Mortgage Interest Deduction Part I. What follows is the start of my discussion on the home mortgage interest deduction as allowed under the Internal Revenue Code (IRC.)
Most Americans know well the opening lyrics to the song, Home on the Range, that put wistful words to that most treasured American dream: home ownership.
“Oh give me a home, where the buffalo roam, where the deer and the antelope play…”
And like so many other actions, that American dream has been translated into a tax preference – the deduction for home mortgage interest.
By now, it is likely clear to my readers that I believe we must drastically reform our tax code. In order to effect any real tax reform, we must get out the scalpel for those numerous and sundry tax preferences. But to be thorough, this effort will more likely require a chain saw.
However, any attempt to change the favorable tax treatment bestowed on home mortgage interest will certainly generate a firestorm of controversy. I place this tax treatment second only to Social Security in terms of its sacrosanct political nature.
I can just picture the physical response of my readers. Middle class homeowners are curled in a fetal apposition. Hands unconsciously move to cover vulnerable body parts. But let me reassure you. I do not, nor would not advocate for a unilateral interest deductionectomy (I just made that word up).
I do believe we need a COMPLETE overhaul of our tax code including the elimination of all deductions, credits, preferences, exclusions and the ever popular Alternative Minimum Tax. This would necessarily come with a change to a basic, standard deduction or to the tax tables or both. But it would include the excision of the mortgage interest deduction.
Advocates for the Home Mortgage Interest Deduction assert
- If the deduction is reduced or eliminated, real estate prices will plummet; and,
- If the deduction is reduced or eliminated, most Americans will be priced out of the market
I don’t know about you but those two statements seem to be at odds with one another. How can ‘plummeting’ prices result in a situation in which most Americans are 'priced out of the market?' I will come back to that later.
Just what is this tax preference and where did it come from?
Those two questions are simple enough, right? So the answers should likewise be uncomplicated and clear-cut, correct? Wrong! You must always keep in mind the subject of this blog, the Internal Revenue Code!
Let’s start with the name of this deduction, Home Mortgage Interest. Most of us can offer a reasonably accurate definition of a mortgage. This definition would likely be similar to the one provided by Merriam-Webster's on-line dictionary.
“A legal agreement in which a person borrows money to buy property (such as a house) and pays back the money over a period of years”
If correct, then home mortgage interest should be the interest paid under such an agreement. However, given the various definitions, inclusions, exclusions, exceptions, and the occasional whereas and wherefore in the Internal Revenue Code, we find that this straightforward explanation does not work. Publication 936 offers a detailed explanation of this deduction.
The IRC categorizes mortgages as one of three types: grandfathered, home acquisition or home equity. I won’t even get into a mixed use mortgage or a wraparound mortgage. Heaven forbid I introduce mortgages held by Tenant-Stockholders in Cooperative Housing Corporations.
But before we get into specifics, let’s compare two families and see if we think the deduction makes any sense as structured.
As it turns out, one of the McCoy tribe fell on hard times and lost their house to foreclosure. The Hatfields were determined to buy the house and bid up to $200,000, more than twice the value of the home. They offered $40,000 cash at closing and took out a thirty year, $160,000 mortgage. This debt is considered home acquisition debt. All else being equal, and assuming the Hatfields itemize expenses, they would be able to deduct the full amount of interest paid each year.
In the spirit of ‘what goes around comes around’ it was less than a month later that a member of the Hatfield clan lost a home due to unpaid taxes. Being in a vengeful mood, the McCoys similarly set their mind to buy the the Hatfield home. Out of spite, they offered a purchase price of $200,000, likewise almost twice the value of the home. In their effort to demonstrate superiority, they paid for the house in cash, all $200,000. That might not be the best use of their funds, but they did so regardless.
Eighteen months later, the McCoys were hit with a family emergency. They needed $150,000 to (for ____________ fill in your own emergency choice here) bail the middle McCoy out of the local lockup. Seems he got into a scuffle with one of the Hatfields and got himself arrested. Because they did not owe any money on their house, they took out a loan against the house for the full amount needed. This loan met the IRS requirements for a home mortgage but was classified as home equity debt.
