Mortgage Interest Deduction Rules Continue to Confuse
Changes to the tax break known as the mortgage interest deduction made by the Tax Cut and Jobs Act (TCJA) way back at the end of 2017 continue to be a source of confusion for many taxpayers, and a compliance headache for tax preparers and tax agencies like the IRS. The TCJA changes put a limit in some ways on the ability to take an itemized deduction for mortgage interest, defined broadly as interest on a loan that is secured by real property.
For instance, prior to TCJA, you could take an itemized deduction for interest paid on a home equity loan or line of credit regardless for what the loan proceeds were used. You could use the loan proceeds to, say, buy a car or pay off credit cards, and the interest on the loan would be deductible, whereas car loan or credit card debt interest was not deductible, effectively converting nondeductible interest into deductible interest.
But no more. TCJA put the kibosh on such maneuverings; well, at least it does until the end of 2025, when it is scheduled to sunset and return to pre-TCJA law.
To understand the changes, let's first look at the rules prior to TCJA. Before 2018, you were able to deduct mortgage interest on either what is called "acquisition debt" and/or on "home equity debt", both within limits.
Acquisition debt is debt incurred to buy, build or substantially improve a home. To qualify, the debt must be secured by the home. Further, the home must be a "qualified residence", meaning it is either your principal residence or a second home. Under pre-TCJA law, the interest could be deducted on acquisition debt up to $1 million.
Home equity debt, on the other hand, is debt that is not acquisition debt, but is secured by the equity built up in a qualified residence. Pre-TCJA, you could deduct such debt up to interest paid on the first $100,000 in loan amount (but such loan amount not to exceed the equity in the home) no matter how the loan proceeds were used, as mentioned earlier.
TCJA, in what was clearly a revenue raising measure, made a couple of substantial changes to the above rules.
First, the loan balance for deducting interest paid on acquisition debt was decreased from $1 million to $750,000, but only for loans originating after December 15, 2017 (or April 1, 2018 if there was a binding contract in place before December 16, 2017). Therefore, some existing homeowners are "grandfathered" under the old rules for acquisition debt. If grandfathered, you can still deduct all the mortgage interest allowable up to the $1 million threshold.
In another change, the deduction for interest paid on home equity debt was suspended from 2018 through 2025, regardless of when you acquired the residence.
As you may surmise by now, there are several complications that arise from these changes.
For one thing, if you made a past financial decision based on your ability to deduct interest on a home equity loan (such as that car buy I mentioned), you now find yourself in a situation where that decision isn't as affordable, since you no longer can deduct the interest. Ouch!
For another, the amount of interest on acquisition debt you can deduct will depend on when the loan originated (see important dates above), so that has to be kept in mind to see under what rule you fall.
Further, if the average acquisition debt loan balance is greater than the maximum amount, you must allocate the total interest on the loan between deductible and nondeductible portions. This gets a bit tricky in situations such as when you have one loan that is "grandfathered" under the $1 million rule and another that falls under the TCJA $750,000 rule. This could be the case, for example, where your principal residence was purchased under one rule and a second home under the other.
Math geeks love this kind of thing, and for them, the IRS provides worksheets in Publication 936.
Some other rules of note. If you refinance an existing loan and the new loan amount is more than the refinanced balance of the old loan, your interest deduction may also be limited, since only the refinanced balance is considered acquisition debt, while the excess amount is considered home equity debt.
All is not lost, however, for all home equity loans. For example, home equity loans used for substantial home improvements may still be considered qualified residence debt allowing a deduction. Also, proceeds of such loans that can be specifically tracked as used for a qualified business purpose may also give rise to deductible business interest expense.
Because so much information goes in to determining what amount, if any, of mortgage interest is deductible, the IRS began a few years back requiring more critical information be reported by lenders on Form 1098, Mortgage Interest Statement. The current form shows not only the amount of interest expense paid, but also information about the outstanding mortgage balance, the mortgage origination date and even the address for the property securing the mortgage. All of this designed to help the IRS police the legitimacy of deductions taken.