Understanding the New Mortgage Interest Rules
Correctly Managing Your Home Debt
By Matthew E. Miller, CPA, MBA
The Tax Cuts and Jobs Act signed by the president this past December contained many changes, some positive, some negative, but changes with enough significance that we should be mindful of our compliance requirements. One change effecting home mortgage debt results from the conflict between economic policy and tax policy which has been lingering for some time – what role should the US Treasury play in the housing market through the deductibility of home mortgage interest?
We have found that many taxpayers don’t have a clear understanding of the mortgage interest rule. So, let’s clear up the confusion and uncertainty regarding home mortgage debt and, in particular, the interest deduction associated with the debt.
The limitation on deductible home mortgage interest, that we were previously familiar with, was introduced to taxpayers under the Tax Reform Act of 1986. Subsequent to the change, homeowners faced a maximum loan balance on which mortgage interest could be deducted. Legislation limited the mortgage interest deduction to interest incurred on loans used to secure the taxpayer’s principal residence or second home in an aggregate amount of $1 million dollars. New terminology was introduced to our tax lexicon – Home Acquisition Debt.
Under the TRA of 1986, Congress also eliminated the personal interest deduction for car loans, credit card debt, and other consumer debt stating that the US Treasury was not to be a clearing house for the fiscal decisions of the US taxpayer. After much lobbying effort by the real estate and financial industries, the final legislation allowed taxpayers to deduct interest on up to $100,000 of debt, as long as the debt was secured by the taxpayer’s principal residence. Thus, the creation of Home Equity Debt.
Terminology
As we give you a Tax 101 lesson on home mortgages, the following definitions are important for you to understand in order for you to determine what mortgage interest is deductible.
Home Acquisition Debt is debt, secured by the property, which is used to buy, build, or substantially improve a main or secondary home.
Home Equity Debt is debt, secured by the property, which is used for any other purpose.
I actually don’t like the above definition of Home Equity Debt. Well, actually, I like the definition. What I am concerned about is the marketplace meaning of the words “Home Equity Debt”. The marketplace use of the words doesn’t match the intended tax meaning of the words.
For here is our conflict. In the lending world, Home Equity Debt, is simply a second trust on your home. You have withdrawn some of the equity you have in your home through a repayment agreement with the lender. But, the label of “Home Equity Debt” that the lending world uses to market this product does not determine the deductibility of the interest associated with the instrument. Rather, the use of the money determines the deductibility.
Requirement – For any interest on debt to be deductible, the debt must be secured by the property.
For years, you, our client, have been very patient with us (at least for the most part!) as we have asked a series of questions about the purchase of your home and the financing structure of the acquisition. Our questions are purposeful in that we are trying to help determine the deductibility of the interest you pay to your lender. The following story illustrates the complexity of mortgage debt and the challenges taxpayers face determining the deductibility.
Example:
Young, married taxpayers purchase a home for $450,000. The taxpayers finance the purchase with $50,000 cash and acquire a loan, secured by the home, in the amount of $400,000. The loan is considered Home Acquisition Debt because the loan was used to buy the taxpayers’ main home. The interest on the loan is fully deductible.
The house is great, just what the couple needed. One of the taxpayers works remotely from home, so an extra bedroom is converted into a home office.
The family begins to grow – the taxpayers rescue a dog. They have a great yard with lots of room for the dog to run and play. The only requirement is they need a fence. So, the taxpayers hire a company to install a fence. As to not use up cash, they pay for their fence using their credit card. The interest rate isn’t bad and they agree between themselves to pay off the credit card in 18 months. Even though the debt is incurred to substantially improve the property, the credit card debt is not secured by the property, so interest the taxpayers pay on the credit card is non-deductible personal interest.
The taxpayers live in the home for a number of years. As the family grows larger, they soon realize they need to convert the home office back to a bedroom. The basement of their home was unfinished when they purchased the home. For a couple of years, the basement was used as a makeshift mancave; fridge, big screen on the wall, an old rug was thrown down over the cold concrete floor, and a couple of worn out wingback chairs. The wife considered the area a dungeon, the Pit of Misery if you will. Dilly-Dilly!!! Dilly-Dilly!!!
