As a homeowner, one of the best ways to reduce your annual tax liability is through the mortgage interest tax deduction. There are two basic categories of loans and each is treated a little differently.

As the name implies, secured loans used to buy, build, or improve a home fall under this category of home acquisition debt. Depending upon when you took out a mortgage, the interest on this type of debt is usually fully tax deductible and applies to a first and second home.

• Interest on home loans acquired prior to October 13, 1987 are fully tax deductible regardless of the loan amount.
• Interest on home loans secured after October 13, 1987 are fully tax deductible up to a combined loan value of $1 million.

Example: Let's say you purchased a primary residence for $195,000; a second home in Florida for $350,000; and borrowed $100,000 to build an addition to you primary or second home. The combined loan value is $645,000 and all the interest is tax deductible, with room to spare. You could borrow an additional $355,000 before reaching the maximum loan value for deducting mortgage interest.

Exception: If married and filing separately, the maximum loan value is now reduced to $500,000.

In this home equity debt category, you can borrow up to $100,000 against the equity in your home, for whatever purpose you choose, and fully deduct the interest. The IRS specifically defines this category as debt incurred for reasons other than to buy, build, or improve a home.

Example: A possible alternative to financing a new car is to take out a home equity loan. This would then make the car payment tax deductible and possibly secure a better interest rate. In addition, you could stretch out the payment plan typically up to 10 years. That's not advisable, but it is possible. The point being the added flexibility in the length of the loan plus the tax deductibility can make this a smart financial decision.

Exception: Once again, if married and filing separately, the maximum loan value is reduced by half, or $50,000.

If an individual owns a rental home, for instance, the mortgage interest on this property does not count towards the $1 million loan limit mentioned above. Provided the owner did not live in the rental home for any time during the year, or more specifically less than 10% of the time (14 days), the interest is tax deductible as an investment property and not as a first or second home.

Now that we've looked at how much mortgage interest can be deducted, it's time to move on to some required rules set for by the IRS.

1. In order to deduct mortgage interest, you must complete an itemized tax return using form 1040 and Schedule A. Otherwise, you will not be able to take advantage of the tax deduction.

   In general, it makes sense for the taxpayer to file with itemized deductions if he exceeds the standard deduction. Homeowners typically find their itemizations easily surpass the standard deduction due to mortgage interest.

2. You must be the person who is legally responsible and liable for the debt. In other words, you signed the loan and all required documents.

   If you make mortgage payments for someone else, you cannot deduct the interest on your tax return. There must exist a debtor to creditor relationship that is well documented and recognized legally. Otherwise, any payments made for or to someone else without proper proof of liability are not eligible as a tax deduction.

3. Finally, the mortgage or home equity loan must be secured against a qualified home.

For more information, see IRS Publication 936 atwww.irs.gov.