Owning My Mistake

Richard Connor

I RECENTLY WROTE an article about our purchase of a new primary residence, and our plans for our existing beach house. On the same day, HumbleDollar published a companion article that I also wrote. That second piece discussed the tax implications—and complications—of converting a former primary home to a rental property.

We had purchased the new home using a mortgage, and our plan was to refinance the beach house and use those funds to pay off the mortgage on our new primary residence. Borrowing seemed preferable to withdrawing a large sum from our retirement accounts and triggering a big tax bill.

Our hope: After all this maneuvering, we’d have a mortgage-free primary home, and a mortgaged second home. The second home would be dual use: We’d rent it out during the summer season and use it occasionally during the off-season. Here’s what I said toward the end of my earlier article:

I’ve spoken to our mortgage person about refinancing the beach house so our new, primary residence has no mortgage. This makes financial sense because there’s a strong tax incentive to have a mortgage on the rental property. Expenses incurred in owning a rental property, including mortgage payments, are deductible against the rental income received.

Unfortunately, the reference to the deductibility of mortgage payments was vague to the point of being misleading. Several commenters gently pointed out the glaring error in my article.

Where did I go wrong? The Tax Cut and Jobs Act (TCJA) of 2017 made significant changes to the tax code, including changes to tax brackets, increasing the standard deduction, and limiting the deductibility of state and local taxes. The law also made key changes to the home-mortgage interest deduction rules—rules that many financial experts are unaware of, as I’ve discovered over the past few months.

Prior to the enactment of TCJA, married couples filing jointly could deduct mortgage interest on up to $1 million of what the IRS calls “home acquisition debt.”  Home acquisition debt is defined as mortgage debt that was used to buy, build or substantially improve your home. You could also deduct interest on an additional $100,000 of home-equity debt used for any purpose.

Any mortgages originated after Dec. 15, 2017, are governed by the new TCJA rules. The limit for total home acquisition debt was lowered to $750,000, unless you’re married filing separately, in which case the limit drops to $375,000. This limit applies to the combined amounts of all mortgages on your primary and second home.

The TCJA also eliminated the deductibility of the additional $100,000 of home-equity debt. Under TCJA, any home-equity loans are combined with all mortgages in counting toward the $750,000 limit. There’s also another important proviso: Only home acquisition debt is counted in this calculation.

What about refinancing your mortgage to, say, access some of the equity in your home for personal use? Publication 936 provides this guidance:

“Any secured debt you use to refinance home acquisition debt is treated as home acquisition debt. 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. Any additional debt not used to buy, build, or substantially improve a qualified home isn’t home acquisition debt.”

Note that the qualifying phrase “just before the refinancing.” This means that the interest on a “cash-out” refinanced mortgage, where you borrow more than you currently owe, is not likely to be totally deductible if any of the additional funds weren’t used to substantially improve your home.

There are special grandfathering rules for mortgages that predate the TCJA. The interest on mortgages initiated before Oct. 14, 1987, is generally fully deductible, regardless of how you used the proceeds. Loans taken after Oct. 14, 1987, but before Dec. 15, 2017, are subject to the home acquisition debt rule and a $1 million limit.

There are special rules for second homes, including second homes that you occasionally rent out.  If you rent out the house, and use it for 15 days or more of personal use, you divide the expenses proportionally between the rental use and personal use. 

This is the IRS, so there are lots of interesting nuances and caveats. If you’re interested in the topic, financial-planning expert Michael Kitces published an excellent article explaining the changes.

Our refinancing plan included using a new mortgage on our vacation home to pay off our primary home mortgage. But this wouldn’t count as “buying, building or substantially improving” our vacation home, and thus the mortgage interest on that loan wouldn’t be fully deductible.

But that may not be the end of this tortured tale. The wild card: The TCJA changes to the home-mortgage interest deduction sunset at year-end 2025. If Congress does nothing, we go back to the pre-TCJA rules for deducting mortgage interest. Stay tuned.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

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