The recently enacted tax reform package changed the way we think about itemized deductions by placing caps on some items and outright repealing others. The change that's garnered the most attention is the new $10,000 cap on the state and local income and property tax deduction, and understandably so. But after that, the next most impactful change may be the new limitations on the mortgage interest deduction.
Or so it may seem.
The Tax Cuts & Jobs Act included two significant changes to the way taxpayers deduct interest on loans related to their home. While at first glance these changes may appear significant, both provisions include exceptions that allow taxpayers to continue claiming many of the deductions they claimed in 2017.
Deduction for mortgage interest
The tax law lets taxpayers deduct the interest on loans used to acquire a qualified home, which can be either their primary residence or a second home. For 2017, the deduction is limited to the interest paid on up to $1 million of debt. For 2018, however, the deduction is limited to the interest on only $750,000 of debt.
The trick on this deduction is that the new debt limit only applies to loans incurred after Dec. 14, 2017. Loans incurred before that date will continue to be subject to the $1 million debt limit. In other words, unless you took out a new mortgage after Dec. 14, your tax deduction for mortgage interest will be the same in 2018 as it was in 2017.
To further soften the impact of this rule, the old $1 million limit applies for taxpayers who entered a binding written contract to purchase a house as of last Dec. 14 with a plan to close on the sale by Jan. 1, even if the closing was subsequently delayed to as late as March 31.
In 2018, homebuyers, especially those who already own a primary residence with a mortgage, will need to be careful with these new limits, but most existing homeowners won't see a change this year.
Deduction for home equity interest
The other big change is the elimination of the deduction for home equity interest. No grandfathering, no lower limits — just a complete repeal.
Except that not all home equity loans generate home equity interest. If the proceeds of the equity loan are used to buy, build or substantially improve your home, the interest continues to qualify as mortgage interest. The loan amount would be subject to the old $1 million debt limit ($750,000 for a new loan), but otherwise the interest remains fully tax-deductible.
On the other hand, if the loan proceeds were used like many home equity loans — to purchase a car, pay for college, consolidate other loans, etc. — the interest is true home equity interest, and in that case is no longer deductible. Period.
Borrowers do need to remain watchful, especially for creative lending terms. Things like cash-out refinancing or "second mortgagees" may sound like traditional mortgage loans, but to the extent the new loan isn't used to pay off an original loan, the excess is an equity loan, regardless of what the lender calls it. And in that case the new rules will apply — meaning possibly no tax deduction.
So how will the IRS know how a home equity loan was used? They won't. But they'll expect the borrower to know, and to be able to prove it if the deduction is ever questioned. Borrowers will need to be more careful than ever to keep good records.
There's no question that nearly all taxpayers will be impacted by the tax reform act, but for many, any fear of the changes around the mortgage interest deduction may turn out to be unnecessary.
Tim Steffen is director of advanced planning for Baird. Follow him on Twitter @TimSteffenCPA.