Among the most attractive features of second mortgages is the federal tax-deductibility feature of their interest payments, which reduces the effective cost of the loans to borrowers. However, before signing those loan papers, it's important to understand just what you can and cannot deduct off your taxes.

To qualify for mortgage interest tax deductions, your mortgage must be secured by your first or second home. Loans secured by subsequent homes (e.g., third or fourth homes) do not qualify. A home, according to the Internal Revenue Service (IRS), must be a house, condominium, cooperative, mobile home, boat, recreational vehicle or similar property that has sleeping, cooking and toilet facilities.

IRS Publication 936 states that all of your mortgages must fit into one or more of the following three categories at all times during the year.

1.Mortgages taken out on or before October 13, 1987 (grandfathered debt).

2.Mortgages taken out after October 13, 1987, to buy, build, or improve your home (home acquisition debt), but only if throughout the current tax year these mortgages plus any grandfathered debt totaled $1 million or less ($500,000 or less if married filing separately).

3.Mortgages taken out after October 13, 1987, other than to buy, build, or improve your home (home equity debt), but only if throughout the current tax year these mortgages totaled $100,000 or less ($50,000 or less if married filing separately) and totaled no more than the fair market value of your home reduced by (1) and (2).

Types of Mortgage Debts

A grandfathered debt is fully deductible with no limits.

A home acquisition debt, also known as acquisition indebtedness, is money you borrow to buy, build or substantially improve your qualified residence (an IRS term for your first or second home).

A home equity debt, also known as equity indebtedness, is money you borrow against the equity in your qualified residence or money you cash out on a mortgage refinance for any reason other than home improvement.

To deduct the mortgage interest, you will need to file a Form 1040 (the long form with itemized deductions, not 1040 EZ). Your lender will send you a Form 1098 listing the mortgage interest you paid during the tax year. Check with a licensed tax professional for other conditions and limits that may apply.