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Mortgage Interest Expense Limitations under the TCJA

If you’re a resident of Simi Valley, Thousand Oaks or Moorpark, you know that housing prices are sky high. According to Zillow, the median asking price for a home in Simi Valley is $605,000. While asking price doesn’t necessarily equate to mortgage liability, it’s safe to say there are plenty of homeowners in Simi Valley with hefty mortgages.

Maybe you’re one of them.

If so, you might have heard about changes to the mortgage interest deduction under tax reform (Tax Cuts and Jobs Act of 2017) but didn’t pay much attention to the specifics. But now that the end of the year—and tax season--is fast approaching, it might be time to take a closer look at the mortgage expense limitations under tax reform.

If you thought tax law was complicated before tax reform, it’s even more so now.

While tax reform did little to simplify the tax code, the good news is that I am here to help. As a Certified Public Accountant and owner of Simi Valley’s top accounting firm, Kami L. Molin, CPA, my job is to keep up on current tax law so I can help taxpayers in Simi Valley, Moorpark, and Thousand Oaks—many of them homeowners just like you—save money on their taxes.

Mortgage Interest Deductions before Tax Reform

Prior to tax reform legislation passed last year—and dating back to the mid-1980s and the Tax Reform Act of 1986--homeowners who itemized were able to deduct mortgage interest on the first $1,000,000 of mortgage debt principal used to acquire, build, or substantially improve a primary residence. The IRS refers to this as "acquisition debt." You can deduct your home mortgage interest only if your mortgage is a secured debt such as the home you are buying. Homeowners could also deduct interest on mortgage debt principal (up to $100,000 for married filing jointly) used for any other purpose, generally a home equity loan (i.e., home equity line of credit or HELOC) or a larger first mortgage. The IRS refers to this as "home equity debt." Many taxpayers used home equity loans for personal reasons as well, such as paying off credit cards.

Now, let’s take a look at how tax reform changes the mortgage interest deduction and how it could affect your tax situation this year:

Mortgage Interest Deductions after Tax Reform

First, because of the larger standard deduction ($24,000 married filing jointly in 2018), fewer taxpayers will be able to itemize and take advantage of the mortgage interest deduction. As such, some taxpayers will not be able to deduct mortgage interest on their 2018 tax return.

Second, keep in mind that although many tax provisions under tax reform became effective on January 1, 2018, the new rules regarding mortgage interest deductions apply to debt acquired after December 15, 2017. The new TCJA rules on mortgage interest did not affect 2017 tax returns that were filed in 2018, however.

Third, home equity debt is no longer deductible except where the loan proceeds are used for home improvement. Home equity debt is then treated as an acquisition debt and is an allowed deduction.

Fourth, the new tax law applies only to tax years 2018 through 2025.

Fifth, you are generally allowed to deduct interest on only up to $750,000 ($375,000 for single filers) of mortgage debt incurred to buy or improve a first or second residence. In tax-speak this is known as the home acquisition indebtedness limit.

Exception. Existing mortgages are grandfathered. That is, a taxpayer still qualifies for the $1,000,000 mortgage expense limitation that was in effect prior to tax reform. Also, homes entered into a binding contract before December 16, 2017, and closed on before April 1, 2018, can use the prior limit of $1 million.

Another notable exception is that prior to tax reform, the home acquisition indebtedness limit of $1,000,000 ($500,000 for married filing separately) continues to apply to home acquisition indebtedness that was taken out before December 16, 2017, and then refinance during the period of time from December 16, 2017, through the end of 2025.

However, to qualify under the grandfathered provision, the initial principal balance of the new loan cannot be greater than the principal balance of the old loan at the time of the refinancing.

Let’s look at a few examples:

Example 1: Steve and Karen, married filing jointly

Steve and Karen bought a home, their principal residence, in Thousand Oaks in 2016 and took out a $1.5 million mortgage. They paid $65,000 of mortgage interest in 2017 and were able to deduct $47,667 of that interest on their tax return. Here’s the math: ($1.1 million ÷ $1.5 million) x $65,000 = $47,667

Under the TCJA their mortgage is grandfathered in and exempt from the $750,000 limit. They paid $60,000 in mortgage interest in 2017. However, for tax years 2018 through 2025, they can only deduct mortgage interest of $40,000 on up to $1 million (not the additional $100,000) of acquisition indebtedness. Once again, here is the math: ($1 million ÷ $1.5 million) x $60,000 = $40,000.

Example 2: Patricia, Single filer A

In March 2018, Patricia took out a $600,000 mortgage to purchase a home, her principal residence. The home secured the debt. In May 2018, she decided to buy a vacation home and took out a $500,000 loan to purchase it. Once again, the debt was secured by the home. Under the new law, because the total amount of both mortgages exceeds the $750,000 limitation, not all of the total interest paid is deductible.

Example 3: Alan, Single Filer B

Alan is unmarried with a first mortgage of $790,000 on a principal residence that he bought in 2013. In 2016, Alan took out a home equity line of credit (HELOC) and borrowed $79,000 to pay off a credit card debt, a car loan, and other personal debts. He was able to deduct all of the interest on the first mortgage on his 2017 tax return because his acquisition indebtedness was below the $1.1 million limitations ($1 million + $100,000). 

For tax years 2018 through 2025, Alan is still able to deduct all of the interest on the first mortgage under the grandfather exception (up to $1 million of home acquisition debt), but he cannot deduct any interest from the HELOC. If he had used the HELOC to pay for home improvement such as remodeling the basement or kitchen for example, then that interest would also be deductible under tax reform.

Personalized Tax and Accounting Services for Simi Valley Homeowners

If you have any questions about the mortgage interest deduction or are still wondering how tax reform affects your tax situation, don’t hesitate to call me, Kami L. Molin, CPA, at 805-526-8355. You’ll be glad you did.

Kami L. Molin | 12/18/2018