Example

Alice Gamos took out a $100,000 mortgage to buy her home in 1986. In March of 1994, when the home had a fair market value (FMV) of $220,000 and she owed $95,000 on the mortgage, she took out a second mortgage of $80,000. She used $60,000 of the loan proceeds for home improvements and the remaining $20,000 for other personal purposes.

All of the interest is deductible. The interest on the first mortgage is deductible simply because it was taken out before October 13, 1987.

Of the second mortgage, the $60,000 used to improve the home falls into category (A), above. The $60,000 must be added to the balance on the existing loan to be sure that the $1 million limit is not exceeded; in this case, $60,000 + $95,000 = $155,000, well short of $1 million. The remaining $20,000 is subject to the limits on home equity loans in category (B); because it is less than $100,000 and does not exceed the home's FMV reduced by grandfathered and home acquisition debt (i.e., $220,000 - $95,000 - $60,000 = $65,000), it is fully deductible.