Mortgage Interest Deduction Traps

Article By: Jeff Skolnick, CPA, M.S. Taxation

At a time when interest rates are at a very low level and many people contemplate whether or not to refinance to either take advantage of the low rates or to pull out some equity from their home, I thought it was a good time to point out some of the traps of the mortgage interest deduction.

What is deductible Home Mortgage Interest?

Home mortgage interest can be divided in to two basic categories.  The first is acquisition debt and the second is home equity loans.

The first rule to keep in mind is that for any acquisition or equity debt to be deductible it must be secured by your main or second home.  This rule is not normally a big deal if you are obtaining a loan through a bank, however it can be important if the borrowing is from a nontraditional source such as a friend or relative.  If the borrowing is done between friends or relatives, then it is important that the loan be recorded and be secured by the main or second home.

Acquisition debt is defined as loans used to buy, construct or improve first or second homes.  Taxpayers are allowed to have $750,000 in acquisition debt between their main and second homes ($375,000 if married filing separately).  If a taxpayer has loans exceeding $750,000 in principal, then a portion of the interest is nondeductible.  These figures came into play after 2017. Prior to 2018 this $750,000 was $1,000,000 ($500,000 if married filing separately).  If you had a loan that met the $1,000,000 threshold before 2018 you are still able to deduct the interest after 2017. These loans have been grandfathered in.

After 2017 home equity loans are no longer deductible unless the money was used to buy, construct or improve a first or second home. These loans are not grandfathered.

Refinancing – What’s the worry?

I’ve briefly outlined the basic rules of the mortgage interest deduction above.  I want to now try to explain how refinancing can and does cause unexpected issues when there is no planning.

A common example of how individual taxpayers run in to interest deduction issues is the following:

Taxpayers purchase a home for $300,000; they put down $60,000 and finance $240,000.  Clearly the $240,000 is home acquisition debt and fully deductible.  Ten years down the road the house is now worth $425,000, and the original loan is down to $200,000.

The first trap I will discuss is the taxpayer’s taking out a home equity loan of $150,000.  Based on the rules outlined above no  interest will be deductible because it is a home equity loan.  This of course assumes that the $150,000 was not used for additional improvements on the house.  If the proceeds were used for example on an addition to the home, then the portion of the proceeds related to the improvements would be considered additional acquisition debt and the remainder would be considered home equity debt.

A second example would be that the taxpayers decided to refinance the original mortgage with a new $350,000 loan. Only the first $200,000  used to pay off the original loan would be considered mortgage acquisition debt while the rest is considered home equity, once again unless substantial improvements are made.

One last thing to keep in mind regarding refinanced loans is that points paid are generally not deductible in the year paid and must be amortized over the life of the loan unless the new loan is used for home improvements.

Business Interest

I just wanted to mention that acquisition debt used to purchase or improve a rental property is a separate type of interest and is 100% deductible assuming the proceeds were used to buy, construct or improve the rental property. Keep in mind that just as with a home mortgage if a landlord refinances a property to take out equity, then this would be considered nondeductible.  Again the only deductible interest is onproceeds used to purchase, construct or improve the property.

Investment Interest

Investment is interest is interest charged on monies borrowed to purchase investment property. This includes margin interest.  Some examples of investment property are stocks, bonds and mutual funds. Investment interest is deductible up to the amount of investment income and any unused investment interest expense is carried over to be used against future investment income.

Conclusion

Although it can be the biggest deduction on many taxpayers’ returns, the home mortgage interest deduction is more complicated than most people think.  Always make sure to check with your tax professional before making any decisions regarding your mortgage debt.

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Listen to the most recent episode of my podcast: Episode 16: Mortgage Interest rules. https://anchor.fm/jeffrey-skolnick/episodes/Episode-16-Mortgage-Interest-rules–What-you-should-be-aware-of-e47lpb