If anything good came out of 2020, it was the ability to significantly reduce the interest rate on your mortgage. I'm pretty sure a lot of people did. And based on tax returns I'm doing this year, many don't understand the full tax consequences of doing so. That is because the Tax Cuts and Jobs Act (TCJA) otherwise known as the new tax law. Let's take a look at how the law changed the mortgage interest deduction and then we'll take a look at how it might affect you.
How the TCJA Changed the Mortgage Interest Tax Deduction
Prior to the TCJA both acquisition and home equity interest was deductible (with some limits). The TCJA eliminated the deduction for home equity interest and lowered the loan value to $750,000 on which you can deduct acquisition debt. To understand how this affects you, we need to define acquisition and equity debt. To start with, it has nothing to do with what the loan is called. A home equity loan can be acquisition debt and a portion of a first mortgage can be equity debt. The determination on type of debt is determined by how the loan is used. If the proceeds of the loan are used to acquire or improve a residence, then the proceeds are considered acquisition debt. If the proceeds are used for any other purpose, the proceeds are considered home equity debt.
How the Changes to the Mortgage Interest Tax Deduction Affect You
There are two likely scenarios that I can envision and one of them I'm seeing a bunch of one of them already.
- Mortgage Refinance. This is the one I'm seeing most often. Let's say you refinanced your loan in 2020 and you didn't want to pay for your closing costs with cash. So, you refinanced them. So your new loan balance is higher than your old loan balance. The amount of the new loan that equals the balance of the old loan that you paid off is acquisition debt. But, the amount used to pay closing costs was not used to purchase or improve your property. Therefore, that portion of the debt is home equity debt and the interest on it is not deductible.
- Home Equity Debt Used to Improve Property. Let's say that you took out a home equity line of credit (HELOC) and use it to add an in-law suite so your mother can move in. When you pull out your tax software to do your return, it asks if the debt is home equity debt. You know your loan is a home equity loan and you answer yes. If you do that, the software will not include the interest on the debt in your deductible interest.
Things to Keep in Mind
You need to do the calculation to determine how much of your interest is deductible if you did a refinance (your software may do the calculation for you). The IRS has some worksheets to help you work through the calculations.
The good news is the equity interest gets paid off first, so this is a problem that will eventually go away.
Military Finances are Different
While this issue applies to all taxpayers, there are a lot of places in the Tax Code and in finances in general where military members and veterans are treated differently than civilians. We think you should work with a financial advisor or planner that deals with these differences each and every day. If that makes sense to you, give us a call or schedule a free initial consultation.
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