The tax deduction for mortgage interest (and its limitations) has been a pillar of the U.S. tax code for decades. Yet last year's tax overhaul significantly raised the stakes on properly qualifying what is deductible mortgage interest for homeowners.

The real issue is not just the headline-grabbing reductions on upper limits that were implemented under the new law, but the thousands of taxpayer dollars in deductions that can pivot on a fine distinction: acquisition indebtedness or home equity indebtedness.

Knowing how to navigate this sometimes treacherous ground will be critical in coming years — and another way for planners to add client value the next time tax season comes around.

Prior to the enactment of the Tax Cuts and Jobs Act of 2017, the mortgage interest deduction under IRC Section 163(h)(3) had been around, and largely unchanged, since the Tax Reform Act of 1986.

Under the rules established at the time, mortgage interest could be treated as deductible Qualified Residence Interest as long as it was interest paid on either acquisition indebtedness or home equity indebtedness.

Acquisition indebtedness was defined as mortgage debt used to acquire, build, or substantially improve the taxpayer’s primary residence or a designed second residence (and secured by that residence). Meanwhile, home equity indebtedness was defined as mortgage debt secured by the primary or second residence and used for any other purpose.

These distinctions were important, because interest on up to $1 million of acquisition debt principal was deductible, while home equity indebtedness interest was only deductible on the first $100,000 of debt principal. In addition, interest home equity indebtedness was not deductible at all for AMT purposes under IRC Section 56(b)(1)(C)(i).

Despite the relatively straightforward wording of these provisions, they impact homeowners in myriad ways, depending on those individuals’ unique circumstances — as these following scenarios demonstrate.

Example 1. Bradley and Angela purchased their $700,000 residence by putting 20% down and financing the rest with a traditional 30-year mortgage. Because the $560,000 loan proceeds were used to acquire their primary residence, interest on the mortgage would be tax deductible.

Several years later, the residence has appreciated to $800,000 and the couple has taken out a $150,000 HELOC to repay some outstanding credit card debt and finance the last two years of college for their children. The $150,000 HELOC is treated as home equity indebtedness, which means only interest on the first $100,000 of it will be deductible.

Notably, IRC Section 163(h)(3)(H)(i) also explicitly states that if acquisition indebtedness is refinanced, it remains acquisition indebtedness to the extent of the original amount of acquisition indebtedness remaining.

Thus, if after several more years Bradley and Angela have repaid their HELOC and decide they want to refinance their original mortgage — which has now amortized down to a loan balance of $400,000 — they can retain acquisition indebtedness treatment on the $400,000 balance on their refinanced mortgage. However, any additional debt — e.g., from a cash-out refinance — would not be acquisition indebtedness (unless it qualified on its own), even if the total debt remains under the original $560,000 balance, because only the $400,000 remaining balance is considered acquisition indebtedness when refinancing.

In the most common use case where a mortgage is taken out to buy a house, the loan is clearly acquisition indebtedness, as the loan proceeds are literally used to acquire the primary residence.

Yet because the determination of acquisition indebtedness is based on how the mortgage proceeds are used — not the structure of the loan itself — a HELOC can also be considered acquisition indebtedness if it’s used to acquire, build or substantially improve the residence.

Example 2. Jeremy has an existing but fully paid off primary residence worth $350,000. He decides to take out a $40,000 home equity line of credit, and draws on the HELOC, with a five-year repayment period, to build an expansion to the house for his daughter and granddaughter. Because the proceeds of the HELOC were used to make a substantial improvement to the primary residence, any interest on the HELOC will be treated as acquisition indebtedness, and not home equity indebtedness.

In addition, the fact that the determination of mortgage debt treatment is based on how the proceeds are used also means that there can be multiple loans that are treated as acquisition indebtedness.

