Talking Tax Reform - Part IV

To better understand the mortgage interest deduction and how the Trump Tax Plan has altered it, a review of its history might be instructive.  When the Income Tax became constitutional again in 1913, all types of interest were deductible.   Mortgage interest wasn't even on the minds of the members of Congress at the time.  The proof of this is that back then, most home purchases were cash transactions.  Mortgages grow in popularity in the 1930s with the birth of the Federal Housing Administration, which ultimately led to creation of Fannie Mae.  But all interest was deductible.

That remained the case until the Tax Reform Act of 1986.  That law phased out the deduction for all types of interest except mortgage interest and investment interest.  

The mortgage interest deduction requires the taxpayer to be using itemized deductions rather than the standard deduction.  The deduction is limited to the mortgages that are secured by the taxpayer's primary or secondary residence.  Then there are two different limitations.

The interest on a personal residence mortgage of up to $1 million is deductible.  Under a different limitation, a Home Equity Line of Credit (HELOC) mortgage's interest on up to $100,000 is deductible.  So what happens if your mortgage is more than those limits?  The allowable interest deduction is prorated.  

Example.  Mortgage taken out to buy home is $2.5 million.  40% of the total mortgage interest debt paid that year would be deductible.

The Trump Tax Plan changed this deduction in several ways.  First, the deduction for HELOCs and other similar loans was completely eliminated.  That includes mortgages taken out prior to and after 1/1/2018.  

As for the other limit of $1 million, all mortgages that were taken out prior to 12/31/2017 are grandfathered in and unaffected by this tax reform.  But for mortgages that are started on or after 1/1/2018 the limit has been lowered to $750,000.  

I have a friend who is closing on a new home later this month.  Their mortgage amount is $1.2 million.  Under the old rules, 83.33% of the mortgage interest my friend paid would have been deductible.  But since this mortgage is beginning in 2018, only 62.5% of the mortgage interest paid will be deductible.  

How big a difference is that to my friend?  For simplification purposes, let's assume that the amount of interest paid in year 1 of this mortgage is $36,000.  Under the old rules, $30,000 would have been the allowable mortgage interest deduction.  Under the new rules that deduction drops to only $22,500.  

But the tax rates changed as well.  My friend's old marginal income tax rate was 28%.  The mortgage interest deduction savings would have been $8,400.  The new marginal tax rate is actually higher.  32%.  The tax savings would be only $7,200.  

Not a huge difference.  However, when you combine this reduction in conjunction with the elimination of the loss of the SALT deduction, the effect is far more pronounced.  Under the 2017 rules, my friend would have been able to deduct the $15,000 property tax bill and the $9,600 in CA taxes paid in additional to the mortgage interest deduction of $30,000.  That's a total deduction of $54,600 and at a marginal tax rate of 28% a tax savings of $15,288.

Under the new rules my friend's mortgage interest deduction will be $22,500 and the maximum SALT deduction of $10,000 is added to that.  That's a deduction of $32,500 and at a marginal tax rate of 32% is a tax savings of only $10,400.

End result of the Trump Tax Plan as far as my friend is concerned is that their tax bill will be $4,712 higher.

This chart is a reminder that the Trump Tax Plan is a giveaway to the wealthiest Americans, financed by an increase of more than $1.5 trillion in the national debt over the next decade.