Mortgage interest rules

No argument on your #20 post TaxMonkey, but at #18, certain parts of equity debt will be deductible:

Regardless of how the loan is labelled
Loan is used to buy, build or substantially improve the taxpayers home.

In my mind the definition of equity debt does not include acquisition debt. It just makes me sleep better at night.

No argument on your #20 post TaxMonkey, but at #18, certain parts of equity debt will be deductible:

What you are not getting is that this is NOT equity debt, so please stop calling it equity debt. No interest on equity debt will be deductible for the next eight years, but acquisition debt, which is what you keep on mis-identifying, still qualifies.

Write a letter to IRS then. They seem to be calling it equity debt "no matter how it's labeled". The part where there is no deduction is the part where a taxpayer pays off his/her credit card, buys a car, pays for tuition, pays for a vacation. You can call it whatever makes you sleep well at night. But when your client brings in a HELOC document and tells you how the funds were used, that's when there is a division between deductible and non deductible.

Write a letter to IRS then. They seem to be calling it equity debt "no matter how it's labeled".
and throughout that advisory they refer to equity debt

No they don’t. Not a single time in that advisory is the phrase “equity debt” used. And it’s not used because it’s a faulty phrase. You (Action) are using it interchangeably with the following lender labels: “Home Equity Loan” and “HELOC” and “LOC.” But we are not taking the phrase “equity debt” to be a lender label. Rather, we are taking it to be a shortened version of the phrase “Home Equity Indebtedness.” Home Equity Indebtedness is a very specific Tax Code phrase (not a lender label) that has a very specific Tax Code meaning. And if we have a loan – no matter what the lender calls it – that properly represents “Home Equity Indebtedness,” then the interest on it ain’t deductible any longer.

In terms of classifying a loan (no matter what label the lender attaches to it) as home equity indebtedness, acquisition indebtedness, or something else…nothing has changed. The classification scheme is unaltered. What has changed is the result that arises once a $50k “home equity loan” has been classified as “home equity indebtedness.” Under the old law, the interest was deductible. Not so under the new law.

Interest on a “Home Equity Loan” or “HELOC” or “LOC” was NEVER deductible simply because of the label the lender attached to the document. If it was deductible, it was because it represented Tax Code “home equity indebtedness” or Tax Code “acquisition indebtedness.” Heretofore, if you were deducting interest on a “home equity loan” simply because of that label the lender gave it, you were unknowingly stipulating that the loan represented “home equity indebtedness” and/or “acquisition indebtedness.” Chances are, you ended up with the right result even though you took an improper path. I can’t speak to the AMT Adjustment, however.

Related, a cash-out refinance, where I use the cash for personal expenses, is partially acquisition indebtedness and partially home equity indebtedness. The lender's paperwork will just call this a "mortgage" and report the full amounts on 1098, even though part of it is nondeductible.

(Similarly, a loan that is 100% used for qualified education expenses is a "qualified education loan", no matter what the lender calls it. It could even be a credit card that is used strictly for buying school books for example.)

For example, suppose I have a home worth $350,000 and a mortgage of $100,000 and I refinance to $150,000, keeping $50,000 cash to spend on my kids' college. My home acquisition indebtedness is still only $100,000 and I can only deduct the interest on this first $100,000. The other $50,000 is home equity indebtedness and is not deductible starting in 2018. Unfortunately, it's not a qualified education loan either because some of the proceeds were used to pay off my previous lender, which is not a qualified education expense.

Thank you for further notes about how what a bank calls a loan has little to do with what the tax classification is.

Just as 1099-B forms took a turn for the better back in 2010 when mandatory basis reporting began, so too have 1098 forms taken a turn for the better, now that mortgage year begin balance and origination date are mandatory. While the older history is much harder to audit, there will henceforth be the data available to match, for example, property tax re-assessments vs. increase in loan balance via re-finance.

Some of the posters here are far too stuck on the terms HELOC and equity LOC, and I know that comment will further annoy them. When the TCJA was first passed, there were many discussions indicating interest on those specific forms of financing would be non deductible in general which isn't true. As the OP, that was the point of my discussion I wanted to clarify that I was understanding what I was reading correctly because of the variance.

In MSchmahl's scenario, if the additional funds were used to "buy, build or substantially remodel" the taxpayer's residence, the entire interest amount will be deductible (per the IRS Tax Advisory, see post #19) no matter what it's labeled. Sometimes those funds are going to come from a vehicle the bank has created a special name for, sometimes it will be called a second mortgage, sometimes it will be a single refinanced mortgage document. The determining factor is going to be how the funds were used and clients will need to be clearer with tax preparers on the use of those funds. No matter how you get to that, I think we do agree on that point. It'll take more sleuthing on our part, especially with a new client, to be sure how much of the mortgage interest is actually deductible because no matter the improvements on the 1098, they don't include an indication of the use of the funds.