Example 3. Jenny is trying to qualify for a mortgage to buy her first residence, a $250,000 condo. Given her limited down payment and desire to minimize her exposure to PMI, she takes out a $200,000 30-year primary mortgage with no PMI, a $25,000 15-year second mortgage with PMI, and makes a 10% (e.g., $25,000) cash down payment at closing. Even though there are multiple loans, all of them were used to acquire the residence, meaning that all the interest will be treated as acquisition indebtedness.

Notably, there isn’t even a requirement that a mortgage loan be made by a traditional bank for it to be considered acquisition indebtedness. It simply must be a loan, for which the proceeds were used to acquire, build or substantially improve the primary residence, and it must be secured by that residence (i.e., recorded as a lien against the property). Accordingly, even the interest payments on an intra-family loan can qualify for acquisition indebtedness treatment for the borrower.

Example 4. Harry and Sally are hoping to purchase their first home to start a family, but Harry’s poor credit is making it difficult even to qualify for a mortgage. Fortunately, Sally’s parents are willing to loan the couple $250,000 to purchase a townhouse, financing 100% of the purchase, with favorable family terms of just 3% on a 10-year interest-only balloon loan, which amounts to a monthly mortgage payment of just $625 per month before property taxes and homeowner’s insurance.

To protect the parents though — and to ensure deductibility of the interest — the intra-family loan is properly recorded with the county as a lien against the property. As a result, the $625/month of mortgage payments will be deductible as mortgage interest.

On the other hand, while a wide range of mortgages — including both traditional 15- and 30-year mortgages, intra-family interest-only balloon loans and even HELOCs used to build an addition — can qualify as acquisition indebtedness, it’s also possible for traditional mortgage loans to be treated as at least partially as home-equity indebtedness and not acquisition indebtedness.

Example 5. John and Jenna have been living in their primary residence for seven years. The property was originally purchased for $450,000, which was paid with $90,000 down and a $360,000 30-year mortgage at 5.25%. The loan balance is now down to about $315,000, and the couple decides to refinance at a current rate of 4%. In fact, they decide to refinance their loan back to the original $360,000 amount, and use the $45,000 cash-out refinance to purchase a new car. In this case, while the remaining $315,000 of original acquisition indebtedness will retain its treatment, interest on the last $45,000 of debt — i.e., the cash-out portion of the refinance — will be treated as home equity indebtedness. That’s because the proceeds were not used to acquire, build or substantially improve the primary residence.

In other words, to the extent that the proceeds of a mortgage loan or refinance are split toward different uses, even a single loan may end out being a combination of acquisition and home equity indebtedness, based on how the loan proceeds were actually used.

And the distinction applies equally to reverse mortgages as well. In these cases, often interest payments aren’t deductible annually because the loan interest simply accrues against the balance and may not actually be paid annually in the first place. However, to the extent that interest is paid on the reverse mortgage, the underlying character of how the debt was used still matters to determine whether or how much of the interest payments are deductible.

Example 6. Shirley is a 74-year-old retiree who lives on her own in a $270,000 home that has a $60,000 outstanding mortgage with a principal and interest payment of about $700/month. She decides to take out a reverse to refinance the existing $60,000 debt to eliminate her monthly payment, and then begins to take an additional $300/month draw against the remaining line of credit to cover her household bills. The end result is that any interest paid on the first $60,000 of debt principal will be acquisition indebtedness — e.g., a refinance of the prior acquisition indebtedness — but any interest on the additions to the debt principal at $300/month in loan payments will be home equity indebtedness payments.

Ultimately, the distinction between interest on acquisition indebtedness versus home equity indebtedness isn’t merely that they have different debt limits for deductibility and different AMT treatment. Rather, under the Tax Cuts and Jobs Act of 2017, the acquisition indebtedness limits have been reduced, and home equity indebtedness will no longer be deductible at all anymore!

