The Tax Cuts and Jobs Act of 2017 (TCJA) reduced the maximum amount of acquisition indebtedness for which mortgage interest is deductible. The limit was reduced from an acquisition indebtedness maximum of $1 million ($500,000 if married filing separate or MFS), to a maximum acquisition indebtedness of $750,000 ($375,000 if MFS).
The new limit applies to acquisition indebtedness incurred after Dec. 15, 2017. The TCJA also eliminated the deduction for interest paid on home equity indebtedness unless the home equity loan debt proceeds are used to buy, build or improve one’s main home or principal residence.
This column explains the new rules for deducting mortgage interest as employees and annuitants prepare and file their 2018 federal income tax returns.
Qualified residence mortgage interest is defined and potentially deductible on one’s federal income tax return as an itemized deduction (Schedule A) in one of three ways:
Acquisition debt – mortgages incurred after Oct. 13, 1987
Mortgage interest paid is deductible under the following conditions:
- The debt incurred is used to acquire, build, or substantially improve an individual’s main home (principal residence) or a second home (vacation home). The interest paid on a mortgage secured by a third home is nondeductible personal interest, unless the home is business or investment property;
- the mortgage debt must be secured by the home;
- for determining qualified residence interest, debt is limited to $750,000 ($375,00 if married filing separate), for mortgages incurred after Dec. 15, 2017. For mortgages incurred before Dec. 16, 2017, the debt limit is $1 million ($500,000 if married filing separate); and
- additional amounts borrowed to make substantial improvements to the home increase acquisition debt. Additional amounts borrowed include home equity loans, home equity lines of credit, and second mortgages used to buy, build or substantially improve the individual’s main home that secures the loan.
Note the following with respect acquisition debt limits: For unmarried co-owners of a residence, the debt limits for each owner, not to the property. The following example illustrates:
Carla and Tammy, both single, bought a house as joint owners. The house was purchased for $1.2 million on June 15, 2017. Carla and Tammy each made a $50,000 down payment, resulting in a mortgage loan of $1.1 million. Both Carla and Tammy are eligible to deduct the mortgage interest paid on the $1.1 million mortgage. This is true that even though the total mortgage debt of $1.1 million exceeds the $1 million acquisition debt limit (the house was purchased before Dec. 16, 2017), both Carla and Tammy each have a $1 million mortgage loan deductability limit themselves. Carla and Tammy are responsible for paying on one-half of the total mortgage of $1.1 million, or $550,000, which is below the individual acquisition limit for mortgages incurred after Oct. 13, 1987 and before Dec. 16, 2017.
Home equity debt – incurred after Oct. 13, 1987
This is debt secured by the main home (principal residence) or a second (vacation) home. Before Jan. 1, 2018, interest on a home equity debt of up to $100,000 ($50,000 if married filing separate) was generally deductible. But starting Jan. 1, 2018, interest paid on home equity debt generally is not deductible unless the home equity loan proceeds are used to buy, build, or substantially improve one’s main home (principal residence).
Interest paid on a home equity loan after Dec. 31, 2017 and used to pay personal living expenses such as credit card debts, auto loans, or college expenses is not deductible. As under pre-2018 law, the home equity debt must be secured by the individual’s main home, not to exceed the cost of the home and, when combined with other acquisition indebtedness, subject to the overall limit on acquisition indebtedness.
The following example illustrate the new rules on home equity debt:
In February 2018, Ted and Alice took out a $500,000 mortgage to purchase a principal residence. The mortgage loan is secured by the principal residence. In April 2018, they took out a $250,000 loan to purchase a vacation home. The loan is secured by the vacation home. Since the total amount of both mortgages ($500,000 plus $250,000) of $750,000 does not exceed $750,000, all of the mortgage interest paid on the two loans is deductible. If Ted and Alice had taken out a $250,000 home equity loan on their principal residence in order to purchase the vacation home, then the interest on the home equity loan would not be deductible. This is because the interest paid on home equity debt in which the loan proceeds are not used to buy, build, or improve a main home is not deductible.
“Grandfathered debt” – mortgage debt incurred before Oct. 14, 1987
All interest on mortgage debt incurred before Oct. 14, 1987 and secured by a main home or a second/vacation home is fully deductible, regardless of the purpose for which the funds were used. A pre-Oct. 14, 1987 debt reduces the limit that applies for additional acquisition debt incurred after Oct. 13, 1987.
Refinancing pre-Oct 14, 1987 debt after Oct. 13, 1987 is treated as acquisition debt to the extent it does not exceed the outstanding principal before the refinancing and the repayment period does not extend beyond:
(a) the remaining term of the original debt, if the original debt was to be repaid over its term; or
(b) if the original debt was not to be repaid over its term, the term of the first refinancing, but not more than 30 years after the first refinancing.
Finally, home mortgage interest is potentially deductible only if the mortgage is considered secured debt. Secured debt is represented by a signed instrument, such as a mortgage, a deed of trust, or a land contract.
An individual may elect to treat mortgage debt as not secured by a qualified residence. This election may be advantageous if the allowable mortgage interest is not deducted because the individual claims the standard deduction instead of itemizing, or the debt is home equity indebtedness not used to buy, build or improve a principal residence, thus resulting in nondeductible mortgage interest.
An example of an individual who may want to make this election is a sole proprietor who wants to treat home equity interest as a business expense on Schedule C. In treating the mortgage debt as unsecured, the interest paid is not subject to the home equity indebtedness rules and the interest paid is a legitimate business expense, and therefore deductible on Schedule C.