You may have heard that the Tax Cuts and Jobs Act has changed the deductibility of interest expenses. While that is true, the bigger change is the amount of the standard deduction. In 2017, the standard deduction was $6,350 for taxpayers filing single, $12,700 for married taxpayers filing jointly. With the tax overhaul, the standard deduction for 2018 went up to $12,000 for a single filer, and $24,000 for a joint return. Because of this dramatic increase in the standard deduction, many people who used to itemize their deductions will now be taking the standard deduction. If you are making this change, you will no longer need to include your mortgage interest (or property taxes, or charitable contributions) on your tax return.
Mortgage interest has been deductible for many years and it remains deductible, but the tax overhaul changed how much mortgage interest can be deducted, as well as the type of interest that’s deductible. Before the change, mortgage interest on up to $1,000,000 of principal was deductible. And if the mortgage originated before December 15, 2017, that $1,000,000 limit still applies. Now though, only “acquisition debt,” or the mortgage used to purchase a residence, is deductible and the limit is $750,000 of principal. Mortgage interest on primary and second homes is deductible, but the $750,000 limit is calculated on the total of the mortgages on both homes. Most American homeowners have far less than $750,000 of acquisition debt on their homes. The $750,000 limit primarily affects high-income homeowners in very high-cost areas, such as the Bay Area.
Non-acquisition debt most often comes in the form of HELOCs (home equity lines of credit). These loans come about when a home is refinanced to take advantage of the increase in the home’s value since it was purchased. In some cases, the HELOC can be considered acquisition debt with deductible interest expense. If the proceeds from the HELOC are used for home improvement, such as a remodel or addition, the HELOC is acquisition debt and the interest is deductible. However, if the HELOC proceeds are used for any other purpose (such as paying off credit cards or buying a boat) the interest is not deductible.
What hasn’t changed is the treatment of mortgage interest on a rental property. Rental income and associated expenses are reported on schedule E. Mortgage interest is reported as an expense on schedule E, which reduces the amount of rental income reported.
In the case of a business, the situation is different since there is no such thing as a standard deduction on a business tax return. Loan interest is deductible as a business expense, meaning it reduces net income. The tax overhaul also placed a limit on how much interest expense a business can deduct, but the limit is only narrowly applied. The new limit doesn’t apply to real estate businesses, which often have a lot of mortgage interest. In addition, the limit only applies to businesses with annual revenue greater than $25-million.
When the limit on interest expense does apply, it is based on the business’ adjusted taxable income. Adjusted taxable income (ATI) is calculated in the process of creating the business’ tax return; that number is then adjusted to calculate the limit on interest expense. The adjustments avoid double accounting and also take into account any interest income. Any interest expense beyond the limit can be carried forward and deducted in future tax years.