Mortgage Interest Deductions – A Slippery Slope

Joseph A. Lux, C.P.A., PLLC

February 1, 2019

Recent changes to the tax laws will reduce various itemized deductions for many of my clients. The change that will have the greatest impact is the limitation of the deduction for state and local taxes. A close second is the loss of the deduction for home equity interest.

While the loss of a deduction usually simplifies the tax code, repealing the home equity interest deduction substantially complicates the preparation of a personal tax return due to the difficult tracking rules related to tax deductible mortgage interest.

Previously the interest paid on up to $1 million of debt to purchase or improve a personal residence (acquisition debt) was fully tax deductible. In addition, interest paid on up to $100,000 of home equity debt, no matter what the funds were used for, was also tax deductible. Under the new law, only interest paid on acquisition debt up to $750,000 is deductible. (Up to $1 million for debt that existed as of 12/15/2017). Here’s the kicker. Interest on home equity debt is no longer deductible. Period. End of story!

Lets take a close look. Home equity debt is defined by the use of the money borrowed and not what the lender calls the loan. If you borrow what the lender calls a home equity loan or open what the lender calls a home equity line of credit, and use the proceeds to pay for improvements to your home, this loan is acquisition debt; the interest on this debt is fully tax deductible up to the $750,000 limit mentioned above.

Now it is more important than ever to keep separate track of acquisition and home equity debt. Homeowners must go back to the original purchase mortgage for each property and forward through all subsequent refinancing, borrowing and consolidation to separately identify acquisition debt and home equity debt.

Unless the homeowner has only had one mortgage loan, the original purchase mortgage for the property, and has never refinanced, the interest reported on the form 1098 issued by the lender is not the amount of the interest that can be deducted on his tax return. When an existing acquisition debt loan is refinanced, the new mortgage is treated as acquisition debt only up to the balance of the old mortgage principal just prior to the refinancing, plus any additional debt used to substantially improve the residence. Any excess principal, including amounts used to cover closing costs, is considered home equity debt, and related interest is not tax deductible. The only way to avoid the home equity debt classification in this case is to refinance only the principal from an acquisition debt mortgage and pay all closing costs with separate funds.

For example: Joe and Gayle purchased a home in 2014. They have one mortgage from the original purchase and no home equity debt. They want to refinance their original mortgage in 2018 to get a better rate. The principal balance on the original mortgage is $110,000. The principal balance of the new mortgage will be $113,000. They did not take any money out, and paid a little over $1,000 at closing. The difference is the closing costs for title insurance, inspection, fees, etc. Even though they only have one loan, Joe and Gayle now have acquisition debt of $110,000 and home equity debt of $3,000. Only the interest on the $110,000 portion is tax deductible. Form 1098 issued by the lender will show the interest paid on the entire debt. Their interest deduction will equal $110,000/$113,000 = 97.3% of the total mortgage interest reported on form 1098. If Joe and Gayle had refinanced and borrowed a total of $200,000 in 2018, and used $40,000 of these funds to improve their home, their tax deductible interest would be limited to the interest on the original acquisition debt of $110,000 plus $40,000 of additional acquisition debt. The $50,000 excess would be considered home equity debt. Interest on the $50,000 would not be tax deductible since it was not used to improve the home and would not be considered acquisition debt.

Ask your CPA to help you to determine the amount of mortgage interest that you may deduct on your 2018 tax returns. He can help you to navigate the difficult tracking rules related to tax deductible mortgage interest.

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