The rules for deducting mortgage interest on home loans have become trickier under the Tax Cuts and Jobs Act (TCJA).
The new rules generally limit the deductibility of mortgage interest on up to $750,000 of debt for the purchase of a home. In some cases, the new rules also prohibit the deduction of interest on home equity loans used in many common transactions.
If you have an existing mortgage acquired last year or earlier, don’t worry. These new limits do not affect up to $1 million of home acquisition debt incurred before December 16, 2017 or incurred to purchase a residence under contract if the transaction was completed before April 1, 2018 .will not be affected because this grandfather rule.
But if you’re looking to take out a home equity loan, buy a new home, or refinance an existing mortgage, you need to know how these new rules may affect you.
Let’s take a closer look at some examples.
A new cap on deductions
First, homebuyers need to understand that mortgage interest deductions are now capped at $750,000 home acquisition debt. This can increase the costs of buying homes in expensive real estate markets where home prices exceed this number.
Interestingly, the $750,000 limit applies to single taxpayers as well as married couples. According to an earlier ruling by the Ninth Circuit Court of Appeals, when two unmarried people buy a home together, they can combine their limits and deduct mortgage interest on the debt up to $1.5 million.
If you take out a home equity loan and you are not using the proceeds exclusively to buy or improve your home, such as spending the money to buy a car or pay off credit card debt , then the interest on the home equity loan is not deductible.
But if the home equity loan was used to renovate or improve your home, the interest is deductible, provided that, combined with your current mortgage, the debt does not exceed the total loan limits of $750,000 under the new rules.
Home Equity Loan Limits
This may raise questions for homeowners who are now considering a home equity loan.
Take a homeowner with a current mortgage of $800,000 taken out several years ago. The homeowner wants to take out a $100,000 home equity loan this year to improve his home. Would the interest on the mortgage and on the loan both be deductible?
Interest on the $800,000 mortgage would still qualify because it is grandfathered under the old rules, which allow mortgage interest deductibility of up to $1 million.
But because the home equity loan would be incurred in 2018 — when the TCJA caps deductions at $750,000 of total acquisition debt — no interest on the new home equity loan is deductible.
If the homeowner’s current mortgage is $650,000 and he takes out a $100,000 home equity loan in 2018 to renovate his home, all interest on both loans should be deductible because the combined loans are lower. up to $750,000.
The IRS prohibits the deduction of interest on home equity loans taken out on a principal residence if it is used to purchase a vacation home. This is because this new loan is not secured by the vacation home. Instead, the best way to finance a vacation home is to use a mortgage secured by that vacation home, not a loan on your primary residence.
Homeowners refinancing a mortgage will also need to consider how the new rules will impact them. The TCJA includes a second grandfather rule for refinancing up to $1 million of home acquisition debt incurred before December 16, 2017.
Refinance grandfathered mortgages
When you refinance a grandfathered mortgage, the mortgage interest remains deductible only if the principal balance of the new loan does not exceed the principal balance of the old loan.
Take a homeowner with a mortgage that was taken out last year for $1 million but now has a balance of $950,000. Mortgage interest on the refinance should be deductible as long as the new mortgage balance does not exceed $950,000.
But suppose in this example the current mortgage balance is $300,000 and you want to replace that mortgage with a new loan with a balance of $400,000, in what is commonly referred to as a cash refinance. In this example, only the interest attributed to $300,000 of the new refinanced mortgage will qualify as deductible mortgage interest. Interest on additional debt cannot be deducted.