Mortgage Interest: What’s Deductible Now and Should I Refinance?

By Kelly Pelletier January 22, 2018

Happy New Year, happy new tax law! On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (“TCJA”) into law. The final bill is very lengthy, and contains numerous changes affecting individuals. Among these changes are new limits on certain itemized deductions, such as state and local taxes and home mortgage interest. This article focuses on the changes to the mortgage interest deduction.

Generally, interest incurred on personal obligations is not deductible. However, an exception has historically been made for qualified residence interest. Qualified residence interest is defined as interest that is paid or accrued during the tax year for (1) acquisition indebtedness or (2) home equity indebtedness. Acquisition indebtedness is essentially a mortgage on your first or second home (“qualified residence”) that was incurred when acquiring, constructing, or renovating that home. Home equity indebtedness is any other debt that is secured by the qualified residence. The qualified residence designation is not limited to a house; it also includes condominiums, cooperatives, mobile homes, and certain boats.

The old rules (2017 and prior years)

Under the prior law (which still applies to the 2017 income tax return you will file this spring), homeowners can deduct mortgage interest paid on acquisition indebtedness up to $1,000,000 ($500,000 for married filing separately status), plus interest paid on home equity indebtedness up to $100,000. Interest on that home equity indebtedness is deductible (up to $100K) no matter the use of the debt proceeds as long as all home-related debt does not exceed the fair market value of the qualified residence which secures the debt.

The new rules (2018 and forward)

The TCJA makes two substantial changes to prior tax policy with regard to mortgage interest: (1) reducing the limit on acquisition indebtedness to $750,000 ($375,000 for married filing separately); and (2) suspending the deduction for interest on home equity indebtedness. Before you rush to refinance your home equity loan or line of credit, please keep reading! We’ll discuss which debt is problematic shortly.

Note that interest deductions for mortgage debt on both a primary and a second home survived in the new law, subject to the limits described above. Although earlier versions of the tax bill proposed disallowing mortgage interest deductions on second homes, the final bill contains no such limit.

The good news for homeowners with large or multiple mortgages is a “grandfather” provision, allowing some of the old rules to continue to apply. If the acquisition indebtedness was incurred before December 15, 2017, taxpayers will still be able to deduct the interest on up to $1,000,000 of qualified debt. (The bill also makes an exception to this limit for individuals who had signed binding contracts before December 15, 2017 to buy homes and closed shortly thereafter.)

There is bad news for those buying or building homes now and needing to finance more than $750,000; the new limitations will prevent the deductibility of interest on debt in excess of that amount.

There is also bad news for those who have borrowed against the equity in their homes (typically by use of a home equity loan or line of credit) and used it for purposes other than to buy, build or improve a primary or second home. Deductibility of interest paid on a home equity loan for 2018 will depend on the use of the borrowed funds.

Let’s turn back, for a moment, to the definition of home equity indebtedness for purposes of the deductibility of interest. As we said earlier, all debt secured by a first or second home and used to buy, build or renovate that home is considered “acquisition indebtedness” and is deductible, subject to the overall limits described above based on when the debt was incurred. That is so regardless of whether the debt is a first mortgage or home equity loan or credit line. For purposes of a tax deduction, “home equity indebtedness” means any debt secured by your home that was NOT used to buy, build or improve it. While the old rules (applicable to 2017 and prior) allow a deduction for interest on home equity debt of up to $100,000 no matter the use of the proceeds borrowed, the 2018 rules will apply to prevent any deduction for interest paid on debt proceeds used for purposes other than to buy, build or improve that home.

Let’s look at an example:

Joe purchased a home in 2015 for $2 million by taking out a $1,000,000 mortgage, and paying cash for the rest. The current mortgage balance is $955,000. In 2016, he took out a $100,000 home equity line against the home and borrowed the full amount to purchase New England Patriots season tickets. The current balance on the home equity line is $40,000.

• For 2017, all the interest Joe pays on both loans will be deductible.
• For 2018, he will only be able to deduct the interest on the loan used to buy the home. Because his home purchase and debt were in place by December 15, 2017, he is grandfathered for 2018 and subject to the $1 million debt limit for home acquisition indebtedness. However, he may not deduct any of the interest on the loan used to enjoy seats at the Pat’s games for 2018.

Now let’s assume Joe used the home equity loan proceeds to build an addition to his home rather than football tickets. For both 2017 and 2018, he can deduct all the interest on both loans. With regard to 2018, his loans predate the new law and his total acquisition debt (used to buy or improve the home) is under $1 million ($955,000 plus $40,000 in our example) for 2018, so he is grandfathered and may still deduct all his interest on both loans. If his total debt were greater than $1 million, only that portion of the interest attributable to $1 million of debt would be deductible.

Should a taxpayer refinance a home equity loan?

Going back to the first example above in which Joe used his home equity line to buy Patriot’s tickets, you might wonder if Joe could refinance to make the interest on both loans fully deductible in 2018. The short answer is no. He could refinance the current first mortgage balance of $955,000 (say, to get a better interest rate) in 2018 and the interest on the new loan will be fully deductible. A provision in the new law relates any refinanced date back to the date of the original loan for limitation ($1 million or $750,000) as long as the new loan does not exceed the amount of the refinanced loan. Therefore, Joe cannot roll the unpaid balance on the home equity loan into a refinanced loan to make it deductible.

Remember that if your home equity loan was used to buy or improve your first or second home, the interest will still be deductible in 2018 if your total home debt is within the limits based on when the debt was incurred.

The mortgage interest deduction is just one of the many concepts revised by the new tax legislation. The rules are complicated; if you have questions about the mortgage interest deduction, or other tax law changes, please contact Kelly Pelletier or your BNN advisor at 1.800.244.7444.