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The Confusion of Mortgage Interest Deductibility

Andrew Tignanelli, CPA, CFP®, President

When clients provide me with a mortgage interest statement, they assume that all of the mortgage interest will be tax-deductible. This assumption was somewhat true under the tax laws before 2018, but since 2018, it will be true only on occasion. To understand why, you must comprehend the definition of acquisition indebtedness.

Acquisition indebtedness is debt secured against a primary or secondary personal residence when either property is first purchased or materially improved. If I buy a new home for $300,000, and borrow $250,000 for 30 years fixed, then $250,000 is my acquisition indebtedness. The only way I can increase my acquisition indebtedness on this same home is if I perform material improvements. If after I buy the home for $300,000, I invest in a $200,000 renovation and secure a new $400,000 30-year fixed mortgage, then my new acquisition indebtedness is $400,000. If, however, I renovate the home over a few years and the home appreciates to $500,000, and then I refinance the home for $400,000 and take the cash out with a new 30-year fixed mortgage, my acquisition indebtedness then remains at the original $250,000 (less principle payments from the beginning of the loan). Only 63% ($250,000/$400,000) of acquisition indebtedness interest payments are deductible on this new $400,000 loan. The reason acquisition indebtedness did not rise in this scenario is because the debt is not directly related to new capital improvements.

Acquisition indebtedness must be secured against the respective property. Assume I have owned a home worth $500,000 for 30 years and the property is now debt free, and then assume I take out a new mortgage for $250,000 on my 30-year homestead and use the cash to buy a beach condo. I bought real estate, but because the debt is not secured specifically on the newly acquired condo, the mortgage is not deductible. If the loan had been against the condo, then the mortgage would be considered acquisition indebtedness and fully deductible.
Cumulative acquisition indebtedness is limited to $750,000. If I have loans in the amount of $1,000,000 secured on a primary and secondary residence, then only 75% of all interest paid is deductible. No additional amounts of capital improvements can increase the deductibility of mortgage interest beyond a cumulative total of $750,000. Real estate acquired before 2018 with debt of $1,000,000 or more, however, is grandfathered to a maximum of $1,000,000 acquisition indebtedness according to the old law.

It is incorrect to believe that since the new tax law took effect, the interest from a Home Equity Line of Credit (HELOC) is no longer tax deductible. The new tax law eliminated the $100,000 home equity loan and no longer allows HELOCs to be used in any way you wish and the interest to be deducted. Under the new tax law, you cannot borrow on a HELOC for condo rentals, college tuitions, sports cars, and caviar and expect the government to pay a portion of your interest. You can, for example, take out a HELOC to renovate your kitchen and still receive the tax deduction. If I take out a $100,000 HELOC and use $50,000 to renovate my kitchen, build a deck, or make any capital improvement, then that half of the credit line interest is tax deductible. If I borrow the other $50,000 of the HELOC to send Johnny to Harvard, then I will not receive a tax deduction for the interest on that half of the loan that I used for college tuition.

Mortgage interest paid on rental properties is deductible because it is investment interest and does not fall under the rules of acquisition indebtedness. Rules for rental properties fall under real estate rules, which depend on whether you are a passive investor, an active investor, or a real estate dealer. Mortgage interest on a property that is rented and used personally allows interest to offset rental income to no lower than zero taxable rent. Any further interest on this hybrid property falls under acquisition indebtedness rules. The focus of this article, acquisition indebtedness, is to give general guidance on when interest is tax deductible on personally owned real estate.

These rules are complex, and I never even mentioned Investment Interest Expense deductions (which is for another article). The key is whether or not you get good advice. Many taxpayers are going to use TurboTax or other tax software programs and they assume the software calculates the correct deductible amount. This is a poor assumption. These rules are very complex and are not easy for the IRS to monitor; therefore, the IRS will depend on professional tax preparers to maintain compliance. Americans who use tax software programs are unlikely to be questioned on the eligibility of interest deductions, but if they are questioned, then they can rely on the “Geithner Turbo Tax Defense.” During his Senate confirmation hearings, Timothy Geithner made famous the Turbo Tax defense, saying that he used TurboTax to prepare his tax returns but the software gave no indication that he underpaid self-employment taxes. “TurboTax didn’t tell me I owed it,” he said.

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