The home mortgage interest deduction under the TCJA

Homeownership is a fundamental part of the American dream. Despite recent economic challenges, the wish to own a home remains strong. But according to a recent survey by Bankrate, while nearly three-fourths of Americans identify homeownership as a major part of the American dream, a majority of respondents who are not homeowners said they can’t afford to buy a home. For those who can afford it, tax implications may influence their purchasing decision.

This article examines how and to what extent the mortgage interest deduction incentivizes homeownership. Of particular focus is the current, temporarily lower limitation on the maximum amount of home acquisition indebtedness for purposes of the deduction and its potential effects. This lower limit applies to acquisition indebtedness incurred after Dec. 15, 2017, with respect to tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, a change enacted by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. The TCJA also prohibits deducting interest from home equity debt for the same tax years. In fact, most TCJA provisions pertaining to individual taxpayers are temporary and scheduled to sunset on Dec. 31, 2025.

EFFECTS OF THE TCJA

The Sec. 163(h)(3) mortgage interest deduction has a long history. When the Tax Reform Act of 1986, P.L. 99-514, eliminated personal interest deductions, the mortgage interest deduction remained, with a $1 million ceiling on home acquisition indebtedness ($500,000 for married couples filing separately) on a qualified residence for which interest may be considered qualified residence interest and thus potentially deductible (Secs. 163(h) (3)(A)(i) and (B)(ii)). For this purpose, a qualified residence is the taxpayer’s principal residence and one other residence selected by the taxpayer that is used as a residence under the vacation home rental rules (Sec. 163(h)(4)(A)(i)). There the ceiling on acquisition indebtedness remained the same until the passage of the TCJA. Also prior to the TCJA, Secs. 163(h)(3)(A)(ii) and (C) allowed an additional deduction for interest paid on up to $100,000 in home equity indebtedness.

The TCJA reduced the acquisition indebtedness ceiling to $750,000 ($375,000 for married couples filing separately) and eliminated any interest deduction for home equity indebtedness (Sec. 163(h)(3)(F)(i), as amended by Section 11043(a) of the TCJA).

Again, these changes apply only to acquisition indebtedness incurred in tax years 2018 through 2025. Acquisition indebtedness incurred before the date of the TCJA’s enactment, Dec. 15, 2017, (or pursuant to a written binding contract entered into before that date) remains subject to the higher limitations. Likewise, for tax years after Dec. 31, 2025, the higher limitation on acquisition indebtedness and the allowance of home equity indebtedness will again apply “without regard to the taxable year in which the indebtedness was incurred” (Sec. 163(h)(3)(F)(ii)).

However, Congress could decide to extend or make permanent some or all of the changes to the home acquisition indebtedness rules by passing legislation to revise these changes or their scheduled sunset dates. Taxpayers considering the effects of entering into home acquisition debt before 2026 should account for this possibility.

Other changes introduced by the TCJA in effect during the period also could affect how much of a tax benefit taxpayers may derive from home mortgage interest and certain other homeownership expenses. These include the increase of the standard deduction (because it makes it less likely taxpayers will gain a tax benefit from claiming itemized deductions, of which qualified residence interest is one), lower marginal tax rates, and a $10,000 ceiling on the state and local tax (SALT) deduction (Sec. 164(b) (6)(B)). This latter reduction in tax benefit is notable mostly for taxpayers residing in areas with higher-value real estate and higher SALT burdens. For a summary of these changes, see the table “TCJA Changes Potentially Affecting a Mortgage Interest Deduction,” below.

To model these changes, before the TCJA (and after, assuming its provisions sunset and revert to prior law), the maximum tax benefit available to high-income taxpayers who itemize and with mortgages on their residence (and any second residence selected by taxpayers used as a residence under the vacation home rental rules) could reflect the home acquisition indebtedness limit of $1 million plus home equity debt of as much as $100,000, for debt incurred during the period. Assuming a 7.8% interest rate for taxpayers in the highest marginal income tax bracket with both of those maximum debt amounts, the benefit would amount to as much as 7.8% × $1.1 million × 39.6%, or $33,977. With the reduced ceilings and tax rates during the TCJA period, it would be considerably less: 7.8% × $750,000 × 37% = $21,645.

