Home Acquisition Interest and Home Equity Interest Changes

Home Acquisition Interest and Home Equity Interest Changes

The Tax Cuts and Jobs Act (TCJA)’s influence on home acquisition and equity interest is significant for high-net-worth individuals who will consider buying, building, or improving their residence after 2017. This article examines the specific changes and opportunities associated with mortgages and home equity interest taxation under the new law. Now, mortgage interest is either deductible as acquisition indebtedness, or is not deductible at all. So, it’s critical to understand the different classifications of debt and how this legislation can influence your tax options.

Under pre-TCJA rules, you could deduct mortgage interest on up to $1 million of acquisition indebtedness. Now, the limit on qualifying acquisition indebtedness is reduced to $750,000 ($375,000 for a married taxpayer filing separately). However, for acquisition indebtedness incurred before December 15, 2017, the $1M pre-TCJA limit applies. Under certain circumstances, you can also refinance up to $1 million of pre-December 15, 2017 acquisition debt in the future and not be subject to the $750,000 or $375,000 limit. Importantly, there is also no longer a deduction for interest on home equity indebtedness. This applies regardless of when the home equity debt was incurred.

The definition of what qualifies as “acquisition indebtedness” versus “home equity indebtedness” is oft-debated. Your debt classification is not based on how the loan was structured or what the bank (or mortgage servicer) calls it, but how the mortgage proceeds were used. Acquisition indebtedness is the extent that debt proceeds were used to acquire, build, or substantially improve the primary residence securing the loan. This is even so for home equity lines of credit (HELOC) or home equity loans. Taxpayers can still deduct the interest on their home equity loans and HELOCs if the proceeds of the loan are used to buy, build, or substantially improve the qualified residence that secures the loan. On the other hand, even a “traditional” 30-year mortgage may not have deductible interest if it is a cash-out refinance and the cashed-out portion was used for other purposes.

Unfortunately when you receive your Form 1098 reporting the interest you paid, it does not indicate if the underlying debt is acquisition indebtedness. This makes sense because the mortgage lender does not know how the proceeds were spent. Also, the mortgage servicer reports the full amount of the mortgage interest paid. You, as the taxpayer, are responsible for determining how much is deductible (albeit with the advice a tax professional). You are responsible for keeping adequate records and tracking the use of debt proceeds.

There Are a Few Other Important Items to Note:

  • Acquisition debt and home equity debt must be secured by a primary or secondary residence, not used as an investment or rental property.
  • A second residence generally includes a house, condominium or boat provided it meets IRS requirements.
  • Acquisition debt that is refinanced is still acquisition debt to the extent of the amount of original acquisition debt remaining.
  • “Substantial improvements” to a home are capital improvements that would add to cost basis, such as an expansion or other permanent improvements, but do not include normal maintenance or repairs.
  • A HELOC can also be acquisition debt if used to acquire, build, or substantially improve a residence.
  • A mortgage loan does not need to be made by a traditional bank in order for it to qualify as acquisition debt. The proceeds just have to be used to acquire, build or substantially improve a residence and must be secured by that residence.
  • If the proceeds of a cash-out refinance are not used to acquire, build or substantially improve a residence, then the debt will be treated as home equity debt.
  • Reverse mortgage debt proceeds used to acquire, build or substantially improve the residence would be treated as acquisition debt, while reverse mortgage funds used for any other purpose would be treated as home equity debt.
  • There are tracing rules for so-called “mixed-use mortgages,” where a portion is acquisition debt and a portion is not.
  • Debt incurred to acquire, build, or substantially improve a residence, but is not secured by that residence (for example, debt secured by the underlying securities in an investment account), does not qualify as qualified acquisition debt. This is treated as personal interest , which is not deductible.

The definitions and classification of debt as home acquisition or home equity are the same under the new law, and both types still require the debt be secured by the residence. The implication of the TCJA is that there are new debt principal limits on acquisition debt and a different alternative minimum tax (AMT) treatment. Note that there were some legacy provisions for existing mortgages and for the remaining debt balance of refinanced mortgages and homes that were under a binding written contact when the law was passed. However, there is no legacy provision for existing home equity debt.

If you currently have outstanding home equity debt, be prepared to lose the interest deduction starting in the 2018 tax year. Since that debt is not deductible, you should consider paying off any home equity debt.

If the interest on the home equity debt is not deductible, you could consider ways that could potentially make it a deductible interest expense. For example, consider converting the property to an investment rental property or use it for a trade or business.

Lastly, TCJA’s mortgage and equity interest tax changes last for eight years, sunsetting in 2025. In the absence of intervening legislation, the pre-TCJA rules come back into effect in 2026. So beginning in 2026, interest on home equity loans will be deductible again, and the limit on qualifying acquisition debt will be raised back to $1 million ($500,000 for married separate filers).

This piece is not intended to provide specific tax or legal advice. You should consult with your own advisors about your particular situation.

Any opinions, projections, or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.

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