Breaking Down the New Mortgage Deduction Rules

Mortgage DeductionsHomebuying and homebuilding are good for the economy. That fact, and not lawmakers’ desire to give working families a break, is what makes the mortgage interest deduction a sacred cow. The government sees the deduction as something of a reverse stimulus. By encouraging people to buy houses, and therefore encourage builders to construct houses, the economy prospers.

Not all nations see it that way. Some industrialized countries, most recently Japan, have either tinkered with the MID or done away with it entirely. Many Tax Cuts and Jobs Act provisions expire in 2025. We’ll see what happens then. But for now, the MID is not going anywhere, at least for the most part.

TCJA Mortgage Deduction Rules

Taxpayers may still deduct the interest payments they make on loans secured by their primary residences. The price ceiling dropped a little, from $1 million to $750,000 in most cases.

The more significant change is the Home Equity Line of Credit deduction. Previously, the IRS treated HELOC interest on a subsequent mortgage just like interest on a first mortgage. That was one driving factor behind the HELOC boom/housing bubble in the mid to late 1990s, and we all remember how that ended up. The government, which still has a bad taste in its mouth after the Financial Crisis, ended that deduction.

But not so fast. HELOC interest may still be deductible if the HELOC is a qualified residence loan. If the borrower re-invests the loan proceeds into the house, the MID still applies. But if the homeowner uses the loan for any other purposes, the interest is not tax-deductible. More on that below.

It’s a bit unclear, but it seems that 100 percent of the proceeds must go to home improvement. If the owners borrow $100,000, use $99,999 to improve the house, and spend $1 on a candy bar, that might cut off the deduction.

To a great many people, all this information may be irrelevant. In recent tax years, about a third of taxpayers have itemized their deductions. But TCJA doubled the standard deduction. That’s great news for people who take a standard deduction, but not so great for everyone else. Many predict that the number of itemized returns may plummet to around 5 percent beginning with the 2018 tax year. The standard deduction will be so high that itemizing, including the MID, simply does not make sense.

When is “Mortgage Interest” Really “Mortgage Interest?”

The tracing rules have always been rather complex. These are the guidelines that separate the sheep from the goats in terms of the MID. Basically, the following types of interest are deductible:

  • First mortgage on a primary residence,
  • Subsequent mortgage on a primary residence (assuming the HELOC is a QRL),
  • Material participation business interest, and
  • Investment interest.

Some examples might be helpful.

Assume you take out a $100,000 unsecured loan and use the money in your freelance consulting business. The interest is tax-deductible because you materially participate in that business.

Assume you are a silent partner in a consulting business and you borrow $100,000. Your house does not secure the loan and all the money goes into the consulting business. The interest is generally not tax-deductible because you do not materially participate in that business. Exception: The interest is tax-deductible if passive activity income exceeds passive activity expenses.

Tracing rules are even more complex if you combine different loans for different purposes. The best practice is to keep all loans and loan funds separate.

The mortgage interest deduction is still around, but the rules have changed. Reach out to us today to learn more about the new tax law changes which take effect in January 2019.