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How Taxes Impact Mortgage Interest

By T. Blake King, CPA, MAcc, CVA, Partner, Director of Accounting

After remaining at historic lows for many years, interest rates are on the rise. While the upward move still keeps most mortgages below 4%, many people are refinancing before rates go any higher. With this increased activity and the recent upswing in new home sales, we thought it would be a good time to go over the tax ramifications of a home mortgage. Below we will discuss the current tax law as it relates to mortgage interest. Please note that the Trump administration has vowed to change our tax laws, and thus significant changes could be possible that may modify our guidance.

To be able to deduct mortgage interest, a taxpayer’s itemized deductions (the largest of which are mortgage interest, charitable contributions, and state taxes) must exceed the standard deduction amount. If all of a taxpayer’s itemized deductions do not exceed the standard deduction (currently $6,350 for single or $12,700 for married filing jointly), then the taxpayer would simply deduct the standard amount.

Assuming your itemized deductions exceed the standard amounts above, then we need to look at what qualifies as mortgage interest. To bore you with some tax code, Section 163(h)(3) allows a mortgage interest deduction for:

Acquisition indebtedness with respect to any qualified residence of the taxpayer, or

Home equity indebtedness with respect to any qualified residence of the taxpayer

So long as the debt was used to acquire your qualified residence or is home equity in your qualified residence, you should be able to deduct it. Simple, right? As with anything in tax, there are some limits. First, what is a qualified residence? Usually, this will be your principal home and possibly a second residence. Both must have sleeping, cooking, and toilet facilities. This sometimes means it can be a boat or house trailer as long as you spent 14 days there or did not rent it out.

For married individuals, the aggregate amount of acquisition debt cannot exceed $1 million (half that for single taxpayers). This is debt incurred when acquiring, constructing or substantially improving the property. For example, if you and your spouse buy a $950,000 home and mortgage $750,000 of the purchase price, that interest is deductible. If, however, you and your spouse purchase a beach home in addition to that home, and it has a value of $950,000 and another mortgage of $750,000, then you have exceeded the $1,000,000 limit. In that case, only a pro rata portion of the total mortgage debt would be deductible. You have $1.5 million of debt but are limited to only a deduction on $1.0mm, so 2/3rds of your mortgage interest is deductible.

The above is an example of debt incurred when purchasing a home, but home equity loans are very common and can occur many years after a purchase. In the case of home equity loans, interest is only deductible on up to $100,000 of debt (again, half that for single taxpayers). In most cases, the two limits are combined allowing for a deduction on interest of up to $1.1 million. The easy take-away is this, if your mortgage is greater than $1 million, expect to have some of that deduction limited.

Many homeowners refinance their mortgages before their original loan is paid off. This can make financial sense for a number of reasons, but there is one big caveat when it comes to the interest deduction. The loan cannot exceed the original cost of the home plus improvements. For example, let’s assume you bought your home in 1990 for $300,000 and mortgaged $250,000. Then again in 2010 (10 years before the 30 year mortgage is paid off), you decide to refinance, but surprise, your home is now worth $600,000 and the bank will let you refinance up to $400,000. Because the $400,000 exceeds the original purchase price, some or all of the mortgage interest deduction may be limited.

As with all areas of the tax code, there are a number of exceptions and limitations. The bottom line is to discuss with your tax advisor any major financial decisions surrounding mortgages BEFORE you take action. There may be ways, with proper planning, to avoid a tax surprise.

Blake King, CPA, MAcc, CVA (tbking@drsmgmt.com). The author is a Partner and Director of Accounting at DoctorsManagement.