Mortgage Interest Deductions May Get Extra Scrutiny (updated for the new tax law)

A newly designed Form 1098 gives the IRS more information, so be prepared to defend your deduction.


In response to criticism that the IRS was not properly monitoring mortgage interest deductions, Congress was asked to require lenders to report more information about the loans. In 2015 Congress passed the new reporting rules, and they went into effect for tax year 2016. Homeowners will see the result this year in a newly designed Form 1098, which is used to report mortgage interest. The new form will include the mortgage origination date, the balance at the end of last year and the address of the property securing the loan, as well as other information useful to the IRS.


With this new wealth of information, it’s expected that the IRS could direct more attention and audit resources toward checking mortgage interest deductions.


The rules that limit the deductibility of mortgage interest have not changed — the same regulations have been in effect for many years. What could change is the IRS enforcement of those regulations. So we thought it would be a good idea to review the rules. (See our *Note below)


What properties are covered


First, the loan must be secured by a lien recorded on your primary residence or a second home. The property can be a house, condo, co-op, mobile home or houseboat. The loan can be a mortgage, home equity loan or home equity line of credit, but you must be legally liable for repaying it in order to take the deduction.


Next are the limitations on the deduction, based on the how the loan proceeds were used and the amount remaining on the loan. (Note: These limits apply only to mortgages that originated later than Oct. 13, 1987. Earlier loans were grandfathered in under the old rules with no limits.) The IRS classifies mortgage debt as acquisition debt or home equity debt.


Acquisition debt vs. home equity debt


Acquisition debt is debt used to buy, build or improve a home. Improve means add value to the home, prolong its life or adapt it to a new use. Acquisition debt is limited to $1 million ($750,000 for loans originating in 2018 or later) and refers to the average remaining balance of the loan for the year. So if you borrowed $400,000 to buy a house and have an average balance left for 2016 of $350,000, your acquisition debt is down to $350,000. This is an important consideration if the loan is refinanced, as will be explained below.


Home equity debt is a mortgage that is not used to buy, build or improve the property but uses your home as collateral. Interest on home equity loans no longer deductible regardless of how you use the loan.


The best way to explain the rules is through some examples.


Example #1: In 2017 you borrowed $1.5 million to buy a house. Your deductible debt then is $1 million, so only about 67% ($1 ÷ $1.5) of the interest is deductible. The exact percentage would be based the average outstanding balance of the loan.


Example #2: In 2018 you borrow $500,000 to buy a house. Since it is under $750,000, the interest is fully deductible. During the year you pay off $10,000 of the principal, so your acquisition debt is down to $490,000. This continues for many years while your house increases in value to say $700,000 and your loan balance drops to $300,000. Then you decide to refinance the original loan and borrow extra against the increased equity.


You borrow $500,000, which goes to paying off the old loan of $300,000 (i.e., the remainder of your acquisition debt) and the rest is used to repay $50,000 of credit card debt, $100,000 to repay your kids’ student loans and $50,000 for a new car and some new furniture. Your acquisition debt is still $300,000 and the rest is home equity debt. So you have $300,000 of deductible debt, which is 60% of the amount you refinanced. Therefore only 60% of the interest is deductible. Again, the actual calculation would be refined to consider the average outstanding balance of the loan during the year.


Example #3: Same as #2, but you use $100,000 to remodel the kitchen instead of paying off your kids’ student loans. Your acquisition debt is now $400,000 ($300,000 from the original loan, plus $100,000 for home improvements). Your home equity debt is $100,000. Your deductible debt is $400,000, which is 80% the entire loan, so 80% of your interest is deductible.


Need for good records


Under the new mortgage interest reporting rules the IRS will know your remaining balance, among other bits of information. We have to expect that IRS will be scrutinizing this more closely, although we don’t know exactly how they will do it. They could just ask for clarification and ask you to send documentation of any refinancing and how you used the proceeds.


You should be keeping a record of home improvements anyway for use in calculating gain or loss when you sell. Now the IRS might be asking for those records sooner, so be prepared.


These simplified examples are intended for informational purposes only.


* Note: We try to explain tax rules in plain English so that it is useful to the reader. In doing so however, there are often exceptions, definitions, special circumstances, etc. that are not covered. If we tried to include them all, it would be like reading the tax code. Our purpose is to give the reader some background and general understanding of the particular issue. This article is not a substitute for professional advice directed to your personal situation. Therefore, we urge you to contact us if you have specific questions.