Example 1: Sara and Amir purchased a home in 2016 for $1.2 million. They made a down payment of $250,000 and financed the remainder with a traditional 30-year mortgage. In 2017, their interest payments were $37,600. Other itemized deductions amounted to $18,200 (which exceeded the $12,600 standard deduction for that year), $14,700 of which were SALT deductions. They file jointly, and their marginal tax rate was 39.6%. Total itemized deductions are $55,800. Assuming their taxable income was at least $37,600 more than the bottom of the highest marginal tax bracket for their filing status, the tax benefit from the mortgage interest deduction in 2017 was $14,890 (39.6% × $37,600).

Example 2: Assume for simplicity that the interest expense in 2018 was also $37,600 and that other itemized deduction amounts were the same. Because Sara and Amir bought their home and incurred its acquisition indebtedness in 2016, the TCJA’s $750,000 limitation does not apply. However, because of the SALT limitation, their itemized deductions were just $51,100; further, the increased standard deduction (to $24,000) and the reduced tax rate lowered the tax benefit from itemizing to $10,027 (37% top tax rate × ($51,100 − $24,000)).

Example 3: Now assume that instead of purchasing the home in 2016, Sara and Amir acquired their home and acquisition indebtedness in 2018. In this case, only $29,684 of the interest will be deductible (($37,600 ÷ $950,000) × $750,000). Total itemized deductions would be $43,184 ($29,684 + $13,500), and the tax benefit would be $7,098 (37% × ($43,184 − $24,000)), which is less than half the benefit computed in Example 1 (see the table “Tax Benefits Compared,” below).

INCURRING HOME ACQUISITION DEBT DURING THE TCJA PERIOD (TAX YEARS 2018–2025)

Personal financial planners cannot rely on homeownership to provide a significant tax benefit to their clients, at least until after 2025. Although mortgage interest rates and home values increased significantly between 2020 and 2022, the number of taxpayers whose tax liability is reduced by homeownership remains relatively small. Of course, this does not mean that real estate is no longer a desirable investment.

Some financial planners, perhaps expecting the lower interest limit to become permanent, have advised taxpayers to try to keep initial mortgage debt at $750,000 or less. Taxpayers who own homes on which they incurred acquisition indebtedness before Dec. 16, 2017, can refinance the original debt and retain the benefit of the pre-TCJA $1 million limitation. However, the new debt will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing.

The mortgage interest deduction, no matter how small, will always benefit those taxpayers who cannot claim the standard deduction (e.g., married individuals filing separately whose spouse claims itemized deductions, nonresident alien individuals, and dual-status aliens). For taxpayers who are claimable as a dependent on someone else’s tax return, the standard deduction is limited in 2023 to the greater of (1) $400 plus earned income or (2) $1,250.

Example 4: Gino, a nonresident alien, earned $250,050 of effectively connected income taxable in the United States in 2023. He purchased a home the same year for $440,000 and paid $18,800 in mortgage interest. Assuming he has no other deductions, Gino’s tax benefit from the interest payments is $6,580 (35% × $18,800).

SHOULD CLIENTS BUY A HOME NOW?

The rise in home values and higher interest rates suggest that, at least in some regions of the country, mortgages and mortgage interest expenses have been and will be rising. According to a study by Lending Tree of its borrowers, average monthly mortgage payments in early 2023 ranged between $1,700 (West Virginia) and $3,696 (Hawaii), with a nationwide average of $2,317. Assuming that, as is common for the early years of a mortgage, between 75% and 80% of these payments consist of interest, many taxpayers are likely to get some tax benefit in the next couple of years — and more if the TCJA provisions sunset at the end of 2025.

