The newly enacted Tax Cuts and Jobs Act of 2017 (TCJA) both simplified and complicated many of the tax rules beginning with the 2018 tax filing season. One of these changes, new rules with regard to taxpayers’ mortgage interest deduction, on the surface seems simple but in reality is quite the opposite.
The new rule with regard to home residence mortgages allows a deduction for interest on a taxpayer’s mortgage and equity debt, where the combined debt is capped at $750,000 ($375,000 if married filing separate status). This cap is for residences purchased after December 15, 2017. However, for taxpayers that have an existing mortgage on their residence obtained prior to December 16, 2017, the debt limit remains $1,000,000 ($500,000 if MFS). This “older” mortgage debt is considered “Grandfathered Debt” and is not impacted by the new $750,000 cap. Additionally, just to confuse taxpayers a bit more, the TCJA made an exception to the new rule where 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, will be considered to have incurred the home acquisition debt prior to December 16, 2017; thus, making the cap on this debt $1,000,000.
Prior to 2018, interest on up to $100,000 of home equity debt was allowed as a tax deduction and taxpayers were not restricted in their use of the home equity loan. Personal use of home equity debt was allowed to qualify for a mortgage interest deduction. The TCJA only allows a deduction for home equity interest if the proceeds of a home equity loan are used for renovating or improving the home. If the proceeds of the debt are used for personal items, the interest paid on the debt will no longer be deductible. For mortgages taken out after 2017, the combined total of mortgage debt plus additional home equity debt (used to improve or renovate a house) is capped at the new $750,000 threshold.
Are you thinking of purchasing a second home? Assuming your total debt combined on both homes will be under the new $750,000 cap, be sure the new mortgage will be secured by the new home. If you take out an equity loan on your primary residence which is then used to purchase the second home, the interest on the home equity loan will not qualify to be deductible mortgage interest – even if the combined loans on the primary residence are less than $750,000. Only interest on mortgage and home equity debt used to purchase, improve, renovate or construct the home being mortgaged will qualify for the mortgage deduction. Taking a loan out that is collateralized by one home in order to purchase a second home will not qualify as deductible mortgage debt.
Refinancing also poses numerous complexities depending on the amount of debt to be refinanced and when the original loan was taken out. Refinancing a mortgage is considered acquisition debt to the extent that the new debt does not exceed the outstanding principal on the old debt immediately before refinancing. Taxpayers that refinance grandfathered debt, are allowed to deduct mortgage interest on the new debt in full, up to the amount of grandfathered debt outstanding just prior to the refinance. For example, if your current mortgage outstanding is $950,000 and this mortgage was in place prior to December 16, 2017, after refinancing you can deduct mortgage interest on the refinanced debt of $950,000. Your refinanced debt will not be capped to the new $750,000 threshold, even if the refinance occurs in 2018.
If a taxpayer does a “cash out” refinance (even if the cash out is solely for closing costs), the amount of new debt in excess of the old debt outstanding just prior to refinancing will not qualify as mortgage debt even if the total new debt is less than the $750,000 threshold. For example, if a taxpayer refinances their existing debt in the amount of $400,000 with a new debt in the amount of $450,000 and does not use the additional $50,000 “cash out” for a home renovation or improvement, then only interest paid on $400,000 will qualify for the mortgage interest deduction..
With the new rules for mortgage debt and home equity debt fully in place as of December 15, 2017, taxpayers will need to pay close attention to the tax ramifications of refinancing existing home mortgages and of using home equity loans, prior to making their financial decisions.
Question about refinanced grandfathered debt and deductibility. Suppose I refinance a 2016 mortgage, present principal $850K. I refinance at a new 30 year fixed and I also finance $5K of closing costs (which is technically cash out). I believe that the refinanced loan’s interest on the $850K is not tainted by the additional $5K financed — I just can’t deduct the interest on the $5K. But it’s tough to find authoritative guidance from the IRS on this.
Aside: I have read that the extended term created by going out to 30 years again creates its own issues issues, but there’s even less written on this matter.
Hi Tripp,
You are correct. In your scenario I assume your new debt would be $855K ($850K of debt refinanced plus $5K of closing costs added into the new debt). Although the refinanced debt is in excess of the new $750K limitation, your allowed mortgage deduction debt would be grandfathered in at the amount of the old debt just prior to refinancing – because the original debt is less than $1M and the debt was in existence prior to December 16, 2017. The refinancing costs added into the new debt would not qualify as mortgage debt for the allowed interest tax deduction because this $5K “cash-out” was not for capital improvements and the refinanced debt is in excess of $750K. Thus, only interest in the percentage of 99.4% (850K/855K) would qualify as tax deductible.
The mortgage interest deduction is not impacted by the term of the loan.