Tax Reform Has Substantially Altered the Tax Benefits of Home Ownership

Article Highlights:

  • Pre-Tax Reform Home Mortgage Interest Deduction
    o Home Acquisition Debt
    o Home Equity Debt
  • Tax Reform Mortgage Interest Deduction Changes
    o Home Acquisition Debt
    o Home Equity Debt
  • Tracing Equity Debt
  • Refinancing
  • Property Taxes

As part of the recent tax reform, the Tax Cuts and Jobs Act of 2017, the deduction for home mortgage interest and property taxes has undergone substantial alterations. These changes will impact most homeowners who itemize their deductions each year.

Mortgage Interest – Prior to the tax reform, a taxpayer could deduct the interest he or she paid on up to $1 million of acquisition debt and $100,000 of equity debt secured by the taxpayer’s primary home and/or designated second home. This interest was claimed as an itemized deduction on Schedule A of the homeowner’s tax return. This tax deduction was often cited as one of the reasons to purchase a home, rather than renting a place to live.

Qualified home acquisition debt is debt incurred to purchase, construct, or substantially improve a taxpayer’s primary home or second home and is secured by the home.

Home equity debt is debt that is not acquisition debt and that is secured by the taxpayer’s primary home or second home, but only the interest paid on up to $100,000 of equity debt had been deductible as home mortgage interest. In the past, homeowners have used home equity as a piggy bank to purchase a new car, finance a vacation, or pay off credit card debt or other personal loans – all situations in which the interest on a consumer loan obtained for these purposes wouldn’t have been deductible.

The old law continues to apply to home acquisition debt by grandfathering the home acquisition debt incurred before December 16, 2017, to the limits that applied prior to the changes made by the tax reform. As explained later in this article, equity debt interest didn’t survive the tax reform’s legal changes.

New Acquisition Debt Limits: Under the new law, for home acquisition loans obtained after December 15, 2017, the acquisition debt limit has been reduced to $750,000. Thus, if a taxpayer is buying a home for the first time, the deductible amount of the acquisition debt interest will now be limited to the interest paid on up to $750,000 of the debt. If the home acquisition debt exceeds the $750,000 limit, then a prorated amount of the interest will still be deductible. If a taxpayer already has a home with grandfathered acquisition debt and wishes to finance a substantial improvement on the home or acquire a second home, the total of the prior acquisition debt and the new debt, for which the interest would be deductible, would be limited to $750,000 less the grandfathered acquisition debt existing at the time of the new loan.

This may be a tough pill to swallow for many future homebuyers, since the cost of housing is on the rise, while Congress has seen fit to reduce the cap on acquisition debt, on which interest is deductible.

Equity Debt: Under the new law, equity debt interest is no longer deductible after 2017, and this even applies to interest on existing equity debt, essentially pulling the rug out from underneath taxpayers who had previously taken equity out of their homes for other purposes and who were benefiting from the itemized deduction. Note: Equity debt used to purchase, construct or substantially improve one’s home or second home is not treated as equity debt for tax purposes, it is instead treated as acquisition debt (See acquisition debt limits above).

Tracing Equity Debt Interest: Because home mortgage interest rates are generally lower than business or investment loan rates and easier to qualify for, many taxpayers have used the equity in their home to start businesses, acquire rental property, or make investments, or for other uses for which the interest would be deductible. With the demise of the Schedule A home equity debt interest deduction, taxpayers can now trace interest on equity debt to other deductible uses. However, if the debt cannot be traced to a deductible purpose, unfortunately, the equity interest will no longer be deductible.

Refinancing: Under prior law, a taxpayer could refinance existing acquisition debt, and the allowable interest would be deductible for the full term of the new loan. Under tax reform, the allowable interest will only be deductible for the remaining term of the debt that was refinanced. For example, under the old rules, if you refinanced a 30-year term loan after 15 years into a new 25-year loan, the interest would have been deductible for the entire 25-year term of the new loan. However, under tax reform, the interest on the refinanced loan would only be deductible for 15 years – the remaining term of the refinanced debt.

Property Taxes – Prior to the tax reform, homeowners could deduct all of the state and local taxes they paid as an itemized deduction on their federal return. These taxes were primarily real property taxes and state income tax (taxpayers had and still have the option to replace state income tax with sales tax). Beginning in 2018 and through 2025, the deduction for taxes is still allowed but will be limited to a total of $10,000. Thus, if the total property tax and state income tax exceeds $10,000, homeowners may not get the benefit of deducting the full amount of the property taxes they paid. In addition, this requires an analysis when the return is being prepared of whether to claim sales tax instead of state income tax, since when state income tax is deducted, if there’s a state tax refund, it may be taxable on the federal return for the year when the refund is received.

Determining when and how much home mortgage interest was deductible was frequently complicated under the prior tax law, and the new rules have added a whole new level of complexity, including issues related to property taxes. Please call this office if you have questions about your particular home loan interest, refinancing, equity debt interest tracing circumstances, and tax deductions.