Deducting Mortgage Interest after Tax Reform

Will you be able to deduct mortgage interest in 2018? What about in the future?

The Tax Cuts and Jobs Act (TCJA) made far-reaching changes to the mortgage interest deduction. While many changes in the law simplified the tax code, this is one that complicated things for some people. The changes also mean that about 14 million people will deduct mortgage interest in 2018, down from 32 million in 2017.

One change that will have a major effect is the increase in the standard deduction. It was doubled almost to $12,000 for single taxpayers and $24,000 for married taxpayers filing jointly ($26,000 for couples 65 and older).

The higher deduction means fewer people will itemize deductions on Schedule A. You either take the standard deduction or deduct itemized expenses on Schedule A, whichever has the higher deduction. If you’re married and filing jointly, you don’t deduct itemized expenses unless the total of your Schedule A expenses (mostly mortgage interest, state and local property taxes, medical expenses and charitable contributions) exceeds $24,000. In addition to the higher standard deduction, another factor that will reduce the number of people deducting itemized expenses is that state and local property tax deductions are limited to $10,000 per tax return and miscellaneous itemized expenses are eliminated.

The TCJA imposed new limits on the mortgage interest deduction itself.

First, it is important to understand the distinction between acquisition mortgage debt and home equity debt. The distinction has been in the tax code for a while, but it is more important to many people now.

Acquisition debt is any debt used to acquire, build or substantially improve a primary residence or a second residence. The loan must be secured by the residence. Home equity debt is any other debt secured by a residence.

Notice that it doesn’t matter what the lender calls the loan. A home equity loan or line of credit can be acquisition debt under the tax law when you used the loan proceeds to substantially improve the home.

Under the old law, you could deduct interest on acquisition debt up to $1 million and interest on home equity debt up to $100,000.

Under the new law, interest on home equity debt isn’t deductible at all, and there’s no grandfather rule. Interest you deducted in the past on a home equity loan or line of credit isn’t deductible in 2018 and later years.

For acquisition debt, interest is deductible only on loan principal up to $750,000.

But there are grandfather rules for acquisition debt. If your acquisition mortgage interest was deductible in 2017, it probably still is deductible in 2018. The new limits apply only to mortgages taken out after December 15, 2017. In addition, if you refinance a grandfathered mortgage, the $1 million limit still applies but only to the extent of the debt that was remaining on the refinanced loan. For example, if you deducted interest on a $800,000 loan in 2017 and refinanced it in 2018 with a new $900,000 mortgage, only $800,000 of the mortgage principal is grandfathered.

Another grandfather rule applies the old limit when there was a binding written contract in place by December 15, 2017, and the transaction was closed before January 1, 2018.

It is important to note that the $750,000 mortgage limit applies per tax return, not per home, and only mortgages on up to two homes qualify for deductible interest. For loans incurred after December 15, 2017, you can deduct interest attributable to principal of up to $750,000. The principal can be on up to two homes, your primary residence and one other home. If the mortgages on the two homes total more than $750,000, you can deduct interest attributable to only $750,000. If you have more than two homes, you can deduct interest on only two of them, even if the mortgages are less than $750,000.

One result of the changes is that it’s more important to maintain good records for any mortgage when you plan to deduct the interest. To deduct interest on more than $750,000 of principal, you have to show the mortgages apply for the grandfather rules.

You also need to show the interest is on an acquisition mortgage. That means in case of an audit you should have paperwork that proves you used the mortgage proceeds to buy, build, or substantially improve the home. That’s particularly important if the loan was considered a home equity loan by the lender, since traditional home equity loan interest isn’t deductible.

So far, the IRS hasn’t required lenders to report on Form 1098 whether interest paid is on a home equity mortgage or some other type of mortgage. But it might do that in the future and use it to determine which taxpayers to audit.

For some taxpayers, the new rules cause a re-evaluation of whether they should continue to carry a mortgage or pay off their debt.

The analysis still is the same as discussed in our June 2018 issue. The first step is the mathematical analysis. When the after-tax return on your cash exceeds the after-tax cost of the debt, it makes sense to keep your money invested and maintain the debt. The second step is to consider the subjective factors. Do you sleep better knowing you don’t have debt? If you pay the mortgage do you have enough liquid assets to handle any emergency expenses that come up?

With the new rules, it might cost more after taxes to have a mortgage than in the past. If you have the cash to pay off the mortgage, you should re-evaluate whether it still makes sense to have a mortgage.