Overview
You may fully deduct mortgage interest paid on your principal residence and
a second residence to the extent that (1) you use the mortgage proceeds in
the acquisition, construction, or substantial improvement of the residence;
and (2) the total indebtedness does not exceed $750,000 (or $1 million if the
mortgage debt was incurred before December 15, 2017, or if you entered into a
written binding contract before December 15, 2017, to close on the purchase of
a principal residence before January 1, 2018, and you purchased the residence
before April 1, 2018).
In 2017, you were able to deduct the interest paid on a home equity loan
secured by your residence of up to either $100,000 or the value of your home
reduced by any outstanding mortgage, whichever was less. This deduction
has been suspended, and is not available in 2018. However, if you used the
proceeds from your home equity loan to acquire, construct, or substantially
improve your home, the interest payments may still be deductible subject to the
limitations discussed above.
If you refinance your mortgage, you can continue to deduct the interest on the new
loan, but only up to the balance of the old loan immediately before the refinancing.
You also can immediately deduct “points” paid on the debt you incurred in
connection with the purchase or improvement of a principal residence. This
deduction is available only if the payment of points is an established business
practice in the area in which the indebtedness was incurred and the amount of
the payment is not excessive. Points paid in connectio
Interest paid on a loan secured only by land does not qualify as mortgage
interest. However, you may treat a residence that is under construction as your
principal or second residence for up to two years, provided you move into it
and occupy it as your principal residence when the construction is complete.
(For further explanation of the residential interest deduction rules, see
Home mortgage
interest below.)
Planning Tips:
-
If you are considering buying
a residence and you have
outstanding personal loans, you
may find it advantageous to
finance as much of the purchase
price as possible, reserving
more of your own funds to pay
off your personal loans. You may
not deduct any of the interest
you pay on personal loans.
This approach will likely reduce
the effective interest rate you
are paying, and may convert
your nondeductible interest to
deductible interest.
- Caution: Taking out a larger
mortgage than is needed is not
advisable unless you currently
have nondeductible interest.
In most cases, it is difficult to
invest the excess mortgage
proceeds in an investment
that has a higher after-tax
yield than the after-tax rate on
the mortgage.
-
Keep careful records of
improvements to your home.
The cost of substantial
improvements can be financed
through mortgage indebtedness
and also can be added to the
cost basis of your home when
you sell, possibly decreasing the
taxable gain at that time.
When You Sell Your Residence
If you sell your principal residence at a gain, some or all of the gain may be exempt
from tax. However, if you incur a loss on the sale, you may not deduct that loss.
If you file a joint return with your spouse, you together can exclude gain of up to
$500,000 from the sale of your principal residence. Other taxpayers can exclude
up to $250,000. The following conditions must be met:
-
You must have owned and lived in the property for two years during the
previous five years; and
-
You must not have claimed the exclusion within the past two years. (If filing a
joint return, this requirement applies to both spouses.)
A reduced exclusion amount may still be available if you fail to meet these
requirements because of a change in place of employment, health issues,
or another unforeseen event such as losing your job, getting divorced, an
involuntary conversion of the residence, or another similar adverse circumstance
that could not have been anticipated before buying and occupying the house.
The amount of gain eligible for the exclusion can also be reduced under the
“nonqualified use” rules if you have rented out your home (or left it vacant) at
any time after 2008 and subsequently re-occupied the house before selling it.
Any gain from the sale of a principal residence that is not excludible under these
rules is subject to tax as capital gain and, as explained earlier, may be subject to
the 3.8% net investment income tax if modified AGI is above a certain threshold.
Example: Tom and Helen sell their home for $2 million.
It had a basis of $800,000 (including capital improvements).
Their net gain is $1.2 million, of which $500,000 is eligible
for exclusion. The remaining gain of $700,000 is subject to
tax at the applicable capital gains rate and may be subject
to the 3.8% net investment income tax.
Planning Tips:
-
If you moved out of your house within the last
five years, whether it’s been rented or left vacant,
avoid re-occupying the property before selling it,
as doing so could trigger the
“non-qualified use” rules, which could cause
part of any gain realized on sale to be ineligible
for exclusion.
-
If you permanently convert your residence to
rental use in a declining market when the value
of the residence is less than the original cost,
consider obtaining an appraisal. The basis of the
residence for depreciation and loss computations
is the lower of (1) cost basis or (2) value on the
date converted to rental property. The decline
in value prior to conversion is a nondeductible
personal loss.
Second Homes and Rental Property
Depending on its usage, property you own—such as a
house, condominium, or dwelling unit—that is not your
principal residence may be classified as a second residence
or as rental property. The classification affects the
deductibility of interest, taxes, casualty losses, and other
expenses, as well as whether you have to report any rental
income from the property.
You do not have to report the rental income you receive
on property you used as a home if you rent it to others for
fewer than 15 days a year. However, you may not take any
deductions for rental expenses for that property other than
mortgage interest, taxes, and casualty losses.
