The tax reform framework recently released by President Donald J. Trump proposes eliminating most itemized deductions, except for those regarding mortgage interest and charitable contributions. It also nearly doubles the standard deduction, meaning only those individuals who have large mortgages and/or are very charitable will likely continue to itemize their deductions.
Conversely, the latest IRS statistics estimate that 32.7 million tax returns were filed in 2015 claiming the deduction for mortgage interest. That would certainly decrease under the proposed change, but those who remain are likely your biggest clients. And while tax reform is a priority for the president, there's no certainty what the final bill will include or when it will be effective.
So don't discount this seemingly basic yet complicated deduction. Although it's a long-standing part of our tax code, recent changes create planning opportunities.
The Basics: The first test when deducting mortgage interest — and the rule that's most likely to trip up financial advisers — is determining how the loan is secured. It's not unusual for clients who want to avoid securing a traditional mortgage, especially when they are building a new home, to consider a short-term loan secured by their investment portfolio.
However, IRS Publication 936, Home Mortgage Interest Deduction, states that to be deductible as mortgage interest, the loan must be secured by the home. With any other form of security, the interest isn't considered qualified mortgage interest and is therefore nondeductible. That interest also isn't deductible as investment interest, since the loan proceeds weren't used to purchase investments. Bottom line: Clients shouldn't use their investment portfolio to secure a home loan.
Assuming the loan qualifies for a deduction, then your client should consider the size of the loan. Only interest on the first $1 million of "home acquisition debt" is considered deductible. The interest on any debt beyond that level is not deductible. And even though they can deduct the interest on loans for a primary residence and a second home, the $1 million exclusion is a combined amount across both homes.
One twist on this rule — last year the IRS decided that two unmarried individuals who co-own the same home can each deduct the interest on $1 million of debt. Married couples only get a single $1 million amount. Divorce isn't a popular tax planning technique, but it could be a way to maximize the mortgage interest deduction.
Home Equity Loans: A deduction is also available for interest paid on up to $100,000 of debt not considered acquisition debt. This is ideal for those clients who maintain a home equity line of credit, or use their equity to finance a car or other purchase. One caveat: If the equity loan proceeds aren't used to buy, build or improve the home, the interest is not deductible for alternative minimum tax purposes.
On the other hand, in 2012 the IRS ruled that the $100,000 doesn't have to be a true home equity loan. If the acquisition loan exceeds $1 million, the next $100,000 of that debt can be treated as home equity debt. In other words, the $1 million limit is really $1.1 million.
Multiple Homes: Interest is deductible on loans used to acquire a primary residence and a second home, and the rules are flexible about what qualifies as the second home. This can include a home, condo, mobile home and even a boat — as long as it has sleeping, cooking and bathroom facilities.
For those clients with multiple homes, only one home can be the second home each year, but there's also flexibility in changing that when homes are bought or sold during the year. Plus, it's possible to change which home is the second home from year to year.
Although it's uncertain how our tax system will look in the near future, understanding options with the mortgage interest deduction is a great way to add value for clients.