Example 5: Amir and Sara purchased a new home in 2023 for $1.2 million, with a down payment of $450,000 and a traditional 30-year mortgage of $750,000. Interest payments for the year were $37,200, and they had additional itemized deductions of $18,200 ($14,700 of which were SALT). The tax benefit of the interest payments is $8,510 (37% × ($50,700 − $27,700)). The amounts for 2024 and 2025 will probably be slightly less because the interest payments will be lower and the standard deduction higher. In 2026, however (assuming the TCJA provisions sunset), the tax benefit of the mortgage interest deduction for Amir and Sara would more than double (see the table, “Comparison of Payments and Tax Benefits for 2026 Without and With TCJA Sunset,” below).

Financial planners and their clients will need to address the timing of a home purchase. Are taxpayers better off waiting until after the sunset? Should they wait until the real estate market settles? Or should they buy right now? Various scenarios and their pros and cons can be explored.

Example 6: Simon, a single taxpayer, earned his graduate degree in 2022 and got a promotion and a raise to $150,000 a year. He’s never owned a home, but based on his new income, he decided to buy a home, despite working in Boston, where house prices have been rising lately. Simon found a condo he likes and could purchase it with a $380,000 mortgage. Interest payments for the first tax year would be approximately $18,800 and property tax $6,688. (For simplicity, assume that he has no other itemized deductions.) His current and future incremental tax benefit (assuming a TCJA sunset in 2025) is summarized in the table “Comparison of Present and Future Tax Benefit in Example 6,” below.

Example 7: Joan and Martin retired in 2022. They saved substantial assets for retirement, and the income generated by those assets puts the couple in the top marginal tax bracket. They owned a home in the Bay Area that they purchased before 2018 with a mortgage of $1.1 million but moved to Nevada on Jan. 1, 2023, where housing prices and property taxes are lower. In 2022, they paid mortgage interest of $49,000 and property taxes of $11,000. (For simplicity, assume that they have no other itemized deductions.) They financed their new Nevada home in Incline Village with a $750,000 mortgage and will pay $33,500 in interest and $6,400 in property taxes. Joan and Martin received no tax benefit under current TCJA provisions when they moved in 2023. After the TCJA sunset, however, the mortgage interest and SALT deductions would significantly reduce their income taxes (see the table “Comparison of Present and Future Tax Benefit in Example 7,” below).

GUIDING CLIENTS THROUGH CHANGES

Clients of personal financial planners understandably worry about economic uncertainty. Although financial planners and other professional advisers cannot remove doubts and ambiguity, they can help clients make sound decisions by creating different scenarios and developing strategies that address these scenarios. They can show clients how purchasing a home or moving from one state to another will affect their taxes now and could affect their taxes going forward.

Scenarios that assume all (or some) TCJA provisions will sunset illustrate that financial planners need to pay close attention to tax legislation addressing them. Which political party controls the House and Senate and which is in the White House could determine whether some or all TCJA provisions are extended or are left to sunset.

Considering that the $1 million limitation introduced in 1986 would amount to almost $3 million in today’s dollars, it’s quite possible that some politicians will propose higher ceilings for the home mortgage interest deduction. If clients are paying high property taxes, have mortgages exceeding the current $750,000 mortgage interest deduction ceiling, and are in the top marginal tax bracket, it’s crucial that financial planners keep them apprised of Washington’s plans.

About the author

Sonja E. Pippin, Ph.D., CPA, is a professor of accounting at the University of Nevada, Reno. To comment on this article or to suggest an idea for another article, contact Jeff Drew at Jeff.Drew@aicpa-cima.com.

LEARNING RESOURCE

Federal Income Tax Update Part 3: Deduction Issues

This course (Part 3 of a four-part program) is essential for the tax practitioner who wants to update their knowledge of individual income taxation. Specifically, this portion of the four-part program deals with deduction issues (including home mortgage interest issues) that a practitioner encounters when preparing federal income tax returns.

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AICPA & CIMA RESOURCES

Article

“Vacation Home Rentals and the TCJA,“ JofA, Sept. 1, 2018

Resources

Analysis of a Tax Return for Financial Planning Opportunities

AICPA Personal Finance Scorecard