One of the primary deductions the average taxpayer can benefit from is the Tax Deduction on Home Loan Interest. This deduction requires that you itemize your return (meaning all of your itemized deductions need to exceed the standard deduction or itemizing would not reduce the tax owed), but can provide a significant break on your taxable income. There are limits on what can be deducted, however, and with the new tax changes taking effect in the 2018 tax year, there were some questions on what, if anything, would change. The IRS recently released a clarification statement which explains that the majority of home loan interest will remain deductible under the new laws.
Whether your loan qualifies for this deduction depends on several factors including the type of property, type of loan product, the amount of your loans, and how you file your taxes (single, married filing jointly, or married filing separately). Generally speaking, the loan must be secured by the taxpayer's primary residence or second home (known as a qualified residence), and the loan amount cannot exceed the cost of the home. So what does all of this mean?
First, how you file matters because the limits on what is deductible change depending on your tax status. Single taxpayers and taxpayers who file married filing jointly may deduct home loan interest on loans up to $750,000 of loans (more about these amounts later), while taxpayers who are married but file separately may deduct home loan interest on loans up to $375,000. These limits are lower than they were in the past, when they were up to $1,000,000 for married filing jointly and single taxpayers and $500,000 for a married taxpayer filing separately. Also remember, all of these new regulations are for the 2018 tax year, so for 2017 you will still file as you previously have (Guidelines for 2017 can be found here IRS Publication 936).
Second, the loans must be secured by a qualified residence. There are two points to consider in that sentence: the loan must be secured and we must define what the IRS means when they say "Qualified Residence." To the first point, a loan is secured when there is a recorded document connecting the loan to a piece of property, which acts as collateral, or a guarantee for repayment of the debt. An unsecured loan is not connected to any particular collateral. A credit card is a good example of an unsecured loan. The credit card company provides you with a line of credit by assessing how big of a risk there is that the loan will not be repaid, typically based on your credit score and income. If you fail to repay the debt, their only option for repayment is to sue you or send your account to a collection agency.
A home loan or vehicle loan are good examples of secured loans. When you apply for a home or vehicle loan you are providing the creditor with information on both yourself and your creditworthiness and with a source of collateral that has its own value. Ideally a creditor would like to loan no more than 80% of the value of the collateral property. This provides them with a 20% cushion so that if you never make a single payment on the debt, they can recover the property and be paid back the full amount they loaned you and enough to cover the legal fees incurred to recover the property. There are some loan products that allow you to borrow 96.5% to 100% of the value of the property (namely FHA and VA loans) but they come with government backing to cover the lender's additional risk.
A home loan is secured by recording a mortgage in the official records of the county where the property is located, which essentially puts all future purchasers on notice that the debt is owed before the seller can provide clear title. In the State of Florida, a lender secures its loan on a vehicle by retaining possession of the original title and recording the interest with the state registration system. In order to sell the vehicle and provide a title to the new buyer, the loan has to be paid off in order for the lender to release the title. If the vehicle owner fails to pay the debt, the lender can repossess the vehicle and sell it to recoup the funds lent to the borrower.
How could this affect your ability to deduct your home loan interest on your tax return? If you obtain financing for your home from the Seller or other non-conventional financing, such as a hard money investor, if they do not record a mortgage to secure repayment of the loan, the interest you pay to them is not deductible because it is unsecured debt. Most lenders record a mortgage as insurance against a borrower's nonpayment but others do not so it is important to know if your loan is secured.
You have determined that your loan is secured but is your property a Qualified Residence? The IRS defines a Qualified Residence as a main home or second home, and further defines "home" as a condominium, cooperative, mobile home, house trailer, boat, or similar property that has sleeping, cooking, and toilet facilities. This is a fairly broad definition of "home." You can only have one main home at a time, which is the home where you live most of the time during the tax year. If you use part of your home for a home office, you will need to allocate the percentage of your home used as a home office or other non-residential purpose, you will need to adjust the value and cost of the home accordingly.
A second home that is not rented out at all during the tax year can be treated as a qualified residence, even if you never use it. If your second home is rented out, even if only for part of the year, you must also use it for yourself for part of the year. You must use the second home for at least 14 days, or 10% more than the number of days that it is rented out at a fair market rental rate, whichever is longer. If you don't meet the use requirement on a second home which is rented out, then it is not a second home, it is treated as an investment property. If you own more than two homes, only one can be treated as a second home for qualified residence purposes. The IRS Code does not differentiate between a U.S. mortgage and a foreign mortgage, so even if your property is located in another country you should still be able to deduct the mortgage interest if the property otherwise meets the requirements of a Qualified Residence. The dollar amounts will need to be converted into U.S. Dollars for the return, but otherwise the calculations are the same.
By now you have determined that it makes sense to itemize your deductions and that you have a secured loan on a qualified residence, or two. How do the maximum loan limits come into play? The dollar limits apply to the combined amount of loans used to buy, build, or substantially improve the home. The clarification by the IRS explains that the deduction applies to first mortgages (sometimes referred to as purchase money mortgages) and to second mortgages or equity lines, as long as the loan is used to buy, build, or substantially improve the home. Below are some examples provided directly by the IRS:
Example 1: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home with a fair market value of $800,000. In February 2018, the taxpayer takes out a $250,000 home equity loan to put an addition on the main home. Both loans are secured by the main home and the total does not exceed the cost of the home. Because the total amount of both loans does not exceed $750,000, all of the interest paid on the loans is deductible. However, if the taxpayer used the home equity loan proceeds for personal expenses, such as paying off student loans and credit cards, then the interest on the home equity loan would not be deductible.
Example 2: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home. The loan is secured by the main home. In February 2018, the taxpayer takes out a $250,000 loan to purchase a vacation home. The loan is secured by the vacation home. Because the total amount of both mortgages does not exceed $750,000, all of the interest paid on both mortgages is deductible. However, if the taxpayer took out a $250,000 home equity loan on the main home to purchase the vacation home, then the interest on the home equity loan would not be deductible.
Example 3: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home. The loan is secured by the main home. In February 2018, the taxpayer takes out a $500,000 loan to purchase a vacation home. The loan is secured by the vacation home. Because the total amount of both mortgages exceeds $750,000, not all of the interest paid on the mortgages is deductible. A percentage of the total interest paid is deductible (see Publication 936).
The clarification is helpful for taxpayers who have equity lines or Home Equity Lines of Credit (referred to as a HELOC) and should help you with your tax planning for 2018. The current law suspends deducting home loan interest on any secured loan that is not used to buy, build, or substantially improve the home, which may impact your decision to acquire such a loan. Another factor to consider is that the standard deduction for 2018 is significantly higher than past years for most taxpayers so itemizing will not make sense for many more taxpayers. If all else fails, contact an accountant for clarification as each taxpayer's individual circumstances are unique.
Now the fun disclaimer:
Yes, I am an attorney, but I am not your attorney simply because you read this article. Or maybe I am your attorney but this article does not create an attorney-client relationship. I am licensed to practice law in the State of Florida only and have based this information on the laws of this State and the United States of America. This article is for informational and entertainment purposes only and should not be construed as legal advice. Before relying on the information in this blog, you should consult with an attorney.
This particular post is not intended to provide, and should not be relied upon for tax, legal, or accounting advice. You should consult with your own tax, legal, and accounting advisors before engaging in any transaction or making tax decisions. This blog post also won't help you lose weight or regrow your hair but if you have questions about real estate, please contact me and I can help you with your specific situation.