In 2017, Congress passed the Tax Cuts & Jobs Act (TCJA), which represents the largest tax reform since the 1980s. This reform is so wide-sweeping that it affects virtually everyone, usually in more ways than one. Given that, it’s difficult for many people to figure out whether they’re better off or worse off than before.
While there are many aspects of TCJA that may impact each taxpayer, it’s important to understand each aspect in a little more detail, as opposed to trying to put it all together at one time. This article explores one of the most pertinent, and widely impacted, tax deductions: home mortgage interest.
Home Mortgage Interest Background
To understand the deductibility of home mortgage interest as it stands today, it’s worth looking at the previous significant tax reform: The Tax Reform Act of 1986 (TRA86). TRA86 did a lot of things that TCJA has promised to do: lower overall tax rates & simplify tax returns. However, the biggest impact to deductions was that it eliminated a LOT of personal interest deduction, which had been largely deductible since 1913. Prior to TRA86, credit card debt, personal loans, car loans, signature loans—all of that interest was deductible.
After TRA86, home mortgage interest was pretty much the only type of personal debt left intact as an itemizable deduction. And even then, you couldn’t borrow more than the original purchase price of the house, plus improvements. Over time, deductions for student loan interest & investment interest became fully deductible again, but other personal debt…not so much. Even then, people didn’t really understand what it meant. Banks were not required to issue Form 1098s detailing how much interest and real estate taxes were paid in a tax year, and taxpayers were left to figure this out on their own.
While this has slightly changed over the past 30+ years (such as financial institutions being required to issue Form 1098s to their clients), it has largely remained intact.
Mortgage Interest Deductions Prior to TCJA
Although TRA86 allowed mortgage interest deductions, there were limits, based upon one of two definitions of home mortgage interest.
The first type of home mortgage interest was called home acquisition debt. This was defined as:
A mortgage, taken out after October 13, 1987 (previous mortgages were grandfathered under slightly more liberal rules), that was used to buy, build or substantially improve a main or secondary home.
Some examples include:
- Buying a house
- Buying land, then building a house
- Home improvements
Under TRA86, home acquisition debt was limited to $1 million.
The second type of deductible home mortgage interest was called home equity debt. The Internal Revenue Code defines home equity debt as:
Debt, other than acquisition debt, secured by the taxpayer’s principal or secondary residence, to the extent the aggregate amount of the debt does not exceed the excess of fair market value of the residence over the amount of acquisition indebtedness.
Huh? What this means is that any home equity debt secured by the taxpayer’s primary or secondary residence, up to the fair market value of the residence minus what is already in the primary loan. The most common examples would be a home equity loan or home equity line of credit (both second mortgages), where there’s already a primary mortgage in place.
The important thing about home equity debt was that you could deduct interest on up to $100,000 of home equity debt. Without respect to why the debt was taken out in the first place. Want to take out a HELOC to pay down credit cards or buy a car? No problem deducting the interest!
So, if TRA86 intended to eliminate the deduction for personal interest, except for home mortgages, then TCJA pretty much finished the job.
Mortgage Interest Deductions After TCJA
It’s important to note that TCJA did not rewrite the definitions of either home equity debt or home acquisition debt. However, it made a couple of changes worth noting.
First, the deduction for home equity loans & lines of credit, has been suspended until 2026. There is an exception: if the home equity loan or line of credit can meet the definition of home acquisition debt, then it is deductible as home acquisition debt. The example on the IRS website states:
Interest on a home equity loan used to build an addition to an existing home is typically deductible, while interest on the same loan used to pay personal living expenses, such as credit card debts, is not.
In other words, no more buying a car with a HELOC and writing off the interest. At least until 2026. But probably beyond that, since I don’t see a future Congress reopening that loophole. Of course, it will take some time for the IRS to incorporate this into their audits. For example, will there be an increased audit risk for people who have multiple 1098’s? It’s plausible that future audits will actually want homeowners to keep detailed records of how their home equity lines were used, and to keep receipts that prove that those loans did meet the definition of home acquisition debt.
Second, the overall deduction for home acquisition debt (to include home equity debt that meets this definition) is now $750,000 ($375,000 for married couples filing separate returns). This is down from the $1 million ($500,000 for married filing separately), in years past.
Third, the effect of this deduction is likely diluted by a couple of things, namely the changes to other itemized deductions and the sharp increase in the standard deduction. In other words, taxpayers are less likely to itemize home mortgage interest because they’ll be more likely to take the standard deduction. According to the Tax Foundation, an independent tax policy research organization, state & local taxes & mortgage interest are the two largest itemized deductions.
Since the new limit on state and local tax deductions is now $10,000 (which includes either sales or income tax, AND real estate taxes), it’s easy to see why the Tax Foundation projects these changes to TCJA to raise over $600 billion in federal revenue between now and 2025. With that said, it’s important to note the Tax Foundation also projects that increasing the standard deduction, eliminating personal exemptions, and increasing the child tax credit aim to simplify the tax code for most taxpayers, while remaining revenue neutral. In other words, all of these changes should result in a simpler tax return for most taxpayers without increasing the deficit.
It’s worth noting that deducting home mortgage interest was previously, a very minor consideration in deciding whether to buy a home. Or, at least it should have been. After TCJA, it appears that most people will probably benefit from the increase in standard deductions to the extent that they stop itemizing things such as home mortgage interest.
As for taking out a home equity line to pay down credit cards…expect that to be a thing of the past. It might take some time for the IRS to come out with clear guidance on what records they expect taxpayers to keep. However, TCJA does make it clear that any mortgage interest is expect to meet the definition of home acquisition debt: to buy, build, or substantially improve a primary or secondary residence.
However, for those who used to itemize deductions, it might be worth talking with a tax professional to see how your tax bill is going to change (that's us!). You may need to discuss how your significant financial decisions, such as buying a home or taking advantage of a HELOC might be affected. After all, it’s better to be informed BEFORE you make that big financial decision than find out after the fact that a tax deduction you were counting on isn’t as good as you thought.
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