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The Tax Cuts and Jobs Act (TCJA) imposes new limits on home mortgage interest deductions. Here's how the changes could affect your tax situation.
What Is Home Acquisition Indebtedness?
Under the tax law, home acquisition debt is a mortgage taken out "to buy, build, or substantially improve a qualified home (your main or second home). It also must be secured by that home."
An improvement is "substantial" if it:
Repairs that maintain your home in good condition, such as repainting your home, aren't substantial improvements. However, if you paint your home as part of a renovation that substantially improves your qualified home, you can include the painting costs in the cost of the improvements.
For the 2018 through 2025 tax years, the new law generally allows you to deduct interest on only up to $750,000 of mortgage debt incurred to buy or improve a first or second residence. This type of debt is called "home acquisition indebtedness" in tax lingo. (For married individuals who file separately, the home acquisition indebtedness limit is $375,000 for 2018 through 2025.) Under prior law, you could deduct interest on up to $1 million of home acquisition indebtedness (or $500,000 for those who use married filing separate status).
In addition, for 2018 through 2025, the TCJA generally eliminates deductions for interest paid on home equity debt. Under prior law, individuals were allowed to deduct interest on up to $100,000 of home equity indebtedness. (Married individuals who filed separately could deduct interest on up to $50,000 of home equity indebtedness.)
Under prior law, you could also treat another $100,000 of mortgage debt as home acquisition indebtedness ($50,000 for married people who file separately) if the loan proceeds were used to buy or improve a first or second residence. The additional debt could be in the form of a bigger first mortgage or a home equity loan. So, technically, the limit on home acquisition indebtedness under prior law was $1.1 million (or $550,000 for those who use married filing separate status).
Exceptions for Grandfathered Debts
The TCJA "grandfathers" in existing home mortgage debt under the old rules. That is, the new law doesn't affect home acquisition indebtedness of up to $1 million (or $500,000 for married-separate filers) that was taken out 1) before December 16, 2017, or 2) under a binding contract that was in effect before December 16, 2017, so long as the home purchase closes before April 1, 2018.
Under another grandfather provision, the previous home acquisition indebtedness limits of $1 million (or $500,000 for married-separate filers) continue to apply to home acquisition indebtedness that was taken out before December 16, 2017, and then refinanced during the period extending from December 16, 2017, through 2025. But the grandfather provision applies only to the extent that the initial principal balance of the new loan doesn't exceed the principal balance of the old loan at the time of the refinancing.
Are you confused yet? Here are some examples of how the new mortgage interest deduction limits work.
The Andersons. This married joint-filing couple has a $1.5 million mortgage that was taken out to buy their principal residence in 2016. In 2017, the Andersons paid $60,000 of mortgage interest, and they could deduct $44,000 [($1.1 million ÷ $1.5 million) x $60,000].
For 2018 through 2025, they can treat no more than $1 million as acquisition indebtedness. (Their mortgage is exempt from the new limit, because it's grandfathered in and the old limit applies.) So, if they pay $55,000 of mortgage interest in 2018, they can deduct only $36,667 [($1 million ÷ $1.5 million) x $55,000].
Now, let's assume that the Andersons decide to refinance their mortgage on July 1, 2018, when the existing loan's outstanding balance is $1.35 million.
Under the grandfather provision, the couple can continue to deduct the interest on up to $1 million of the new mortgage for 2018 through 2025.
Bob. This unmarried individual has an $800,000 first mortgage that he took out to buy his principal residence in 2012. In 2016, he opened up a home equity line of credit (HELOC) and borrowed $80,000 to pay off his car loan, credit card balances and various other personal debts.
On his 2017 return, which he will file in 2018, Bob can deduct all the interest on the first mortgage under the rules for home acquisition indebtedness. For regular tax purposes, he can also deduct all the HELOC interest under the rules for home equity debt. (However, the interest deduction is disallowed under the alternative minimum tax (AMT) rules, because the HELOC proceeds weren't used to buy or improve a first or second residence. Contact your tax advisor for more information on the AMT rules.)
On his 2018 through 2025 tax returns, Bob can continue to deduct all the interest on the first mortgage under the grandfather provision, because the loan balance is below the $1 million limit on home acquisition indebtedness. But he can't treat any of the HELOC interest as deductible home mortgage interest. The HELOC is characterized as home equity debt and interest on home equity debt is nondeductible under the new law.
Connie. She's an unmarried taxpayer in the same situation as Bob, except her $80,000 HELOC was used entirely to remodel her principal residence. So, her home acquisition indebtedness included her first mortgage of $800,000 plus $80,000 of home equity debt used to remodel the home.
On her 2017 return, Connie can deduct the interest on the first mortgage and the HELOC because she can treat the combined balance of the loans as home acquisition indebtedness that doesn't exceed $1.1 million.
For 2018 through 2025, Connie can continue to deduct the interest on both loans under the grandfather rule for up to $1 million of home acquisition indebtedness.
Diana. She's an unmarried individual with an $800,000 first mortgage that was taken out on December 1, 2017, to buy her principal residence. In 2018, she opens up a HELOC and borrows $80,000 to remodel her kitchen and bathrooms.
For 2018 through 2025, Diana can deduct all the interest on the first mortgage under the grandfather provision for up to $1 million of home acquisition indebtedness. However, because the $80,000 HELOC was taken out in 2018, the $750,000 limit on home acquisition indebtedness under the new law precludes any deductions for the HELOC interest.
The entire $750,000 limit on home acquisition indebtedness was absorbed (and then some) by the grandfathered $800,000 first mortgage. So, the HELOC balance can't be treated as home acquisition debt, even though the proceeds were used to improve Diana's principal residence. Instead, the HELOC balance must be treated as home equity debt and interest on home equity debt is disallowed for the 2018 through 2025 tax years under the new law.
Eddie. He's an unmarried taxpayer with a $650,000 first mortgage that was taken out on December 1, 2017, to buy his principal residence. In 2018, he opens up a HELOC and borrows $80,000 to remodel his basement.
For 2018 through 2025, he can deduct all the interest on the first mortgage under the grandfather provision for up to $1 million of home acquisition indebtedness. In addition, the $80,000 HELOC balance can be treated as home acquisition indebtedness, because the combined balance of the first mortgage and the HELOC is only $730,000, which is under the new limit of $750,000 for home acquisition indebtedness. So, Eddie can deduct all the interest on both loans under the rules for home acquisition indebtedness.
Important: If Eddie had used the HELOC to purchase a new car or pay off his credit card debt, it would not qualify as home acquisition indebtedness. To be eligible for this deduction, the HELOC proceeds must be used to substantially improve the taxpayer's qualified residence. (See "What Is Home Acquisition Indebtedness?" at right.)
The new limits on deducting home mortgage interest won't affect all taxpayers. But homeowners with larger mortgages and home equity loans must take heed. Also, please understand that what you see here is based purely on our analysis of the applicable provisions in the Internal Revenue Code. Subsequent IRS guidance could differ. If you have questions or want more information about how the new home mortgage interest deduction rules affects homeowners, contact your tax advisor.