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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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Steve Woodward
10 months ago

Kudos on tackling a complex, ever changing topic and communicating it here!

We have owned our home 35 years. We’ve remodeled the stuff we remodeled. It’s long been paid off. My wife and I have considered moving to a smaller home with less maintenance. It seems we will take a substantial financial hit to do so. It’s my understanding that we will pay long term capital gains on anything over our basis plus $500,000. We still would still have to buy another home but would have less money to do so. It motivates a person to more frequently so appreciation/inflation does not have a detrimental effect, or to never move at all. So here we remain.

I believe it is to our countries detriment that the tax code gets used as it does. It gets changed frequently to guide our behavior. It gets changed on political whims. Ultimately the ever changing laws keep armies of accountants, businesses and their leaders, government employees, and citizens/residents trying to interpret existing and guess future laws. I don’t begrudge paying taxes as the price to live in this great country but I do grumble about the complexity. Does it really need to be this hard?

DrLefty
10 months ago
Reply to  Steve Woodward

Yes, that’s right. You take your original purchase price, the cost of any improvements, and sales costs, and that’s your basis. If you make a profit of more than $500K over the base on the sale, you pay capital gains taxes on the overage. On the other hand, you got to live there for 35 years, take tax deductions while you had a mortgage, and benefit from $500K of tax-free appreciation. So I’m not sure I’d characterize that as a “substantial financial hit” for moving. I’d say you’d be doing pretty well.

Nick Politakis
10 months ago

Wow! Former CPA here and I had a hard time keeping up. Thanks for writing about it.

Rick Connor
10 months ago
Reply to  Nick Politakis

Thanks Nick. It was a lot of fun researching it.

Edmund Marsh
10 months ago

Rick, I confess that those “interesting nuances and caveats” have me struggling to keep up on a first read-through. But I compliment you on not shying away from a complicated problem in both your personal life and your writing—and Jonathan for tackling the editing. I’ll be looking for the next installment in the series!

Michael1
10 months ago
Reply to  Edmund Marsh

I second Ed’s comment. I read it once and decided I needed another coffee before giving it another go. What a complex topic, well done.

Rick Connor
10 months ago
Reply to  Michael1

Thanks Michael. I consumed a lot of coffee researching it

Rick Connor
10 months ago
Reply to  Edmund Marsh

Thanks Edmund. I’m also looking forward to the next installment. Who knows what comes next!

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