Q: I’ve been reading a lot about tax reform and frankly I understand very little of it. I am thinking about buying a new home and I am concerned that I will lose my mortgage interest deduction. Is there anything else I should worry about?
A: If you are thinking of buying or selling a home, you should pay attention to the proposed changes in the rules governing the home mortgage interest deduction and Section 121 capital gains exclusions. The proposed bill will allow you to only deduct interest on the first $500,000 of mortgage debt (down from $1,000,000 today) and only for acquisition indebtedness secured by your primary residence.
Acquisition indebtedness is defined as debt used to acquire, build or substantially improve your home. Borrowers who already have acquisition indebtedness in excess of $500,000 will be grandfathered up to the current $1,000,000 limit. Interest on mortgages secured by second homes will no longer be deductible.
If you have a home equity line of credit that is used for any purpose other than acquiring, building or substantially improving your home, the interest on that borrowing will not be deductible. Current law allows borrowers to deduct interest on up to $100,000 of home equity debt when it is not used as acquisition indebtedness.
The net effect of this change will be to increase the after-tax cost of borrowing for many individuals. Individuals without a lot of home equity will be the hardest hit, especially those trying to buy a home in expensive areas such as the Monterey Peninsula. For example, a borrower with a $750,000 mortgage balance at an interest rate of 4 percent will pay about $3,500 more in after-tax interest expense during the first year of this new law than they pay under the existing law.
You should be aware that this section of the bill is retroactive to November 2, 2017—the day the bill was released from committee. Most other sections become effective on January 1, 2018.
If you are thinking of selling your home, you should also watch for changes in the Section 121 capital gains exclusion. Current law allows married couples filing jointly to exclude up to $500,000 of capital gains ($250,000 for individuals) if they are selling property that was their primary residence for 2 of the last 5 years.
Under the proposed law, the exclusion amount stays the same, but sellers will need to have lived in their homes for 5 of the last 8 years. What’s more, sellers will be able use this exclusion only once every five years. Under the proposed law, the exclusion is gradually phased out for married couples with adjusted gross incomes over $500,000 ($250,000 for individuals).
Please note that these proposed changes to the tax code do not apply to real estate owned as rental property. Investment property owners will still get to deduct mortgage interest and they will continue to benefit from 1031 like-kind exchanges, thereby allowing them to defer capital gains.
Above all, remember that we are still very early in the tax reform process. We have yet to see anything from the Senate and until we get a vote, the House bill is just a proposal. Given the state of Congress, the process may take a while.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.