Losing Interest

Julian Block  |  October 24, 2017

SEVERAL OF MY clients took advantage of low interest rates earlier this year and refinanced their home mortgages for the second or third time. I alerted them to the tricky tax rules on deducting mortgage interest. Here’s the gist of what I told them.

Let’s say Amy Brown owns a personal residence. Her lender is willing to let her refinance for more than the balance on her existing mortgage. Under the tax rules, she’s allowed to deduct interest payments on the refinanced loan, as long as the new mortgage’s size is no larger than the balance on her existing loan.

But what about deducting interest on the part of the refinanced loan that exceeds the existing balance? And does it matter that she plans to use the excess to pay off credit card balances and other debt that charge higher rates of interest, which is often a smart strategy?

I explained that whether Amy is entitled to deduct interest on the excess amount depends on how she uses the proceeds from the refinancing and the amount of the proceeds. When she uses the amount in excess of the existing mortgage to buy, build or substantially improve a principal residence or a second home, her interest payments come under the rules for home acquisition loans. Those rules allow her to deduct the entire interest, as long as all her home acquisition loans combined don’t exceed $1 million. That limit drops to $500,000 for married couples filing separate returns.

Another set of rules, however, apply when borrowers use the excess for other purposes. Those rules prohibit deducting interest on “consumer loans.” This wide-ranging category includes credit card bills, auto loans, medical expenses and other personal debts, such as overdue federal and state income taxes. There is a limited exception for interest on student loans, one of those above-the-line subtractions that you can take directly on the first page of Form 1040, where you also list items like deductible alimony payments and IRA contributions.

Fortunately, Amy is able to sidestep these restrictions, thanks to the rules for home equity loans. Those rules allow her to deduct the interest she pays, provided the amount in excess of her existing mortgage, plus all other home equity loans, don’t exceed $100,000. That sum is reduced to $50,000 for married couples filing separate returns. It makes no difference how Amy uses the $100,000: She could pay off credit card debt, buy a car or even take a vacation.

What happens when her refinanced loans are partly home acquisition loans and partly home equity loans? There’s an overall limit of $1.1 million, which is a combination of $1 million from the home acquisition debt and $100,000 from home equity debt. That number drops to $550,000 for married couples filing separately. And what if her loans exceed the ceiling of $1 million for home acquisition loans and $100,000 for home equity loans? The excess will usually be categorized as nondeductible personal interest, unless the loan proceeds are used for business or investment purposes.

There’s yet another complication—if Amy is burdened by the alternative minimum tax. Under the AMT rules, Amy can deduct the interest on home acquisition loans of up to $1 million ($500,000 for married couples filing separately). But AMT rules deny any deductions for interest on home equity loans for first or second homes, unless Amy uses the loan proceeds to buy, build or substantially improve a dwelling.

Julian Block writes and practices law in Larchmont, N.Y., and was formerly with the IRS as a special agent (criminal investigator). His previous blogs include Capital Punishment, Unending Pain and Moving On. This article is excerpted from Home Seller’s Guide to Tax Savings, available at Follow Julian on Twitter @BlockJulian.

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