When the TCJA was first passed

When the TCJA was first passed, it was clearly indicated, in the text of the bill, that interest on “home equity indebtedness” would be disallowed. We have all tried to explain this to you, but you’re still not understanding.

In MSchmahl's scenario, if the additional funds were used to "buy, build or substantially remodel" the taxpayer's residence, the entire interest amount will be deductible (per the IRS Tax Advisory, see post #19) no matter what it's labeled.

No, not per the stupid IRS Tax Advisory…but per the law on Acquisition Indebtedness that has always existed. If I took out a HELOC five years ago to add a second floor to my house, the interest was deductible back then, because the loan represented Acquisition Indebteness. And the interest is still deductible now, because the loan still represents acquisition indebtedness. And interest on acquisition indebtedness wasn’t eliminated with the new tax Act…interest on home equity indebtedness was. The loan in question never represented “home equity indebteness” even though it was labeled a HELOC. What it represented, in Tax Code speak, was acquisition indebtedness.

The determining factor is going to be how the funds were used

That’s always been the determining factor.

It'll take more sleuthing on our part

The sleuthing should have already been done with existing clients. How else would you know if the debt was (1) acquisition indebtedness or (2) home equity indebtedness that required an AMT Adjustment or (3) a little bit of both or (4) none of the above?

Reviving this thread. In the latest TaxPro Monthly, there is an article on home mortgages, what counts as acquisition and equity debt. When there has been a cash out refinancing, acquisition indebtedness has always been the loan amount immediately before the refinancing for tracking purposes. What was new to me is that the author says you have to do the same thing any time there is a straight refinancing (no cash out) if the loan fees are added to the mortgage balance and the mortgage balance is slightly higher as a result. We have always been treating these cases as being full acquisition debt, as long as no cash came out. Have I been wrong all this time? The author states that the loan fees (anything above the prior mortgage amount) is home equity indebtedness and thus is now non-deductible. That would mean that any client who has refinanced (which is probably most) will cause us to need to do home acquisition indebtedness tracking. Now, the disallowed mortgage interest in most cases would be small, and would be paid down first, but still that is a lot of tracking. Anyone else care to comment?

Have I been wrong all this time?

Yes.

That would mean that any client who has refinanced (which is probably most) will cause us to need to do home acquisition indebtedness tracking

Right. Many of us have already been doing that and would have made a small AMT add-back.

Again, the underlying rules here are not new.

Now, the disallowed mortgage interest in most cases would be small, and would be paid down first

Right. And it probably has already been paid down to $0 in a lot of cases. If you’re not sure, then assume it has been and move on. One possibly unanswered question is if we can still use the old “the non-Acq debt piece is paid down first” rule.

Note that you're talking about a refi where costs are added into the loan balance, so it's not 100% of refis that have this issue. And in a cash-out refinancing, acquisition indebtedness isn't limited to the loan balance before the refi, if the cash-out proceeds can be attributed to a buy/build/improve cost on the such residence.

Thanks for clarifying and correcting my understanding. Most of our clients haven't been in AMT, so probably (little) harm was done, but we'll have to watch out for recent refis and refis going forward. A percentage of our clients pay the closing costs out of pocket, but many fold them into the loan. Followup question for TB - in the case where 100% of the cash is used for improve the residence, are the loan fees in that case still considered non-acquisition debt if the mortgage balance exceeds the sum of the pre-refi mortgage balance plus the cost of the addition?

I may be misreading this but doesn't 26 CFR 1.163-8T (c)(6)(iii) tell us that the borrowing costs that are added to the principal on a "zero cash" refinance are allocated in the same way as the principal of the previous loan? I.e. if the mortgage was 100% acquisition indebtedness, the costs to refinance are also considered acquisition indebtedness.

[Edit: I was misreading; see below.]

