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The new tax law creates some potential pitfalls for home buyers and how they finance their property.
Much of whether interest on the mortgage can be deducted comes down to whether the loan is considered “acquisition debt.” Timing is everything.
Pay cash for your home — whether for your primary residence or a second home — and decide later to get a mortgage? It won’t qualify for a deduction because the loan wasn’t used to buy the property from the start. Nor can you get around that with a home-equity loan. Under the old rules, you could deduct the interest associated with up to $100,000 of home-equity debt regardless of when you got the loan.
Here are three more examples that illustrate the complexity of the rules that took effect at the start of this year:
• If you buy a second home and take out a mortgage at the same time, the interest is fully deductible if you itemize — and if the mortgages on both the primary and secondary home don’t exceed a combined $750,000. That limit applied to all taxpayers, except married couples filing separately, who are each limited to $375,000.
Single taxpayers are each subject to the $750,000 limit. A Ninth Circuit Appeals Court decision ruled that if an unmarried couple buys a home, they can pool their caps, which would mean they could deduct interest on a mortgage of up to $1.5 million.
Under the old rule, the deductible interest was limited to the combined mortgage of up to $1 million for all taxpayers, except for married taxpayers filing separately, who were limited to $500,000 each.
• How about if you buy that same second home but get the cash to pay for it by taking a second mortgage on the primary residence? Then interest on the second mortgage isn’t deductible, even if the combined mortgages don’t top $750,000. And if the secondary residence is funded with both a second mortgage on the primary residence and a mortgage on the secondary residence, only the interest on the secondary residence’s mortgage is deductible, again up to that $750,000 limit for both mortgages.
• Likewise, if a primary or secondary residence is funded with both a primary and secondary mortgage at the time of purchase, the interest from both mortgages would be deductible up to the combined $750,000 limit because both mortgages were part of the purchase.
The old limit of deducting interest on mortgages of up to $1 million still applies to homes bought before Dec. 15. But if the second home is purchased after that date, when this part of the Tax Cuts and Jobs Act of 2017 took effect, then the combined limit is $750,000 if the outstanding mortgage on the primary residence is below $750,000.
If the outstanding mortgage on the primary residence is above $750,000, then interest on the primary residence is still deductible but not on secondary property.
What qualifies as a residence? The government defines a residence to include but not limited to single-family homes, co-op apartments, condominiums, mobile homes, house trailers, and boats that include sleeping space as well as toilet and cooking facilities.
And of course, whether it even pays to itemize mortgage interest depends on whether all your deductions exceed the new, higher standard deductions of $24,000 for married couples, $18,000 for head of household taxpayers and $12,000 for single taxpayers or married couples filing separately. Don’t forget that there’s a $10,000 cap on the amount of state and local income taxes plus property taxes that can be deducted.
What about home equity loans?
The new tax law no longer allows any interest on home-equity loans to be deducted. This is because it doesn’t count as acquisition debt. Previously, interest associated with home-equity loans of up to $100,000 could be deducted. This new rule covers even home-equity loans in existence prior to the new law.
If a home buyer plans to fund remodeling of a new home, it’s wiser to take a second mortgage instead of a home-equity loan at the time of purchase. Then the interest would be deductible if, as always, the total mortgage balance is below $750,000.
New rules for mortgage refinancing
For those individuals with a mortgage on their home prior to Dec. 15, the $1 million limit continues to apply if you refinance your mortgage to lock in a lower interest rate.
But if the refinancing is also used to increase the size of the mortgage, interest on the additional debt can’t be deducted.
For example, a couple currently has a mortgage of $400,000 and a 4% interest rate on their primary residence. They refinance and get a $500,000 mortgage at an interest rate of 3%. Only the interest on the $400,000 portion of the mortgage is deductible.
Some individuals may believe they can still claim the interest on the excess debt amount because the IRS won’t notice it. But while a person may not notice the increased interest amount being claimed, you can be sure the IRS computer will spot the change.
Finally, consult a qualified tax adviser before making any decision involving federal and state income taxes.
Anthony P. Curatola is the Joseph F. Ford Professor of Accounting at Drexel University’s LeBow College of Business and editor of the Taxes column for “Strategic Finance”.