Riddle Me This ...
When is a door not a door?
When it’s ajar!
When is a brown book not a brown book?
When it’s read!
When is a swimmer not a swimmer?
When she changes into her bathing suit!
When is deductible mortgage interest not deductible? When, under the new Tax Cuts and Jobs Act, it includes equity interest.
Ok, that last one wasn’t funny. It might not even make sense yet. But it does make an important point about a rarely discussed change to mortgage interest deductions.
Before we get into this new wrinkle in the law, let’s review the basics of deducting mortgage interest. Taxpayers should receive form 1098 from their mortgage holder; among other things, this form reports the amount of interest paid during the year. In the past, if the mortgage was secured by a first or second home, the interest was deductible on Schedule A by taxpayers who itemized. This was true for both first mortgages and second mortgages, frequently called home equity loans. A common strategy was to use a second mortgage on a home to obtain funds for other uses, such as buying cars or boats, to get a tax break on the interest paid.
Under the new law, only mortgages used to “buy, build, or improve” a home (second homes still count) can be used for the mortgage interest deduction. This is called acquisition interest. Interest on a second loan, even if labeled a home equity loan by the bank, may still be deducted if the loan meets the “buy, build, or improve” standard. Interest on home loans used for other purposes can no longer be deducted, even if the loan originated several years ago and previously qualified for the interest deduction. This not only means it no longer makes sense to use a second mortgage to buy a car; it also means anyone still paying on an old equity loan used this way will no longer get a tax break on it.
However, even if the mortgage was used to “buy, build, or improve” your home, interest on it may not be fully deductible if the loan has been refinanced. It’s common practice to roll closing costs into the new loan amount, but the IRS considers these closing costs to be an equity loan. The portion of interest attributed to this equity amount is not deductible. Likewise, if you’ve taken cash out when you refinanced and used it for anything other than the “buy, build, or improve” standard you have some non-deductible equity interest. If this sounds a bit confusing, just wait until you do the calculations necessary to figure out the deductible amount of interest you paid in this situation!
Figuring the deductible part of the interest paid requires the taxpayer to determine how much of the interest was attributed to the equity portion. This percentage changes as the loan is paid down. We had someone come to us for assistance who had tried to use do-it-yourself software (here’s why you might not want to do your own taxes ). When they told the software they had refinanced their home mortgage, it did not “allow” any interest to be deducted. This is a circumstance where using a tax pro can be a wise choice since the necessary calculations are probably beyond the scope of off-the-shelf tax software.
Of course, many taxpayers will no longer itemize due to the new tax law’s increased standard deduction. The issue of deductible home mortgage interest will only affect a few, but those who can benefit from this deduction need to understand how to take it. Everyone else can relax and try to figure out when a car is not a car. (Give up? When it turns into a parking lot!)
If you haven’t filed your tax return yet, the deadline is quickly approaching. Turn your car into our parking lot and let us make sure you’re getting all the deductions you’re qualified to take.