While the new tax legislation signed by President Trump in December does change the mortgage interest deduction rules, the changes are not as clear cut as many may assume. In order for individuals to understand the amount of mortgage interest deduction they will be allowed to deduct in 2018, a careful examination of the Tax Cuts and Jobs Act (TCJA) is needed.
Under the TCJA, the principal balance related to acquisition indebtedness for purposes of acquiring, constructing, or substantially improving a home was decreased from $1 million to $750,000 in the case of taxable years beginning after December 31, 2017, and before January 1, 2026. This limits the interest deduction on an individual’s return to mortgages with a principal balance up to $750,000. For example, assume a married, filing-joint taxpayer purchased a principal residence with a mortgage of $850,000 at 4 percent in January 2018, resulting in a $34,000 payment of interest. The married, filing-joint couple would be limited to a 2018 mortgage interest deduction of $30,000 ($750,000/$850,000 x $34,000).
The ability to deduct mortgage interest up to a principal balance of $1 million still exists in 2018, if individual loans are grandfathered. If a taxpayer entered into a written binding contract before December 15, 2017, they can fall under the grandfathering rules, which would apply the previous $1 million principal threshold. Using the same example as above, but adjusting that the mortgage was entered into during 2015, will allow an increased 2018 mortgage deduction for the taxpayer. Now, instead of being limited to $30,000 of mortgage interest, their 2018 mortgage interest deduction would be $34,000. In addition, loans can be grandfathered even if refinanced after December 15, 2017, to the extent the amount of the indebtedness resulting from the refinancing does not exceed the refinanced indebtedness.
The TCJA also eliminated the deduction for interest on home equity loans in case of taxable years beginning after December 31, 2017 and before January 1, 2026. Under previous law, taxpayers were allowed to deduct mortgage interest related to home equity indebtedness not exceeding $100,000. Unlike acquisition indebtedness, there were no limitations on what the home equity debt proceeds could be used for, including home improvements or paying off student loans.
Individuals will need to review when they received a home equity loan and the reason why the home equity indebtedness was obtained in order to establish whether they are allowed a continued mortgage interest deduction going forward. If an individual obtained a mortgage and a home equity loan before December 15, 2017, and both loans were used for the acquisition, construction, or substantial improvement of the home, the 2018 mortgage interest that will be deductible is limited to a principal balance of $1 million. On the other hand, if the mortgage and home equity loan that were used for the acquisition, construction, or substantial improvement of the home were entered into after December 15, 2017, then the mortgage interest deduction would be limited to a principal balance of $750,000. Lastly, if the home equity loan was used for something other than the substantial improvement of the home then, in general, the interest on the home equity loan would not deductible in 2018.
For example, assume a married, filing-joint taxpayer received their first mortgage for $850,000 and purchased their principal residence in 2015. In addition, in 2016 they received a $50,000 home equity loan to remodel their kitchen. Both loans were utilized to acquire and substantially improve the home. In addition, the loans are grandfathered and thereby fall under the $1 million principal limitation. Therefore, the interest related to both the first mortgage and home equity loan would be deductible on the taxpayer’s 2018 tax return.
Assume the same example as above, but the first mortgage and home equity loan were entered into in January of 2018. Neither loan is grandfathered, and even though both were used to acquire and substantially improve the home, the $750,000 limitation applies. Therefore, only 83 percent ($750,000/$900,000) of the mortgage interest is deductible in 2018.
Lastly, assume a married, filing-joint taxpayer received a first mortgage of $850,000 to purchase a principal residence in 2015. In addition, in 2016 they received a home equity loan to pay off student loans. Both loans are grandfathered and would be subject to the $1 million limitation. However, since the home equity loan was used for something other than the substantial improvement of the home, only the interest related to the first mortgage is deductible in 2018.
Another key point to the legislation is to understand that not all interest related to a home equity loan entered into after December 15, 2017, results in a disallowed deduction. The interest deduction generally still will be allowed in 2018, as long as the taxpayer utilized the home equity loan to substantially improve their home, and in combination with the first mortgage does not exceed $750,000.
For example, assume the taxpayer entered into their first mortgage for $500,000 in 2016 to purchase their home. In 2018, the taxpayer obtained a home equity loan of $75,000 to remodel their kitchen. The interest related to the first mortgage and the equity loan are both deductible in 2018, because the combined principal amount is less than $750,000 and both loans were used to acquire, construct, or substantially improve the home.
However, a different answer would be obtained if the facts were altered so that the first mortgage was $850,000. The entire interest related to first mortgage loan would be deductible in 2018 because it would be grandfathered and fall under the $1 million principal threshold. However, the home equity loan is not grandfathered, and since the combined balance between the first mortgage and home equity loan exceeds $750,000, the mortgage interest on the home equity loan would not be deductible in 2018.
Even though the goal of the TCJA was to make the tax law less complicated, the intricacy of the mortgage interest deduction rules has greatly increased. Please contact your tax advisor with any questions you may have for existing loans or planning discussions surrounding potential mortgage and home equity loans in the future.
Lynn Mucenski-Keck is a manager based out of our Rochester, NY office.