The big tax bill passed by Congress at the height of its Christmas spree has some surprises tucked away in its fine print for thousands of American homeowners and home buyers in 1988.
A close look at the full text released last week turns up some ominous new tax rules. For example, you may have heard or read about the $1 million limit on mortgage deductions, or the $100,000 limit on deductible home-equity loans.
Odds are you gave those numbers barely a passing glance, since they exceed your own mortgage situation. But look again. The $1 million cap isn't the ball game at all. The fact that you think you'll never hit the limit is irrelevant. You're still affected by the law, potentially far more so than you'd assumed.
The 1987 tax act rejiggers the mortgage interest deduction formula, giving homeowners their third mind-bending set of rules in three years. The keys to the latest revision are in the words "acquisition indebtedness" and "home-equity indebtedness."
Acquisition indebtedness is the amount of debt you rack up "acquiring," "constructing" or "substantially improving" your first and -- if you have one -- your second home. The simplest way to grasp its significance in the new law is to remember this: Congress says the more acquisition indebtedness you've got, the better, at least for tax purposes.
Up to the $1 million limit, you can take deductions on your full acquisition indebtedness each year. If you're married and filing separately, the "cap" is $500,000. Here's where things get sticky, though. On any given home -- whatever its current market value -- your acquisition indebtedness becomes your deduction high-water mark.
You can't take writeoffs on any interest beyond that, unless you've spent money on fixing up the place with "substantial improvements." If your mortgage debt at purchase was $50,000, and you spend nothing on capital improvements, that's it -- even if your home jumps in value to $500,000.
Moreover, for most people, acquisition indebtedness will be a constantly receding number as they pay off their mortgage and their principal balance shrinks.
What's so bad about that? Maybe nothing. Maybe plenty. If you've owned your home for 10 years, stop and think about your own situation. Or if you're a new owner, think about relatives or friends who've owned their residences for years. What does your or their "acquisition indebtedness" look like at the moment? Are you or they able to refinance and pull out substantial amounts of tax-free equity in cash, and still take full deductions on the new debt?
It depends. In one of its most significant sections, the 1987 tax law restricts deductions on home refinancings. You can only take deductions on new debt up to the principal amount of the loan outstanding when you refinanced.
Say you bought your home 18 years ago for $70,000, and your mortgage is paid down to $40,000. You put in $10,000 worth of capital improvements over the years. Thanks to high appreciation in your area, your house could sell for $300,000 today. You decide to refinance.
But under the new law, you're limited in the amount of deductible refinancing debt you can take. You're capped, in effect, at your acquisition debt level: $40,000 plus $10,000, or $50,000. You can't refinance a cool $200,000 out of your house anymore and expect to write off all the interest. That's a fundamental change that could hit you -- and many other owners and buyers -- like a pail of ice water in the coming months or years.
But the 1987 tax act offers a safety valve of sorts. Besides acquisition debt, the law contains allowances for "home-equity indebtedness." That's mortgage debt in the form of second deeds of trust, revolving lines of credit and other junior liens. Anybody with sufficient equity can pull out up to $100,000 in home-equity debt, beyond their acquisition debt, and still take deductions on the interest.