The Tax Cuts and Jobs Act of 2017 contains numerous changes that affect income tax planning and preparation for 2018 through 2025 after which most of the provisions expire. Two of the more significant changes are a reduction in the amount of principal on which residential mortgage interest can be deducted and the elimination of the home equity loan interest deduction with one notable exception.
Tax Reform Act of 1986 – The Beginning of the Interest Deduction Demise
This isn’t the first time that legislation has been enacted that has limited or eliminated the ability to deduct certain types of interest. The Tax Reform Act of 1986, which was a significant overhaul of the income tax law, included five changes that affected the deductibility of interest. Three of the changes targeted real estate indebtedness, one personal borrowing, and the fifth reduced tax rates.
The five changes are as follows:
1. Limitation of $1 million on loans for mortgage interest deduction
This applied to acquisition indebtedness which was defined as mortgage debt used to acquire, build, or substantially improve one’s primary residence and was secured by that residence.
2. Limitation of $100,000 on home equity loans for interest deduction
This included loans that were secured by the primary or secondary residence and were used for any other purpose.
3. Creation of passive activity loss rules deferring deduction of losses on rental properties
One of the largest expenses associated with owning a rental property that’s often responsible for losses is mortgage interest. Unless you materially participate as a real estate professional, net losses from rental properties in excess of income from other passive activities are nondeductible in the year incurred and subsequent years with two exceptions.
There’s a special $25,000 allowance for deduction of rental property losses which is phased out when your modified adjusted gross income exceeds $100,000 and is eliminated when it goes over $150,000. Second, you can deduct 100% of suspended losses associated with a particular rental property in the year that you sell your entire interest in the property.
4. Personal interest deduction on consumer loans nixed
Prior to the Tax Reform Act of 1986, credit card, auto loan, student loan, and other forms of personal interest were deductible. The ability to take this deduction was eliminated since it was seen as encouraging Americans to spend money rather than save it. Like other deductions, it also reduced income tax revenues.
5. Reduction of top marginal tax rate from 50% in 1986 to 28% beginning in 1988
The income tax savings from all deductions, including mortgage interest, was reduced by as much as 44% for those in the top tax bracket as a result of this change. As an example, suppose your mortgage interest was $10,000 and you were in the top tax bracket. In 1986, your income tax savings from this deduction would have been 50% x $10,000, or $5,000. Beginning in1988, your tax savings would have been 28% x $10,000, or $2,800. This was a reduction of $2,200, or 44%.
The 28% rate was in effect for three years before increasing to 31% in 1991 and 39.6% in 1993 where it settled for the next eight years. With a top bracket of 37% in effect for eight years beginning in 2018, top income tax rates have been, or are on track to remain, at between 35% and 39.6% for 33 years between 1993 and 2025.
Omnibus Budget Reconciliation Act of 1990 – Introduction of the Pease Limitation
A discussion of the slow death of the interest deduction wouldn’t be complete without mention of the Pease limitation on itemized deductions. The Pease limitation, named after the late Congressman Donald Pease, was introduced by the Omnibus Budget Reconciliation Act of 1990 and was effective beginning in 1991. The purpose of the limitation was to increase tax revenue by limiting overall itemized deductions for high-income earners. It was a stealth surtax since it didn’t reduce or eliminate any individual deductions.
The limitation reduced the value of a taxpayer’s itemized deductions by 3% for every dollar of taxable income above a certain threshold. This included mortgage and otherwise allowable interest deductions. The phase-out of the limitation was capped at 80% of the total value of itemized deductions. The effect on taxpayers impacted by the Pease limitation was an increase in their marginal tax rate of approximately 1%.
The Pease limitation was phased out in the mid-2000s, re-enacted in 2013, and was suspended for tax years 2018 through 2025 by the Tax Cuts and Jobs Act of 2017.
Taxpayer Relief Act of 1997 – Revival of the Student Loan Interest Deduction
After being eliminated by the Tax Reform Act of 1986, the deduction for student loan interest was revived by the Taxpayer Relief Act of 1997 as an “above the line” deduction. As such, it can be taken as a deduction regardless of whether you itemize.
The maximum deduction for student loan interest was $1,000 in 1997, increased to $1,500 in 1999, $2,000 in 2000, and $2,500 in 2001 and subsequent years.
The 2010 Tax Relief Act reduced the ability of many individuals to take a deduction for student loan interest by introducing income caps. In 2018, the deduction begins to phase out for single individuals when modified adjusted gross income (“MAGI”) exceeds $65,000 and is eliminated when MAGI exceeds $80,000. The MAGI limits for those using married filing joint status are $130,000 and $160,000.
Tax Cuts and Jobs Act of 2017 – Interest Deduction Axe Continues to Fall
The Tax Cuts and Jobs Act of 2017 includes four provisions that reduce or eliminate the ability to take deductions associated with residential indebtedness beginning in 2018. All four changes affect the mortgage industry; with the first two being direct hits. A limitation on the deductibility of business interest expense is also part of the new tax law, a discussion of which is beyond the scope of this post.
The four changes are as follows:
1. Limitation of $1 million on loans on which mortgage interest can be deducted reduced to $750,000
Despite the fact that over 30 years has transpired since the Tax Reform Act of 1986 and housing prices have escalated substantially in most parts of the country, the $1 million limitation on deductibility of interest on mortgage acquisition indebtedness was reduced to $750,000. The good news is that there’s grandfathering for mortgages under the previous $1 million limit.
2. Elimination of deduction on home equity indebtedness unless used for acquisition indebtedness
As previously discussed, acquisition indebtedness is defined as mortgage debt used to acquire, build, or substantially improve one’s primary residence and is secured by that residence.
3. Sizable increase in the standard deduction
Two other changes indirectly affect one’s ability to take interest deductions associated with residential indebtedness. The first is a sizeable increase in the standard deduction. The deduction has almost doubled beginning in 2018, going from $6,350 to $12,000 for single taxpayers and $12,700 to $24,000 for those using married filing joint status.
4. Cap on state and local tax, or “SALT” deduction
The second change is a cap on the state and local tax, or “SALT” deduction. The cap reduces the previously unlimited deduction for property, income, and sales taxes to a maximum of $10,000. Residents of states with high income taxes such as California, New York, and New Jersey are most affected by this change.
The increase in the standard deduction, combined with the SALT deduction cap, will significantly reduce the number of taxpayers who itemize their deductions, including mortgage and home equity interest. The Joint Committee on Taxation estimates that the number will decrease from 46.5 million, or 30%, of 150 million households in 2017, to just over 18 million, or 12%, of all households in 2018.
So What’s Left?
The interest deduction has been dying a slow death beginning with the Tax Reform Act of 1986 and continuing through the Tax Cuts and Jobs Act of 2017. Income tax savings attributable to residential and rental property indebtedness has been significantly reduced over the last 30 years as a result of the various changes. The interest deduction associated with consumer loans was eliminated by the Tax Reform Act of 1986 with the deduction on student loan interest, subject to an income limitation, making a revival ten years later.
You can still take a deduction for investment interest expense to the extent that you have investment income and you itemize your deductions, i.e., your standard deduction doesn’t exceed your total itemized deductions. And don’t forget about amortizing points that you weren’t allowed to deduct in the year you paid them. That’s a topic for another day.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.