Q) I understand that Congress has once again changed the rules on deducting home mortgage interest, and I am in the process of preparing my 1987 tax return. Can you explain what the new law is all about?
A) If you are preparing your 1987 tax return, ignore the provisions of the new law, since they did not take effect until last month. However, even the laws and rules of 1987 are complex.
Many years ago, Congress created the great American dream. To encourage home ownership, interest on home mortgages was fully deductible and to further encourage this concept, Congress permitted the taxpayer to "roll over" any profit if the taxpayer sold the home and purchased a new home at a price equal or greater than the selling price of the old home. Finally, in deference to senior citizens who reached the age of 55 and wanted to sell their home, Congress enacted a once-in-a-lifetime exemption of $125,000 of profit.
Periodically, however, presidents would throw out a trial balloon, suggesting that perhaps some restrictions should be placed on the deductibility of home mortgage interest. When Jimmy Carter was president, he suggested there should be limitations on these deductions and Congress and the public strongly reacted against this proposal.
President Reagan also suggested that restrictions be enacted, and in 1986, when Congress enacted its tax reform act, certain limited restrictions were placed on deducted mortgage interest.
For taxpayers preparing their 1987 returns, there are unlimited deductions on home mortgage interest, but if you settled after Aug. 16, 1986, the mortgage cannot exceed the original cost of the home. However, if the taxpayer made improvements to the home, or if the money was used for certain medical or educational expenses, the taxpayer is permitted to deduct the amount needed to borrow for these expenses.
Congress has often tap-danced around placing restrictions on this sacred cow called "home ownership." With the stock market crash of 1987, and with the concerns raised by Wall Street and other major financial institutions to reduce the size of the U.S. debt, Congress decided to stop dancing and tackle the subject directly. However, in the law that President Reagan signed Dec. 22, Congress appeared to have continued the dance, by virtue of a "two-step" approach to deduction of interest on mortgage loans.
We all must learn new terms. The most important term is "acquisition indebtedness." According to the new tax code (Section 163 (h) (3)), acquisition indebtedness "means any indebtedness which is incurred in acquiring, constructing or substantially improving any qualified residence of the taxpayer and is secured by such residence." There is, for the first time, a dollar limitation on the amount of interest that can be deducted. However, this limitation is $1 million ($500,000 in the case of a married individual filing a separate return), and probably will not affect too many taxpayers. However, the real estate industry has raised a concern, saying that since Congress has established a ceiling, in future years this ceiling can be reduced -- thereby affecting more homeowners.
However, on all mortgage loans taken out for the purchase of residential property after Oct. 13, 1987, taxpayers are permitted to deduct interest on their mortgage loans, provided the loan does not exceed $1 million. It should be pointed out that this interest is deductible at the taxpayer's ordinary income bracket -- whatever that may be.
And there are restrictions when an old loan is refinanced. The acquisition indebtedness described earlier is reduced as payments of principal are made, and cannot be increased in amount by refinancing. Thus, if a mortgage is refinanced, only the amount of refinancing equal to the unpaid balance of the previous loan is considered "acquisition debt," plus, of course, any money incurred to substantially improve the home. Thus, if your home has a market value of $250,000, and your current mortgage is $50,000, even if your new lender permits you to refinance up to $200,000, you are only permitted under the new tax loans to deduct the acquisition indebtedness (i.e. the $50,000) plus $100,000, for a total of $150,000. The remaining interest on the additional $50,000 is not deductible, although when you sell your home the interest that you pay can be used to reduce any profit you have made.
It is important to note that mortgage loans obtained prior to Oct. 14 remain deductible under the old rules permitted under the Tax Reform Act of 1986.
This is the first step.
The second step deals with home equity loans. Here, Congress attempted to remove uncertainty created by the 1986 law, which would permit deductions only for home improvement loans, or qualified medical or educational expenses.
Under the new law, a homeowner of a principal or second residence is permitted to take out additional debt in an amount up to $100,000 and use the proceeds for any purpose whatsoever. But home equity borrowing cannot exceed the fair market value of the home, less the acquisition indebtedness. If, for example, the fair market value of your home is $130,000, and your first mortgage is $50,000, although your lender may lend you $100,000 on a home equity loan, Congress will permit you to deduct interest on only $80,000 ($130,000 minus $50,000).
Although the House tried to restrict interest deductions for mobile homes and boats, these restrictions were knocked out by the Senate. Thus, if you can treat your mobile home or your boat as a principal or second residence (in other words, if it has sleeping, toilet and cooking facilities), then you may treat it as your first or second home.
Finally, in order to deduct any interest, the loan or loans you obtain must be secured.This means that if you borrowed money from a friend or family member, and the note is not secured by a mortgage or deed of trust, then you are not permitted to deduct any interest as a homeowner. In 1988, only 40 percent of these interest payments are deductible and this will drop to 20 percent in 1989. Cooperative owners should be able to deduct their interest as homeowners if they can demonstrate that their indebtedness is secured by stock in a cooperative corporation.
These rules are complex. As one critic has suggested, what you may save in interest deductions may be eaten up by the cost of legal and accounting advice to assist you in understanding these new laws.
Benny L. Kass is a Washington attorney. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1060 17th St. NW, Washington, D.C. 20036. Readers also may send questions to him at that address.