Forbes.com is reporting that the IRS has amended their stance on large mortgage interest deduction. Prior to their amendment homeowner’s who borrowed >$1.0 million to purchase their home were only able to deduct interest on the first $1.0 million. However, if that homeowner borrowed only $1.0 million to acquire their home and then later took out a $100,000 equity loan they were then able to deduct interest on the entire $1.1 million.
What this article is reporting is that the IRS is effectively viewing these two scenarios as being the same. Therefore, the interest on the $1.1 million in acquisition indebtedness is now tax deductible. Homeowners who benefit from this change can amend their taxes back 3 years to take advantage of this change.
Do you know what your “acquisition indebtedness” (AKA “home acquisition debt”) is? You probably do know and don’t even know it. Your acquisition indebtedness is simply the amount of mortgage you took out to buy your home.
For example, if I buy a home for $300,000 and take out a loan for $240,000 at the time of purchase then my acquisition indebtedness is $240,000.
Why should anyone care?
Acquisition indebtedness is important because it is what the IRS uses to determine how much interest you can deduct from your income to determine your tax liability. At the time of this writing the IRS would allow a household to deduct the interest expense on their acquisition indebtedness (plus $100,000 if the household does a cash-out refinance after they’ve purchased the home) so long as the loan amount(s) do not exceed $1.0 million.
Therefore, if you purchased your home back in 1980 for $50,000 and took out a $40,000 mortgage then your acquisition indebtedness is only $40,000. If you have taken cash-out refinances over the past 25 years to fund college educations, debt consolidations, and/ or other objectives along the way without making significant improvements to your home then you may only be able to deduct the interest on first $100,000-$140,000 of your current mortgage.
There are a few different ways that this tax rule will impact how we advise our clients. One of the most common is when a client of ours purchases a home for cash. Once they’ve done so they still have 90 days to establish home acquisition debt by taking out a mortgage on the property.
Once a homeowner’s acquisition indebtedness is paid (partially or entirely) that portion is no longer tax deductible unless the mortgage is used to improve the home OR is within the $100,000 cash-out exception.