Homeownership is the American dream, and mortgage loans make buying homes possible for the vast majority of American homeowners. Given the monumental amount of debt that most people have to take on to buy a home, a mortgage can be intimidating. The federal government tries to encourage homeownership by offering tax breaks linked to mortgages, but recent changes to the tax laws will affect how much typical homeowners are able to benefit from these deductions.
The basics of the mortgage interest deduction
Mortgage interest is one of the biggest deductions that the tax laws currently allow. Unlike most interest on borrowing for personal expenses, you can take mortgage interest as an itemized deduction. However, the recent changes to tax law changed many of the aspects of the mortgage interest deduction in ways that are unfavorable.
Several things can count as mortgage interest for purposes of taking the deduction. Every month, a portion of your total mortgage payment goes toward paying interest, and that portion is deductible. There are also some other items that count. If you pay points when you first get your mortgage, you can often deduct the entire amount paid in the year in which you pay them, as long as the mortgage is on your primary residence and you use them to buy or construct that home. If you pay points to refinance your mortgage, however, you'll typically have to spread the deduction out over the term of your mortgage. In addition, a special rule has been extended into 2018 to allow you to treat private mortgage insurance premiums as if they were interest.
Here's what changed about mortgage interest under tax reform
New laws modified eligibility for the mortgage interest deduction in several ways. The change that got the most attention during the debate over tax reform was the reduction in the amount of interest that you're allowed to deduct. Going forward, you'll only be able to deduct interest on up to $750,000 in mortgage debt, down from $1 million under prior law. The old $1 million limit is grandfathered in for existing mortgages, but if you get a new mortgage now, you'll be subject to the lower limit. If you have a larger mortgage, you can still get a mortgage deduction, but it'll be on only the portion of interest attributable to the first $750,000 in borrowings.
However, some other changes could have even greater impacts on taxpayers. Under old law, you could deduct interest on up to $100,000 of home equity debt. This allowed you to do whatever you wanted with the money, including paying down other types of debt or spending on things unrelated to your home, and still deduct the interest.
Home equity debt and refinancing
The new tax reform law partially took away the ability to deduct interest on home equity debt. You can still deduct interest on such debt if it's used to buy, build, or improve your home and doesn't bring your total outstanding mortgage debt above the $750,000 limit. But deductibility is no longer available if you used the proceeds for other purposes. Even worse, unlike the other changes, this one took immediate effect even on existing home equity loans and gave taxpayers no grandfathering provisions.
This makes it critically important to understand how refinancing your mortgage works for tax purposes. When you take out a mortgage to buy or build a home, it counts as home acquisition debt and gets the $750,000 limit. A mortgage for other purposes is treated as a home equity loan and now gets no interest deduction. If you refinance a mortgage that counted as home acquisition debt, the refinanced mortgage will also count as home acquisition debt as long as it's in the same amount. If you borrow more in the refinancing, then the extra amount of cash you pull out will be treated as home equity debt, and so that portion of the interest you pay won't be deductible unless it's used to improve the home.
The big hit for homeowners
Finally, the biggest potential problem for homeowners is that the increase in the standard deduction will effectively take away the tax benefit of paying home mortgage interest. If your total itemized deductions don't exceed the now-higher standard deduction, then you won't itemize, and the fact that mortgage interest is deductible won't do you any good.
Even if you do keep itemizing, it's important to understand how changes might affect you. Before you do anything with your existing mortgage, make sure you know the potential tax consequences in order to avoid what could otherwise be a costly mistake.