Specifically, the law reduces the debt principal limit on acquisition indebtedness from the prior $1 million threshold down to just $750,000. Notably though, the lower debt limitation only applies to new mortgages taken out after December 15, 2017; any existing mortgages retain their deductibility of interest on the first $1 million of debt principal. In addition, a refinance of such grandfathered mortgages will retain their $1 million debt limit — but only to the extent of the then-remaining debt balance, and not any additional debt.

Houses that were under a binding written contract by Dec. 15 and closed by Jan. 1, 2018, are also eligible. And the $750,000 debt limit remains a total debt limit of the taxpayer, which means it is effectively a $750,000 for the combined acquisition indebtedness of a primary and designated second home.

On the other hand, the new rules entirely eliminate the ability to deduct interest on home equity indebtedness, effective in 2018. There are no grandfathering provisions for existing home equity debt.

This means that in practice, the distinction is no longer between acquisition indebtedness versus home equity indebtedness per se, but simply whether or how much of the mortgage debt qualifies as acquisition indebtedness at all or not. If some or all of it does — based on how the dollars are used — then that portion is deductible interest to the extent the individual itemizes deductions.

Further complicating the matter is the fact that IRS Form 1098, which reports the amount of mortgage interest paid each year, makes no distinction between acquisition versus other now-non-deductible debt interest. This isn’t entirely surprising, given that the mortgage lender or mortgage servicer wouldn’t necessarily know how the mortgage proceeds were subsequently spent.

Nonetheless, the fact that mortgage servicers will routinely report the full amount of mortgage interest on Form 1098, when not all of that interest is necessarily deductible, will almost certainly create taxpayer confusion and may even spur the IRS to update the form. Especially since existing guidance from IRS Publication 936 is not entirely clear with respect to how debt balances are repaid in the case of so-called “mixed-use mortgages” — where a portion is acquisition indebtedness and a portion is not.

Example 7. Last year Charles refinanced his existing $325,000 mortgage balance into a new $350,000 mortgage on his $600,000 primary residence, and used the $25,000 proceeds of the cash-out refinance to pay down credit card debt. Now, Charles has received an unexpected $25,000 bonus from his job, and decides to prepay $25,000 back into his mortgage.

At this point the mortgage is technically $325,000 of acquisition indebtedness and $25,000 of non-acquisition debt. But the mortgage servicer simply reports a total debt balance of $350,000. If Charles makes the $25,000 prepayment of principal, will the amount be applied against his $325,000 of acquisition indebtedness, his $25,000 of non-acquisition debt or pro-rata against the entire loan balance?

If the IRS follows the spirit of its prior guidance from IRS Publication 936, the $25,000 would be applied fully against the non-deductible — formerly the home equity indebtedness — balance first, but at this point it remains unclear how payments should be applied. Similarly, even as Charles makes his roughly $1,800/month mortgage payment, it’s not clear which portion of his debt is reduced.

Nonetheless, the fact that Form 1098 doesn’t delineate the amount of remaining acquisition indebtedness, or whether or how much of the mortgage interest is deductible or not, doesn’t change the fact that only mortgage interest paid on acquisition indebtedness is deductible. Taxpayers are still expected to report their deductible payments properly, and risk paying additional taxes and penalties if caught misreporting in an audit.

Of course, it’s worth noting that with a higher standard deduction — particularly for married couples — the higher threshold to even itemize deductions in the first place means mortgage interest deductibility may be a moot point for many in the future anyway. Yet for those who can benefit from itemization, it becomes more important than ever to understand the proper classifications of mortgage debt and its deductibility!

What do you think? How will the changes to tax deductions for mortgage interest under the tax overhaul impact your clients? How are you communicating about these changes with clients and prospects? Do these changes create any new tax planning opportunities? Please share your thoughts in the comments section below.

Michael Kitces

Michael Kitces

Michael Kitces, CFP, a Financial Planning contributing writer, is a partner and director of wealth management at Pinnacle Advisory Group in Columbia, Maryland; co-founder of the XY Planning Network; and publisher of the planning blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.