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Clearing Up Home-Loan Deduction Questions

Christine Benz

Michael Kitces is a partner and the director of wealth management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd's Eye View. You can follow him on Twitter at @MichaelKitces.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With the new tax laws there's lots of confusion about the deductibility of home mortgage and home equity loan interest. Joining me to discuss this topic and clear up the confusion is Michael Kitces. He is a financial planning expert.

Michael, thank you so much for being here.

Michael Kitces: Absolutely. Thanks for having me.

Benz: I want to discuss home mortgage interest and the deductibility of mortgage interest and home equity loan deductibility. Let's start with what's changing with the tax laws that are going into effect with the 2018 tax year.

Kitces: The Tax Cuts and Jobs Act that passed last December made some fairly sudden changes about tax deductibility of mortgage interest, kicked in immediately for this year. We are a few months into the year, the rules are already in effect. At a high level, there were two changes.

The first is, we've had for many, many years a limit that said you can deduct the mortgage interest from the $1 million worth of debt principal. We're pulling that number down, from $1 million down to $750,000. If you have an existing mortgage that was over the $750,000 limit, you can still go up to $1 million. If you refinanced an old mortgage that was over the $750,000 limit, you still get to keep it at $1 million. But any new mortgages going forward, actually all the way back to mid-December since the law was passed, we have a debt limit now that's $750,000 instead of $1 million.

The second change that we made is for the deductibility of interest for home equity debt. The rules changes there were a little bit more harsh. It simply says, all that interest on home equity indebtedness--no longer deductible. No grandfathering, no if I have the existing home equity loan, can I still deduct the interest on the payments. Just flat out effective 2018 no more deductibility for home equity indebtedness. That's gone.

Benz: There's this concept of home acquisition indebtedness versus home equity indebtedness. Let's talk about the difference and why it's important. It depends on what you are using the money for.

Kitces: There has been a lot of confusion around this. This difference between money we use to buy our house and home equity loans isn't actually new to Tax Cuts and Jobs Act. We already had a couple of rules around this. The old rule said, you could normally deduct the mortgage interest up to $1 million; you could deduct home equity loans for $100,000 of debt; there were some special AMT adjustments that applied to the home equity debt but not the rest of the mortgages. We've actually had this separation for a while.

But the confusion that crops up is, it's not actually based on what the bank calls the loan; although traditional mortgages are fully deductible but HELOCs--home equity lines of credit or home equity loans--are not.

As far as the tax code is concerned, the deductibility of the mortgage is based on how you use the money. What do you do with the proceeds of the mortgage? If you use the money to acquire, build, or substantially improve a primary residence that's secured by that mortgage--you borrow money against it and you use it to buy, acquire it, build it, or improve it--it's deductible with that--used to be $1 million--now $750,000 limit.

Any money you borrow against the residence and use for essentially any reason except acquire, build, substantially improve, is treated as home equity indebtedness and now is no longer deductible. The reason why that distinction matters around use is, it means if I take out a HELOC and I use it to build a new room and an addition on my house, that's actually still fully deductible mortgage interest today …

Benz: That's a substantial improvement.

Kitces: It's a substantial improvement. It falls under the $750,000 category. I've still got an aggregate debt limit. I've got a $500,000 mortgage already. I do a $50,000 home equity line of credit, and I do it to do a substantial renovation on my home. I've now got a $550,000 mortgage balance--all of that is deductible, even though part of it is a traditional mortgage and part of it is a HELOC, because I used all the money for--the category is called acquisition indebtedness, but it's acquire or build or substantially improve.

On the flip side, if I take out that HELOC and I use it to send my kids to college, buy a car, or refinance some other debt, I don't use it for anything in the acquisition category, now, it's not deductible debt. My HELOC may or may not be deductible depending on how I use the money, and even my traditional mortgage may or may not be deductible. Classically, when I take out a mortgage, I borrow the money to buy the house, so that's still fine. We do live in a world where thankfully real estate is appreciating again, at least in most areas, people are building equity. It's not uncommon for people to go and do a cash out refinance. I've got a 30-year mortgage with $500,000, I do a cash out refinance for $550,000 and then I take the $50,000, and I send my kids to college and do a little bit of credit card refinancing. That $50,000 excess is now home equity indebtedness. It's a traditional 30-year mortgage, but if I didn't use the money for the acquire, build, or substantially improve category, it's now treated as home equity indebtedness and I literally have like a split loan. The balance is $550,000. I make my monthly payments. But $500,000 of it is acquisition indebtedness, the last $50,000 is nondeductible indebtedness.

Benz: Let's discuss how this should affect how people approach these issues from a practical standpoint. Say someone has home equity debt on their books that they may be used to pay for college or to pay off credit cards or whatever. Does that mean that they should accelerate the payment of that debt because they are not getting a tax break for that any longer?