Second Home
Property may be considered your second residence if
you or a family member use it personally for more than
the greater of 14 days or 10% of the number of days
it is rented at fair market value (FMV). In this situation,
you must apportion expenses such as utilities, repairs,
and insurance between rental and personal use. You can
deduct these and other rental expenses only up to the
excess of gross rental income over the rental-use share
of interest, taxes, and casualty losses. Although you must
divide the interest expense between personal and rental
use to determine the deductible amount of other rental
expenses, you can deduct the interest subject to the home
mortgage interest expense limitations. Real estate taxes
must also be allocated between rental and personal use,
and the personal use portion can be deducted on Schedule
A (subject to the $10,000 limitation discussed in State and
local income tax deductions).
Rental Property
If you use a home for less than the greater of 14 days
or 10% of the days the property is rented at FMV, it is
considered a rental property. Again, you must apportion all
expenses between rental and personal use if both occur
during the tax year. Special rules apply in the year you
convert a rental property to or from your principal residence.
Income and deductions allocable to any rental activity
generally are subject to the passive loss rules (see
Understanding passive activity rules, below). However,
if you actively participate in a rental real estate activity,
and if your adjusted gross income (AGI), subject to
certain modifications, is less than $150,000 before any
passive losses, you may be able to deduct up to $25,000
of net losses from the rental activity. Rental real estate
participation that is considered active includes approving
new tenants, deciding on rental terms, approving capital
or repair expenditures, and making similar decisions. The
$25,000 rental real estate exception phases out as your
modified AGI rises from $100,000 to $150,000 for single
taxpayers as well as for married individuals filing joint
returns. (Special rules apply to married taxpayers who
file separately). Any additional net losses from rental real
estate are subject to the general passive loss rules (see
Understanding passive activity rules, below).
Rental real estate activities are not treated as passive if you
qualify as a “real estate professional” and you materially
participate in the rental activity. (Note that the threshold
for material participation is significantly higher than that
for active participation, outlined above.) You may qualify as
a real estate professional if you (1) devote more than half
your time to one or more real estate trades or businesses
in which you materially participate, and (2) perform more
than 750 hours of service during the year in the real estate
trades or businesses in which you materially participate.
If the average stay at the rental property is fewer than
eight days, or if the average stay is less than 31 days and
significant services are provided, income will be treated
as trade or business income rather than passive rental
income. Losses realized in a non-passive trade or business
generally are fully deductible if you materially participate in
the trade or business. This rule is especially useful for some
vacation property. There are a limited number of other
exceptions to the rule that rental activities are generally
passive that may be relevant in specific situations.
Planning Tips:
-
Because the passive loss rules are so restrictive,
you should consider personally using vacation rental
property enough to qualify it as a second residence.
Use by a family member also generally qualifies
as personal use. This approach may enable you
to deduct all of the mortgage interest as qualified
residence interest. Keep in mind, however, that you
will forfeit deductions for the personal-use portion of
other routine expenses such as repairs, maintenance,
homeowner’s fees, and insurance.
Home Mortgage Interest
The new tax law makes significant changes to the
deductibility of home mortgage interest that are especially
likely to affect you if you purchase a new home during
the years 2018–2025 and incur a mortgage to finance
the purchase.
Under prior law, qualified residence interest could be
claimed as an itemized deduction, subject to certain
limitations. Qualified residence interest included interest
paid on debt incurred to acquire, construct or substantially
improve your principal or second residence (“acquisition
indebtedness”), and also interest on home equity
indebtedness, without regard to how the proceeds of the
debt were used (except for purposes of the alternative
minimum tax—AMT)
The new law suspends the deduction for interest on
home equity indebtedness for 2018–2025. For the same
tax years, the deduction for interest on acquisition
indebtedness is also limited by reducing the amount of
debt that qualifies as acquisition indebtedness from $1
million to $750,000. Any debt you may have incurred
before December 15, 2017, is “grandfathered” and thus
not affected by this reduction. Also, any debt you may have
incurred before that date but refinanced later continues to
be covered by the prior rules provided the amount of the
debt does not exceed the amount refinanced. However,
if you are considering moving your home during the
years 2018–2025 and financing the purchase with a new
mortgage, the reduced deduction for home mortgage
interest is likely to affect you.
State and Local Income Tax Deductions
Under the new law, for tax years 2018–2025, itemized
deductions for state and local income taxes, property
taxes, and sales taxes are limited to $10,000 in the
aggregate. This cap is not indexed for inflation. The cap
does not apply to personal or real property taxes incurred
in carrying on a trade or business or otherwise incurred for
the production of income.
In addition, foreign real property taxes, other than those
incurred in a trade or business (such as a rental activity) are
not deductible to any extent.
Under prior law state and local property taxes and either
state and local income or sales taxes were generally
deductible in full (subject to the phase-out applicable to
taxpayers whose income exceeded prescribed thresholds)
and constituted some of the most significant reductions to
taxable income. However, the new cap on such deductions
will cause many individuals to claim the standard deduction
rather than itemize. If you live in a state that imposes
relatively high state income taxes it is likely that you will
see a significant impact from the imposition of this cap and
it might cause your tax liability to increase notwithstanding
the overall reduction in tax rates