The following year, the Hatfields paid interest totaling $8,676 on their mortgage. As stated before, they are able to include this full amount on Schedule A as a deduction from total income. That same year, the McCoys paid $8,625 interest on their home equity loan.
Forget whether either of these transactions was a smart financial move or that a bank would have actually loaned the money. After all, we are talking about the Hatfields and McCoys (fictionally speaking of course.) Let's stay fixed on the tax code. So the question is, could the McCoys deduct the full amount of the interest paid? Yes? No? It depends? Maybe? What say you?
Allow me to answer that. Nope. No can do. Under the code, because the McCoy debt is home equity, deduction of the interest comes with several provisos, limitations, conditions and disclaimers.
First, it must be determined whether home equity debt was used ‘…for reasons other than to buy, build, or substantially improve your home…’ As it turns out, the proceeds were not used for any of those purposes. Therefore, the amount of qualified debt it is limited to ‘…the smaller of $100,000 ($50,000 if married filing separately), or the total of the home's fair market value (FMV) reduced (but not below zero) by the amount of its home acquisition debt and grandfathered debt.
The house is only worth $100,000. Home acquisition debt and grandfathered debt total zero (they paid cash) thus the limit is $100,000. Because they borrowed $150,000, they can only deduct the interest allocated to $100,000 or roughly two-thirds ($5,750.)
Let me throw a wrinkle into the mix. Several wrinkles actually. Despite the apparent inequity in the above example, it gets much more convoluted when you consider IRS guidance. For example, Publication 936 also states:
A mortgage that does not qualify as home acquisition debt because it does not meet all the requirements may qualify at a later time. For example, a debt that you use to buy your home may not qualify as home acquisition debt because it is not secured by the home. However, if the debt is later secured by the home, it may qualify as home acquisition debt after that time. Similarly, a debt that you use to buy property may not qualify because the property is not a qualified home. However, if the property later becomes a qualified home, the debt may qualify after that time.
Hopefully that cleared up any confusion you might have had. Does anyone know where I left the moonshine?
Regardless, why are the Hatfields and McCoys treated differently? Advocates may reply that the deduction is only offered to encourage home ownership, not to bail brethren out of the slammer.
OK, but why can a homeowner borrow $100,000 against the equity on her home, but not used to improve her home, rather, say, used to bet on the ponies? That loan places the loss of that home at greater risk. However, that interest, assuming all other conditions are met, would be fully deductible which seems inconsistent. Allowing interest to be deducted on a loan that increases the risk of home loss, for the purpose of gambling, seems to be contrary to the notion of encouraging home ownership.
But let’s assume the deduction is solely provided to encourage families to own rather than rent, to finally realize that most treasured American Dream, owning their home. Why then is this deduction available for a second home?
And why do different taxpayers receive a disparate benefit? Assuming the deduction is fully qualified, a taxpayer in the 15% bracket saves fifteen cents of every interest dollar paid while a taxpayer in the 25% bracket saves twenty-five cents of every interest dollar. Said a different way, those with lower incomes subsidize the interest expense of those with higher incomes. Makes sense to me.
And just what is interest anyway? Under IRS rules it can include or exclude points and mortgage insurance premiums. It can include or exclude interest paid to a related party or interest paid to a seller who holds the mortgage. It may encompass late payment penalties, prepayment penalties or prepaid interest. Or it may not.
All of this begs a lot of questions, which, to quote Col Jessup from A Few Good Men, “…I have neither the time nor the inclination to explain…” in this post.
But be of good cheer. If all of this is too confusing, the IRS offers guidance on “How To Get Tax Help.”
Whether it’s help with a tax issue…get the help you need the way you want it: online, use a smart phone, call or walk in to an IRS office…near you.
My thought on that suggestion. Good luck with that.
More on this topic later. Come back next Tuesday for Part II!
Until next time then, adieu, adieu, to you and you and you.