The mortgage interest deduction has been considered by many to be as untouchable as social security whenever Congress crafts tax changes.
In fact, it has not been as much of a sacred cow as you might have thought.
A major change took place back in 1987 that set limits to the interest deduction that could be claimed. It tied the limits to ceilings on mortgage balances. $1.1 million was the maximum balance for which you could deduct interest. That figure includes $100,000 for home equity borrowings. Regardless of the mortgage amount, it limited the deduction to two properties: a primary and secondary home.
Initially, the ceilings only affected the richest of taxpayers, the ones who owned large properties in highly desirable locations. As the real estate market took off, however, more and more average Joes accumulated hefty balances through refinancing and trading up, especially in major population centers in California.
Although many people were aware of the limits, they overlooked a key element of the rule –cash out refinancing not used to improve the home secured by the mortgage was defined as home equity borrowing. As mentioned earlier, the limit for this kind of debt was set at $100,000, a much easier threshold to crack.
Many taxpayers go to their tax preparers with form 1098 in hand and expect that the entire amount shown is deductible. After all, they received the form from their lenders; they must know what they are doing. They are surprised when asked about their loan balances and refinancing history.
They are even more surprised when they learn not all of 1098 interest may be deductible. I have heard some practitioners say that the clients will ask them to deduct the entire amount anyway.
Any reputable preparer will say “no can do.”
You can easily fall into the limitation trap, even in a declining real estate market such as we are experiencing now.
Here are two examples:
A taxpayer is concerned about losing his job, but he has plenty of equity in his home which was purchased many years ago when prices were much lower. He refinances his mortgage and takes out $200,000 above the current mortgage amount and stashes it away as a rainy day fund. All of it counts as home equity debt. Assuming the taxpayer has no other home equity debt; he will not be able to deduct the interest on $100,000 of the take-out.
Another taxpayer invested conservatively and avoided being clobbered by the market crash. Her employment is stable and she also owns a home with much equity. With home prices falling she decides it is the time to buy a vacation beach house. She refinances her existing home and takes $200,000 out to go towards the downpayment.
The entire take-out goes towards the beach house; nothing is used for personal purposes.
Although the cash is used for acquisition and the property qualifies as a second home, she will not be able to deduct the interest on $100,000 of the take-out. Why? Because the cash is not secured by the beach house; it is secured by her primary home.
Both of these examples might be economically sound even with the limitation. What I am saying is you need to be aware of the implications so you do not end up paying more tax than anticipated.
When dealing with a lender, do not assume they know these rules. Almost every lender I have dealt with did not. I actually had one lender suggest I overlook the rule in order to take advantage of a good deal. It would have been a good deal if I could have deducted all of the interest.
“Fat chance,” I said. “As a CPA I cannot pretend the rule does not exist. It would be unethical.”
He could not understand why ethics should be a reason to walk away from the deal.
Caveat emptor!
CONSULT YOUR TAX ADVISER — This article contains general information about various tax matters. You should consult your CPA regarding the implications to your own particular situation.
NEXT WEEK: What is on the horizon for the mortgage interest deduction
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