Mortgage Interest Deduction Under TCJA

By Jason Watson, CPA

Posted Mon, June 4, 2018

Two big things changed with the Tax Cuts and Jobs Act of 2017 for homeowners. The amount of your property tax deduction and mortgage interest deduction is now limited. Here are the highlights-

Debt limit is now $750,000 for acquisition debt incurred after December 15 2017. Yes, this means that loans that were in place on or before this date have the old limit of $1,000,000. We’ll talk about borrowing against your equity to buy a second home and other debt consolidations (such as home equity loans) in a bit. We’ll also define acquisition indebtedness with some examples in a few moments which includes purchase, construction and improvement.

Second homes carry on as they were, and mortgage interest debt for second homes is piled onto the primary residence when applying the mortgage interest deduction rules.

Section 163(h)(3) has this verbiage “The term ‘acquisition indebtedness’ means any indebtedness which- (I) is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and (II) is secured by such residence.” There ya go. Don’t worry about the loan label- HELOC, home equity, second mortgage, 80-10-10, blah blah blah.

Interest on home equity loans, other than those used to purchase, construct or improve the home securing the loan are no longer deductible. Huh? Let’s say you have a home equity loan that is used to buy a car – the mortgage interest is not deductible. However, let’s say you have a HELOC (fancy word for home equity line of credit) that is used to add a wing for your mother in law (yikes), then this debt is being used to improve the property that is securing the loan- this interest is deductible with the limits applied above. So, the property is improved (new wing) and the mortgage interest is deductible but the home is in shambles (your mother in law). Net zero.

Here is a copy and paste version of the IRS’s news release IR-2018-32 on February 21 2018 giving more examples of the mortgage interest deduction (we added emphasis)-

Example 1: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home with a fair market value of $800,000. In February 2018, the taxpayer takes out a $250,000 home equity loan to put an addition on the main home. Both loans are secured by the main home and the total does not exceed the cost of the home. Because the total amount of both loans does not exceed $750,000, all of the interest paid on the loans is deductible. Your mortgage interest deduction is not limited.

However, if the taxpayer used the home equity loan proceeds for personal expenses, such as paying off student loans and credit cards, then the interest on the home equity loan would not be deductible.

Example 2: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home. The loan is secured by the main home. In February 2018, the taxpayer takes out a $250,000 loan to purchase a vacation home. The loan is secured by the vacation home. Because the total amount of both mortgages does not exceed $750,000, all of the interest paid on both mortgages is deductible. Your mortgage interest deduction is not limited.

However, if the taxpayer took out a $250,000 home equity loan on the main home to purchase the vacation home, then the interest on the home equity loan would not be deductible. Read this again! This is a common scenario; you borrow against your primary residence to buy a vacation home… no good. As far as we know today, however, this same home equity loan interest is deductible if you use it for a rental property since that interest is not limited by TCJA.

Example 3: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home. The loan is secured by the main home. In February 2018, the taxpayer takes out a $500,000 loan to purchase a vacation home. The loan is secured by the vacation home. Because the total amount of both mortgages exceeds $750,000, not all of the interest paid on the mortgages is deductible. A percentage of the total interest paid is deductible (see Publication 936). In other words, your mortgage interest deduction is limited.

Property taxes are now limited to $10,000. Said in another way, the combined state and local taxes (SALT for short) is limited to $10,000. This includes all taxes, such as income and property. So, if you have $4,000 in property taxes and $7,000 in state income taxes, the combined amount is limited to $10,000. As a result, in many cases, especially for those living in high income tax and high property tax states such as California, New York City and Wisconsin (our favorite), you are really hosed. But don’t forget that tax brackets were lowered and standard deductions were increased. Tax reform hurts some and helps others in a net-zero sort of way.

This state and local tax limit also includes sales tax. So, if you were one of those who deducted sales tax in lieu of state income taxes, this is tossed into the mix as well.

An anti-abuse rule is also in place for those who wanted to beat the system and prepay income taxes on the last day of December 2017. The Conference Committee explanation of the Act reads in part, “an individual may not claim an itemized deduction in 2017 on a prepayment of income tax for a future taxable year in order to avoid the dollar limitations applicable for taxable years beginning after 2017.”

Note that this reads income taxes. Property taxes are specifically not mentioned by the Conference Committee. However, the IRS blew up and released Notice 2018-54 on May 23 2018 which reads in part, “despite these state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes.“ Oooh, snap!

Before you freak out, the SALT limit does not include business taxes. So… your rentals, for example, do not have this limitation. Your business does not as well including farms. In other words, the state and local taxes (including property taxes and sales taxes) are limited when being deducted on Schedule A. If these same taxes are deducted on Schedule C, E or F, or on a business tax return, then there is no theoretical limit.

A word of caution, however, there are some odd-duck caveats for real property taxes when combined with the election by businesses to not be limited by an interest deduction. More on that weirdness in another blog post.

Jason Watson, CPA is the Managing Partner of WCG (formerly Watson CPA Group), a business consultation and tax preparation firm, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online.