After some negotiation, the taxpayers decided they would remodel the basement to convert the area to the new home office and a play area for the children. Housing prices in their neighborhood have increased handsomely and the taxpayers found they had a significant amount of equity in the property. The taxpayers met with their lender to explain the plan. They acquired a Home Equity Loan (Debt) in the amount of $45,000 for the purpose of remodeling the basement.
Let’s stop the story for a moment to revisit our definitions.
Home Acquisition Debt is debt, secured by the property, which is used to buy, build, or substantially improve a main or secondary home.
Home Equity Debt is debt, secured by the property, which is used for any other purpose.
While the market place uses the term Home Equity Debt, our taxpayers actually have incurred additional Home Acquisition Debt because the debt is being used to substantially improve a main home. There are two requirements the taxpayers must follow to fully deduct the interest as mortgage interest on their tax return.
1. The loan must be secured by the property, and
2. The taxpayers must be able to prove they used the full $45,000 on the improvements.
If the taxpayers use the full proceeds to finish the basement, 100% of the interest is deductible. If the taxpayers use any part of the proceeds for anything other than an improvement to the home, to determine the deductible interest on that portion of the debt, the taxpayers need to trace the use of the money. If they used the money to by furniture for the basement, that fraction of the interest is non-deductible personal interest.
Back to the story……
A few more years go by, home mortgage rates decrease, so the taxpayers decide to consolidate their loans into a new loan. At the time of the transaction the balance on their loans were as follows:
- Original Loan – $365,000
- HELOC – $ 39,000
As long as the new loan amount does not exceed $404,000, plus closing cost, the new loan will be considered all Home Acquisition Debt and the interest will be fully deductible.
You can imagine how far we can take this story and how many variations of situations we can make with home mortgage debt. Most importantly, you can extrapolate this story into your home ownership history to reflect on your home debt and the financing decisions you made with your home.
Here is the simple lesson –
Your initial mortgage to acquire your principal residence (Home Acquisition Debt) has fully deductible interest until the loan is modified by a refinance. Any interest on equity debt subsequently withdrawn from the property is deductible based on the use of the proceeds. You must be able to provide evidence of the use of funds.
The Tax Cuts and Jobs Act and Home Mortgages
There are two important changes to home mortgage debt you need to know.
1. Beginning in 2018, interest on Home Equity Debt is no longer deductible. Period!
If you have a Home Equity Loan and you are concerned that interest won’t be deductible, document the use of all loan proceeds. If the proceeds were used for personal purposes, the interest is not deductible. If the proceeds were used to substantially improve a main or secondary home, the debt is not Home Equity Debt, but rather Home Acquisition Debt and the interest is fully deductible (subject to the debt limits).
2. Effective for contracts entered into after December 14, 2017, interest on Home Acquisition Debt is limited to interest paid on loans up to $750,000. For loans exceeding $750,000, the taxpayer must calculate the fractional amount of interest deduction allowed.
Explanation: If the taxpayer purchases a home for $900,000 with a down payment of $100,000 and Home Acquisition Debt of $800,000. The deductible interest is calculated to be 93.75% of the total interest paid ($750,000 / $800,000).
3. A “Binding Contract Exception” exists for taxpayers who enter into a written binding contracts before December 15, 2017, to close on the purchase of a principal residence before January 1, 2018, and who purchases such residence before April 1, 2018. Those taxpayers qualify for the $1 million debt limitation.
Application of the Rule Change:
- All Home Acquisition Debt currently incurred by December 15, 2017 will follow the old home mortgage limitation of $1,000,000. Taxpayers with existing debt will not lose any portion of their deductible interest.
- Taxpayers can refinance Home Acquisition Debt. The debt limitation amount will be the current balance of Home Acquisition Debt being refinanced.
- The new rule limiting home mortgage debt does not apply to residential rental real estate.
In Closing
The change to the home mortgage debt limitation is not insignificant and will certainly have an impact on some housing markets. The message to be taken from the legislation is to manage your debt within the balance limitations, properly identify the type of debt as Acquisition Debt or Equity Debt, and consider accelerating repayment of mortgage debt.
If you would like to meet with one of our tax advisors, we would be delighted to do so. Please contact our office at 703-591-9280.