Here is the text of 26 CFR 1.163-8T (c)(6)(iii):

(iii)Debt used to pay borrowing costs -

(A)Borrowing costs with respect to different debt. To the extent the proceeds of a debt (the “ancillary debt”) are used to pay borrowing costs (other than interest) with respect to another debt (the “primary debt”), the ancillary debt is allocated in the same manner as the primary debt is allocated from time to time. To the extent the primary debt is repaid, the ancillary debt will continue to be allocated in the same manner as the primary debt was allocated immediately before its repayment. The following example illustrates the rule in this paragraph (c)(6)(iii)(A): [example removed]

(B)Borrowing costs with respect to same debt. To the extent the proceeds of a debt are used to pay borrowing costs (other than interest) with respect to such debt, such debt is allocated in the same manner as the remaining debt is allocated from time to time. The remaining debt for this purpose is the portion of the debt that is not used to pay borrowing costs (other than interst) with respect to such debt. Any repayment of the debt is treated as a repayment of the debt allocated under this paragraph (c)(6)(iii)(B) and the remaining debt is the same proportion as such amount bear to each other. The following example illustrates the application of this paragraph (c)(6)(iii)(B): [example removed]

[Edit: This citation doesn't apply for qualified residence indebtedness.]

Also, in response to Jeff-Ohio's last paragraph, the ordering rules found in 26 CFR 1.163-8T (c)(6)(iii) have as far as I can tell been unchanged by the TCJA. So repayments of principal are deemed to apply to the nondeductible personal portion of the debt first. (26 CFR 1.163-8T (d)(1)) [Edit: More appropriate rules are found at 26 CFR 1.163-10T(c), (d), and (e), but my point stands that these haven't been changed.]

MSchmahl, just curious, but why are you citing Reg. 1.163-8T when it doesn't apply to qualified residence interest? See Reg. 1.163-10T.

Ugh, I was looking to -8T for the interest-tracing rules, and didn't notice that -8T is for everything but residence indebtedness. This is especially embarrassing because I specifically cited -8T(d)(1) which lists the types of indebtedness and didn't notice residence indebtedness wasn't in that list. -10T does reference -8T for a few things, but assimilating the two regulations leads me to conclude, as everyone else has already done, that the loan acquisition costs are nonacquisition indebtedness. (See also IRC 163(h)(3)(b)(i)(*).)

Sorry if I created a snipe hunt.

(But since -10T was not changed by TCJA, the rules under -10T(c), (d), and (e) have the effect of treating non-qualified residence indebtedness as being paid first before qualified residence indebtedness.)

Note that you're talking about a refi where costs are added into the loan balance, so it's not 100% of refis that have this issue.

True. But I think it might be well over 90%, based on anecdote and hunch. I have a friend who used to refinance like clockwork every 18-24 months to take advantage of dropping interest rates; in such a market, refinance closing costs are almost inevitably going to be added to the loan balance so that the borrower feels it didn't cost them anything to refinance -- all they know or care about is that their monthly payment went down.

But since -10T was not changed by TCJA, the rules under -10T(c), (d), and (e) have the effect of treating non-qualified residence indebtedness as being paid first before qualified residence indebtedness.)

Where exactly in the -10T regulation does it say that, in the case of a mixed use mortgage, we take down home equity indebtedness before we take down acquisition indebtedness?

Followup question for TB - in the case where 100% of the cash is used for improve the residence, are the loan fees in that case still considered non-acquisition debt if the mortgage balance exceeds the sum of the pre-refi mortgage balance plus the cost of the addition?

To generalize it, if you borrow to pay loan fees, the interest on that debt does not qualify as acquisition indebtedness. Similarly only limited types of costs can be added to the basis of the home. The IRS publication on this topic covers this.

For the initial purchase this is a distinction without a difference, because of the down payment. Money is fungible so if you bring $50,000 to the closing you can attribute a portion of that down payment to all loan costs that are not AI, and maximize your AI (the result being that the full value of the mortgage is AI rather than having to back out whatever proportion the costs represented as part of the purchase price).

A cash-out refi doesn't have that analogous down payment component, so you need to use a portion of the proceeds to buy/build/improve to raise your AI from the amount brought forward from the old mortgage. Bonus question, how far back or forward from the refi closing can you spend that money on an improvement, and still call it AI?

But since -10T was not changed by TCJA, the rules under -10T(c), (d), and (e) have the effect of treating non-qualified residence indebtedness as being paid first before qualified residence indebtedness.)

Where exactly in the -10T regulation does it say that, in the case of a mixed use mortgage, we take down home equity indebtedness before we take down acquisition indebtedness?

Subsections (c), (d), and (e) tell us to compare the adjusted purchase price to the amount of secured debt. In (c), the secured debt does not exceed the adjusted purchase price: All interest is qualified residence interest. In (d) and (e), the secured debt exceeds the adjusted purchase price: Only that interest attributable to the adjusted purchase price is qualified residence interest. Subsections (d) and (e) give two methods of computing that interest. As the adjusted purchase price does not change while the amount of debt declines, this gives the equivalent effect of deeming the non-acquisition indebtedness being paid first.