get around the problem of limited cash. Instead of putting up dollars buyers get insurance coverage. Lenders accept mortgage insurance because it performs the same function as 20 percent down: If a property is foreclosed lender risk is reduced because mortgage insurance pays for much or all of the lender's possible loss.

The catch is that mortgage insurance is not something you gather for free in the nearby woods. There's a cost -- an insurance premium -- typically in the form of a monthly fee.

Mortgage insurance is available in the form of private mortgage insurance (MI) and through the Federal Housing Administration (FHA), the Veterans Department (VA), and the Rural Housing Administration.

How much you pay depends on how you borrow and which program you use: For instance, fees go up when you buy with less down, use adjustable-rate financing and have poor credit.

To this point mortgage insurance premiums have not been deductible for homeowners, however the equivalent of mortgage insurance premiums has long been an acceptable write-off. If you call what you pay a "mortgage insurance premium" it hasn't been deductible, but if you buy an equivalent form of protection and pay for it with dollars called "interest" then it's a deduction.

As an example, if you buy a home with a first loan equal to 80 percent of the purchase value and a 20-percent second -- so-called piggy-back financing -- you're purchasing with nothing down and no mortgage insurance. If the home goes to foreclosure every dime from the property's sale must go to repay the first mortgage before any proceeds are used to pay the second loan. From the perspective of the first lender, that 20-percent second loan reduces risk in the same way as the use of mortgage insurance.

From a tax perspective however, piggy-back loans enable the borrower to deduct the interest on both the first mortgage and the second mortgage up to allowable limits. In effect, non-deductible mortgage insurance premiums are replaced by higher interest costs which can be written off.

A second form of equivalence concerns self-insurance. In this scenario the lender self-insures and hopefully sets aside sufficient money to cover foreclosure losses. Where does the lender get the extra money to set aside? From a higher interest-rate charged to borrowers, additional interest which is again tax deductible.

The specifics of the new legislation -- which has been passed by the Congress and awaits the President's signature at this writing -- include the following terms:

• The legislation applies to insurance premiums paid for "acquisition indebtedness" made after January 1, 2007. This means that MI premiums for loans made prior to 2007 are not deductible.

• The deduction applies to interest on mortgage insurance associated with a qualified residence, a term that remains foggy. Plainly Congress wanted to have a write off for a prime residence but what about a second home or vacation property? Speak with a tax professional for details.

• The write-off does not apply to refinancing above the amount of any remaining acquisition debt. However, since it does apply to refinancing another reason to restructure old acquisition debt -- perhaps to go from an interest-only mortgage or option ARM to fixed-rate financing -- would be to get the new MI write-off.

• The write-off is fully deductible to those with adjusted gross incomes of $100,000 or less. In practice this means that MI premiums will be deductible for most homebuyers.

• Above the $100,000 income level there's a phase-out: The deduction for married couples is reduced by 10 percent for each $1,000 above $100,000 or a fraction thereof. In other words, if you're married and have a household income of $105,200 you would lose half the deduction. The phase-out for single taxpayers and married individuals filing separately starts at $50,000 in adjusted gross income and is reduced 10 percent for each $500 in additional income.

• If your mortgage premiums amount to more than $600 your lender will automatically send you a notice that can be used to document a tax return claim.

Jeff Lubar with the Mortgage Insurance Companies of America (MICA), the trade association for the nation's private mortgage insurance companies, points out that the legislation as written has a one-year term -- it starts January 1, 2007 and ends December 31, 2007. However, although the current legislation has a one-year term the betting here is that as a matter of political prudence it will be extended and become a permanent part of the tax landscape.

As always with deductions and such, read IRS materials with care and speak with a tax professional for specifics.

For more articles by Peter G. Miller, please press here.

Published: December 12, 2006

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