New Mortgage Interest Deduction Rules

The Tax Cuts and Jobs Act of 2017 creates new mortgage interest deduction rules.

I’m going to briefly describe the new rules, therefore, so you can plan ahead. And I’m also going to point out the two very minor options you have to sidestep the limitations imposed by the new rules.

First, though, let’s review the rules in place in 2017.

Mortgage Interest Deduction for 2017 and Earlier

In the 2017 and earlier years, individuals could deduct the interest on up to $1,000,000 of mortgage debt on one home, or $1,000,000 spread between two homes, as long as

1. The money was used to buy the home, improve the home, or refinance a loan used earlier to buy or improve the home.
2. The loan was actually a mortgage which meant the home secured and provided collateral for the loan.

For example, if you went out and borrowed $100,000 to purchase a $125,000 home and your borrowing was secured or “collateral-ized” by the home, you could deduct the interest on that mortgage.

For another example, if you then borrowed another $25,000 via a secondary mortgage to replace the roof, you got to deduct that interest, too.

But you couldn’t always deduct mortgage interest.

For example, suppose that you owed only $100,000 on a first mortgage, and then went out and refinanced, getting a new mortgage for $200,000. In this case, you only deducted the interest on the first $100,000 of mortgage.

And another example: Suppose you went out and got a $2,000,000 mortgage sometime in the past. In this case—and subject to the home equity indebtedness rule I describe in a few paragraphs—you only deducted the interest on the first $1,000,000 of mortgage debt—and not the second $1,000,000.

Finally, suppose you went out and borrowed $100,000 to buy a $125,000 home but the lender didn’t file a mortgage lien on the home. (Perhaps the lender was a parent with more money than common sense.) In that case, because the loan isn’t a mortgage, you don’t get to deduct the interest.

Home Equity Indebtedness

In addition to the mortgage interest rules described above, taxpayers could, for 2017 and earlier years, also deduct interest on up to $100,000 of home equity debt.

The only other rule was the total of your acquisition indebtedness (so the first mortgage and any follow-on mortgages used to improve the house as well as mortgages used to refinance these mortgages) and then your home equity debt couldn’t exceed the fair market value of the property.

What the above rules meant in practice is you could borrow up to $1,100,000 using mortgages. And you could then deduct the interest as long as the home’s—or homes’—fair market value was at least $1,100,000.

What’s more, in general, the money on the “up to $100,000” of “home equity debt” borrowing could be for anything—including a car or college or starting a business. But the rest of the money needed to be used for buying or improving a home (or refinancing earlier mortgages used to buy or improve a home).

Note: Interest on home equity loan proceeds always worked in the past as a deduction for regular income tax purposes. But if the loan proceeds were used for something other than acquiring or improving the residence, the interest wasn’t deductible for purposes of AMT calculations.

Once you understand (or get reminded of) the old rules, you can easily make sense of the new mortgage interest deduction rules.

Mortgage Interest Deduction for 2018

The new law (the law appears on pages 34 and 35 of this pdf document and then Congress’s explanation appears on pages 256 to 258) makes a couple of minor tweaks, and then provides a grandfather clause for existing mortgages.

The first tweak: The law says that starting in 2018 and going through 2025, that $1,000,000 debt ceiling drops to $750,000.

For example, if you go out in the summer of 2018 and borrow $1,000,000 to buy a home, you only get to deduct the interest on the first $750,000 of borrowing. Note, though, that in 2026, if you owe more than $750,000 you will be able to deduct interest on up to a $1,000,000 mortgage.

The second tweak: The law says that for the years 2018 through 2025, taxpayers can’t deduct interest on home equity debt.

For example, if you have a $100,000 home equity line of credit—maybe money that was used to pay for college for your kids—the interest on that loan isn’t deductible between 2018 and 2015.

And this subtlety about a home equity loan or line of credit: Though a lender may call some bit of borrowing you do a “home equity loan,” if the borrowing is secured by your home and you use the money to fund part of the purchase price or to substantially improve your home or to refinance a mortgage used to purchase or improve your home, the home equity loan counts as qualified mortgage indebtedness.

In other words, someone who goes out an gets a $50,000 home equity loan to buy a car can’t deduct the interest on the loan starting in 2018. But someone who goes out and gets a $50,000 home equity loan to remodel their house can. (In this second case, the home equity loan is a mortgage.)

The Mortgage Interest Grandfather Clause

And now the grandfather clause: You can still deduct mortgage interest on up to $1,000,000 of acquisition indebtedness (so borrowing to buy or improve a home, or borrowing that refinances earlier borrowing to buy or improve) if you borrowed the money before December 15^th, 2017.

Further, as a special break for people who were actually in the process of buying a home before December 15^th, 2017, if you were under written contract before December 15^th, 2017 and were supposed to close before the year ended and in the end you purchased your home before April 1^st, 2018, you also get to deduct the interest on $1,000,000 of mortgage debt.

For example, if you signed a purchase agreement on November 8, 2017 that set a closing date of December 22, 2017 but then, due to some nonsense with the lender, you didn’t actually complete the purchase until the end of March in 2018, you get to use the old bigger mortgage balance limit.

The statute’s specific language appears at Sec. 163(h)(3)(F)(i)(IV)) and is worth reading here if the break possibly applies to your tax return:

In the case of a taxpayer who enters into a written binding contract before December 15, 2017, to close on the purchase of a principal residence before January 1, 2018, and who purchases such residence before April 1, 2018, subclause (III) shall be applied by substituting ‘April 1, 2018’ for ‘December 15, 2017’

And then this grandfatherly clause related to refinancing one of these grandfathered loans:

Taxpayers can refinance a grandfathered loan and deduct the interest on up to a full $1,000,000 mortgage. But if a refinancing extends the repayment term beyond thirty years, you only get the “extra” interest on the larger $1,000,000 mortgage for the first thirty years. And you can’t “refinance” a loan you’ve already paid off. (Tax accountants can peek at Internal Revenue Code 163(h)(3)(F)(iii) for the details.)

Loss Mitigation Tactics

If you’ve lost the deduction under the new mortgage interest deduction rules, you don’t have much you can do about it. Congress doesn’t want taxpayers to deduct mortgage interest on more than $750,000 of debt.

But consider these two options…

First, with the stock market at all time highs, you may want to look at paying down your mortgage more quickly. Paying off the nondeductible chunk of a 4% mortgage is like earning a tax-free 4% return. That’s pretty good in this environment.

Note: We have another blog post here that explains why repaying a 4% mortgage equates to a taxable bond that pays quite a bit more than 4%: Why Early Mortgage Repayment Makes Sense for High Income Investors.

Second, you may want to look at trying to treat part of your home as a home office (if you own your own business) or at turning a second home into a vacation rental since these techniques may move some (or even all) of the mortgage interest deduction off of your Schedule A “itemized deductions” form, where the mortgage interest deduction gets limited, and onto another page in your tax return where the mortgage interest deduction isn’t necessarily limited.

Finally, this obvious comment: You will want to talk with your tax adviser about this when you have your 2017 tax return prepared.