Prior to the tax act, taxpayers who required additional cash for a variety of reasons, including buying our their spouse’s interest in the residence,  would regularly refinance the mortgages on their residence for a larger amount.  The benefit was that the mortgage interest on the refinanced mortgage could be deducted up to a $1,000,000 cap.  

The passage of the Tax Cuts and Jobs Act has effected a huge change limiting the mortgage deduction in this scenario, which may have a significant impact on parties going through a divorce.  The new law limits the amount of the mortgage to funds needed to acquire a residence, construct a residence or substantially improve a residence.  So, if you are refinancing for one of these allowable expenses, and stay below the $1,000,000 cap, the interest would still be deductible.   However, in a divorce that is often not the case.

In a divorce, the party retaining the residence will have to refinance the loans related to the residence to remove the other party’s name.  Often, this will be both a mortgage and a home equity line of credit.  Moreover, the party retaining the residence often has to refinance for a larger amount to make a cash payment to the other party to “buy out their interest” in the house.  With the new law, the parties refinancing the marital residence to take cash out to pay off the other spouse will be limited to the principal balance prior to the cash out refinance in terms of the interest that can be deducted.  For example, if the principal mortgage balance is $300,000 and the party retaining the residence is refinancing for $500,000 to pay off the other spouse, they will be limited for purposes of the deduction to the interest on the $300,000.  Interest on the additional $200,000 cannot be deducted.  In addition, there will be no deduction when the mortgage is refinanced to now include the home equity line of credit.  Parties are going to have to give more consideration to the tax consequences and resulting true cost of retaining the residence.

In my prior installment of this series (Family Law Tip #2), I discussed the substantial reduction in the allowable amount of mortgage interest which is now tax deductible on any mortgage taken out after December 15, 2017.   The 2017 Tax Cuts and Jobs Act reduced the deductible amount by $250,000 on homes purchased after the cut off date - capping the allowable interest deduction to mortgage principal of $750,000 (reduced from $1,000,000 prior to December 15, 2017).  Beyond the lower mortgage cap, another big change is that, in general, the interest on home equity lines of credit is no longer deductible (with some very limited exceptions). This is true regardless of whether the home equity line of credit was taken out before or after the change in tax law.

These changes to the allowable mortgage interest deduction will have a bearing on the decision of divorcing parties as to whether to keep their second residence post-divorce.  In the past, people often kept the second residence, in part knowing that they were able to deduct the mortgage and home equity line of credit interest on their tax returns and the maximum amount of $1,000,000 in indebtedness allowed for flexibility.  In the advent of the Tax Cuts and Jobs Act, some will have to rethink this decision.  If the expenses related to their vacation homes cannot be deducted, the cost to maintain the home will be higher.

While there was some back and forth in the various drafts of the tax code revisions, ultimately the deductions for the mortgage interest apply to both the primary residence and a second home as well.  However, as stated above, the $750,000 cap makes it more likely that parties will not be able to deduct all of the interest on the mortgages for the primary residence and secondary residence when those amounts are combined.  Consulting your attorney and accountant will help you to determine the actual increase in the cost of maintaining your vacation home so that you can make an informed decision.

The Tax Cuts and Jobs Act includes a substantial change to the allowable amount of mortgage interest which is tax deductible.   For those who are contemplating purchasing expensive homes and taking out a mortgage with a principal balance of more than $750,000, the interest on the amount over $750,000 will not be tax deductible.  For mortgages issued prior to December 15, 2017, the mortgage interest is deductible for principal mortgage amounts of up to $1,000,000.  However, after December 15, 2017, that amount is reduced to principal amounts of up to  $750,000.  This only applies to properties purchased after December 15, 2017.  Absent any extension of this law, the amount reverts to $1,000,000 in 2026. 

Another big change relates to home equity lines of credit on your residence.  In the past, the mortgage and home equity line of credit could be lumped together, and the interest on both deducted up to the maximum allowed loan amount.  That is no longer the case.  It does not matter if the home equity line of credit was taken out before or after the change in tax law.  In general, the interest on home equity lines of credit is no longer deductible.  There are some limited exceptions to this where the funds are used to substantially improve the residence, but even this exception requires very specific requirements to be met.  This tax change could have a large impact on those who intentionally took out a home equity line of credit rather than refinance their mortgage to a larger amount. Without this deduction, taxable income will be higher.