As a tax deduction, mortgage interest is not pretty from either a tax rules or tax deduction viewpoint. First, you would think that the rules for deducting home mortgage interest would be straightforward. You would think that, but you would be thinking wrong. The rules are not all that clear, but we will help clarify them in this article. Second, from the tax deduction standpoint, mortgage interest deductions took two hits from the recent tax reform. And for sure, of course, the loss of home mortgage interest deductions increases the cost of homeownership.
Two Big Tax Reform Changes
The recent tax reform contains two big changes to how much you can deduct in mortgage interest for tax years 2018 through 2025:
During this seven-year period, you may not deduct any interest on prior or current home equity debt, with certain exceptions.
Also during this seven-year period, the maximum amount you may treat as acquisition debt for homes purchased after December 15, 2017, is $750,000.
For rules that likely apply to the tax return you are filing for 2017, see Be Alert to Tax Rules That Destroy Mortgage Interest Deductions.
New Rules on Home Equity Interest
Under the new rules, you may not deduct home equity interest during tax years 2018 through 2025, with certain exceptions.
Exception alert. Your home equity loan may include the acquisition or home-improvement debt, and that debt continues as deductible under the recent tax reform rules.
Example. Billy took out a $90,000 home equity loan in 2015. He used $50,000 to remodel portions of his home and used the remaining $40,000 for his daughter’s college. Billy’s total home mortgages never exceed $1.1 million. Under the new law, Billy may deduct 5/9 of his home equity loan interest in 2018.
Planning tip. Make sure to deduct the interest on those parts of the home equity loans that are secured by the home and that were used to buy, build, or substantially improve the home.
When you buy your main home or a second home and take out mortgages secured by those homes, your mortgages are called acquisition debt.3 You can add acquisition debt when you improve your main or second home and that new debt is secured by the home you improved.
Your acquisition debt does not increase when you refinance unless you use the new monies to improve the home.
Example. Tom bought a home in 2010 and took out a $500,000 mortgage that he secured with the home. In 2018, Tom has paid down his mortgage to $430,000 and his home has increased in value to $800,000. Tom refinances the home and takes out a new mortgage secured by the home in the amount of $600,000. If Tom uses none of the new money to improve his home, his mortgage interest deduction in 2018 is based on the $430,000 of mortgage principal that remained as of the date of his refinancing. To put this in perspective, your original acquisition debt never increases on that original home. To increase your debt eligible for the home mortgage interest deduction, you need to use the new debt to improve the home.
Because of tax reform, you now have two possible 2018 ceilings on your home mortgages that are eligible for the mortgage interest deductions.
$1.1 million. For indebtedness incurred before December 15, 2017, you may not deduct interest on more than $1.1 million in mortgages ($1 million in acquisition debt and $100,000 in home equity debt used for acquisition or improvements).5 The original $1.1 million ceiling is grandfathered for acquisition and improvement loans in existence before December 15, 2017.
Example. Sam took out his mortgages in 2013. Sam faces the $1.1 million ceiling in 2018. For home mortgage indebtedness incurred on or after December 15, 2017, you may deduct interest on no more than $750,000 of home mortgages.
Example. Jim took out his mortgage in 2018. He faces the $750,000 ceiling.
Exception. If you entered into a written, binding contract before December 15, 2017, to close on the purchase of a principal residence before January 1, 2018, and you complete the purchase before April 1, 2018, you fall into the $1.1 million ceiling category.
Mortgage Money for College
The 2018 rules on deducting mortgage interest make it impossible to refinance your home mortgage and obtain monies for your child’s college education for which you can deduct the mortgage interest. Remember, refinancing doesn’t increase your acquisition debt ceiling for purposes of deducting home mortgage interest. If you really want to deduct the interest on mortgage debt that you are going to use for college, do this: Sell your existing home and buy the new home with plenty of qualifying debt. Example. Peggy sells her existing home for $650,000. The home had $100,000 of acquisition debt at the time of sale. Peggy buys a new home for $650,000 and takes out a $500,000 mortgage that’s secured by the new home. Peggy now has a qualifying $500,000 mortgage on which she can claim mortgage interest deductions and also $400,000 of available cash that she can use for her children’s college ($500,000 – $100,000).
Examine your investments. When you mortgage your home but use the proceeds for investment purposes, you trigger the investment interest rules that allow you to deduct investment interest to the extent of your investment income.
Your mortgage planning for business depends on how you have your business organized. If you operate your business as a corporation, you first need to remember that the corporation is a separate legal entity. Thus, if you use mortgage money to invest in or make a loan to your corporation, interest on that mortgage is investment interest. If you operate a proprietorship and invest mortgage money in the proprietorship, you trace the mortgage proceeds to the proprietorship. The proprietorship deducts the interest as business interest.
Your ability to deduct home mortgage interest on your first and second homes is limited to acquisition and improvement debt—all of which the lenders must secure with the homes. Be sure to examine any home-equity loans for acquisition and improvement debt. For tax years 2018 through 2025, you may not deduct home equity interest except for that interest allocable to acquisition or improvement debt. Your original debt known as acquisition debt declines as you pay the mortgage, and when you refinance an amount greater than the original debt (as paid down), you have no mortgage debt increase except for amounts used for improvements or home-equity debt. If you use your homes to borrow money that you use for your business or investments, make sure you trace that debt to your business or investments and deduct it as such.