Kitces: We are not necessarily telling people, now that your home equity loan isn't deductible, you just got to pay that off and get rid of it. Mortgage debt is still a pretty compelling low rate these days, certainly compared to where we've been in the past. It does mean, like, we don't look at it and say, I'm borrowing at 4%, but my tax rate is about 25%, so I get the deductions, so the net cost is really 3%. No, if you borrow at 4%, your rate is 4%. It's not 4% minus the tax break. It's 4%. 4% is not a horrible rate, even plus a little as rates start creeping up. I think, we will still see a lot of people that are comfortable keeping the debt. 

We still have clients that we work with where we are going through discussions and saying, this debt isn't deductible anymore, but it's still a compelling rate. We've got cash we are using for other purposes. I'm not going to do a big liquidation of a portfolio just to pay off a loan that's still at 4% because that might be a pretty good rate for them. But it is bringing a fresh look to the conversation when we say, this debt may not be deductible anymore, either a portion of it or all of it depending on what you've been doing with your borrowing into the house over time. We can't just throw it all in one bucket and say, all that mortgage stuff we get all these tax breaks with it. It's a much more nuanced question now about whether or how much tax benefit you are actually getting from a mortgage.

Benz: Another question is, I could see a profile, I think, it's common among some of our readers and users, would be the person who is approaching retirement maybe has some liquidity on hand because they are getting ready to retire. They plan to stay in their home, and say they have like $100,000 left on the mortgage. Does this sort of embellish the case for potentially prepaying the mortgage that they are not necessarily gaining that much from holding on to that debt, and that could improve their overall household balance sheet?

Kitces: It is a conversation now that we've been having more over the first few months of the year. At the end of the day, frankly, we have never been in the camp of saying, you should have a mortgage for a tax deduction and doing it for that reason alone. At the end of the day, by definition, the tax deduction is a portion of your interest. You are still paying interest. They give you a little bit of tax benefit against the interest. 4% minus 1% is a net cost of 3%. But you are still paying 3%. If you don't want the debt and you don't want the payments and you are not invested in a way that's beating 3%,  you should still pay off the debt.

The fact that the rate 3% is not 3% now; it's 4%, because we lose the tax benefit, it's still kind of the same calculus. What else should we be doing with the money; do we have alternatives that are compelling at a higher prospective rate of return than just getting essentially a guaranteed return of 4% by paying off the debt at 4%.

For a lot of clients, we are not seeing, it was a slam dunk to keep my mortgage at 3%, but at 4%, now it's off. The numbers haven't moved that much just for the change in tax treatment. We are seeing more conversations of, we were doing it, maybe tax deduction was at least in the mix as a part of the reason why we were doing it, and now the tax deduction isn't on the table or it's less or the last 100,000 is still there and it's technically deductible, but maybe we'll just pay it off and then we'll borrow it back later if we need to, is entering in the equation a little more.

If I just have a good old traditional amortizing mortgage, I've been paying on it all along, your $100,000 balance is still deductible. Nothing has actually changed. But people who have borrowed against the house and built up debt over time and added to it, now have all these split loans, and that's really where we are seeing the biggest discussion of, do I want to hold on to it. A tax rate savings on a low interest-rate mortgage, usually the tax deduction alone doesn't solely drive the outcome. But it is, I think, making people a little bit more cognizant of, well, if we just take the tax benefit off the table, now, do you really want to actually this mortgage in retirement or not, and taking a fresh look at that.

Benz: Another issue is this idea of carrying some home equity line of credit as a source of emergency funding. In the past, I know that that was kind of a standard prescription for homeowners as a way to protect themselves against emergency cash needs. Would you say that's still the case?

Kitces: We're still a fan of keeping home equity lines of credit in place just as something that's available. Again, it's not like we ever went to someone to said, hey, you need to borrow some money, you should take it all against your house because you get a little tax deduction. You take it out because you need to borrow the money for something, and if we need to borrow the money and we don't have a lot of other sources of liquidity, really thankful we've got that home equity line of credit in place. That to me is as relevant as ever. We needed some emergency funds, it's helpful to have another source of liquidity. Borrowing against equity and a home is a good way to do it.

I suspect we may actually use it a little bit less often because the rates are a little bit higher when we don't get the tax benefits associated with it. But the idea of having an available, an open and frankly, praying we will never actually need to use it, I think it's still as relevant today as it was in the past. When we get to the moment, maybe you'll decide since the interest isn't deductible you want to go somewhere else. But when our HELOCs are a couple of percent and our credit cards are in the teens, tax deduction or not, often still a compelling option to borrow money if we need to borrow money for some purpose.

Benz: Lots to talk about here, but it sounds like this is a classic case of not letting the tax tail wag the dog. Put the other considerations first before you consider …

Kitces: Correct. And we would have argued for doing that in the first place, but there's nothing like losing some of the tax breaks to have a little bit of a reminder of, let's just recognize that a mortgage first and foremost is a debt with some interest payments. They are relatively low interest payments, there are some nice terms about it, it's not the worst place to borrow if you need to. But it's a debt with interest, first and foremost. Does it make sense for that purpose? And then let's see if we get a little bit of tax breaks that go along with it.

Benz: Makes sense to me. Michael, thank you so much for being here.

Kitces: Absolutely. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.