Home mortgage interest taken as an itemized deduction will be limited in 2018 through 2025. Only the interest paid or accrued on acquisition debt will be eligible for the deduction in those years. Additionally, the maximum amount of debt used to calculate the allowable home mortgage interest deduction will be reduced from $1,000,000 to $750,000 on new mortgages incurred after December 15, 2017. This means a taxpayer who financed the purchase of a $1 million home in 2018 won’t be able to deduct interest in excess of $750,000 in principal.

Historical Context

Contrary to popular belief, the home mortgage interest deduction was not created to add a middle class tax incentive for home ownership: the home mortgage interest deduction is the last hold-out of personal interest allowed as a tax write off.

Prior to the passage of the Tax Reform Act of 1986 (TRA86), all personal interest was deductible. Interest paid on personal loans, car loans, credit card debt, and home mortgages were all allowable deductions. After the passage of TRA86 the deductibility of personal interest was reduced to 65% and home mortgage interest remained.

Since then, personal interest is generally not deductible and mortgage interest is limited.

2017 Mortgage Interest Deduction

For the tax year ending December 2017, interest paid on a home mortgage may be taken as an itemized deduction on Schedule A of Form 1040. Eligible mortgage interest can be taken on a primary residence and one other secondary residence. A primary or secondary residence is defined as any house, vacation home not rented out during the year, condominium, Co-op, mobile home, trailer, or boat.

Qualified Home Indebtedness

Qualified home indebtedness is divided into two distinct categories:

1. Acquisition Indebtedness is debt incurred in acquiring, constructing, or substantially improving a qualified residence of the taxpayer, and is secured by the residence. The maximum allowable principal balance for calculating the interest deduction on acquisition indebtedness is $1,000,000 ($500,000 for married filing separately). A personal loan used for major improvements is not considered acquisition indebtedness unless it is secured by the home.
2. Home Equity Indebtedness is any other debt that is not acquisition indebtedness but is secured by the qualified residence. Interest paid or incurred on home equity indebtedness is generally deductible even if the proceeds were used for personal expenditures (i.e. taking out a home equity loan to purchase a vehicle). Only $100,000 of home equity indebtedness may be used in determining the allowable interest deduction ($50,000 if married filing separately).

The allowable interest deduction for home equity indebtedness may be added to the allowable interest deduction for acquisition indebtedness even if the acquisition indebtedness exceeds the $1,000,000 limitation.  Simply stated, the maximum allowable indebtedness is $1,100,000 ($550,000 married filing separately) after combining the acquisition indebtedness and the home equity indebtedness.

2018 Mortgage Interest Deduction

For the tax years ending December 2018 through December 2025, home equity interest is disallowed. This means only acquisition indebtedness is allowed as a qualifying mortgage interest deduction. Thusly, interest incurred on home equity loans used for personal expenditures or minor home repairs (whether used in prior years or used between 2018 and 2025) will not be allowed as an itemized deduction.

• Note: interest incurred on home equity loans used to substantially improve a qualifying residence may still be allowed under the home acquisition indebtedness rules.

The maximum amount used as acquisition indebtedness is reduced from $1,000,000 to $750,000 ($375,000 married filing separately). However, this limitation only applies to acquisition debt incurred after December 15, 2017. Therefore, as a general rule any acquisition indebtedness incurred prior to December 15, 2017 is still subject to the $1,000,000 limitation instead of the $750,000 limitation for the tax years ending December 2018 through December 2025.

Additionally, the higher limit applies to acquisition indebtedness incurred after December 15, 2017 if the proceeds were used to refinance existing acquisition indebtedness (to the extent the refinanced loan does not exceed the amount of the refinanced debt).

Therefore, refinancing a mortgage that was incurred prior to December 15, 2017 will generally not impact the limitation amount (subject to certain exceptions).

Lastly, the acquisition indebtedness on a second residence is still deductible subject to the rules described above. Prior versions of the bill proposed the elimination of the deducibility of mortgage interest on second homes but this provision was removed in the final passage of the bill.

Other Considerations

It should be noted that interest tracing rules still apply to home equity loans and acquisition indebtedness. Essentially, just because the interest on a home equity loan or acquisition indebtedness is disallowed as a schedule A deduction it may be eligible for a deduction elsewhere on the return.

Proceeds Used For The Acquisition of Business Assets

If a home equity loan is used to purchase business assets then that loan is considered a business loan and not a home equity loan subject to the schedule A limitations. Therefore, the interest is fully deductible as a business expense (subject to general business loss limitations).

Home Office Deduction

The portion of the acquisition indebtedness allocable to the home office is fully deductible (subject to loss limitation rules on Form 8829). Therefore, if a homeowner has a $2 million mortgage and 10% of the home is used as a home office then 10% of the mortgage interest is not subject to the $750,000 ($1,000,000 grandfathered mortgage) limitation.

Use of Home Equity Loan to Purchase Rental Property

A home equity loan used to purchase rental property is not subject to the new rules. Therefore, interest incurred on a home equity loan used to purchase rental property will be fully deductible on schedule E of Form 1040 as a qualified rental expense.

Increased Standard Deduction

With the increased standard deduction and the limitation of the state and local income tax deduction to just $10,000, claiming a mortgage interest deduction will be more difficult than ever before. The number of taxpayers who itemize will fall from 1 in 3 to roughly 1 in 10. Therefore, for most taxpayers the mortgage interest deduction will go away in 2018 because of other changes in the tax law.

Conclusion

The new rules surrounding the deductibility of mortgage interest is complex and what may be deductible for one taxpayer may not be deductible for another taxpayer. To fully understand how the new tax changes will impact your specific tax situation please consult your tax advisor.

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This article is intended for educational purposes only and does not constitute paid legal, financial tax or other professional services. To see how the information described in the article impacts your unique tax, financial or legal situation consult with an advisor.

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