When is a Mortgage not a Mortgage?

Mortgages are on my mind this month, as we again are looking at making the move to buy a house.  We are planning to stay near New York for various reasons, but thinking to move outside of the five boroughs (Manhattan, Bronx, Queens, Kings, Staten Island) since doing so will mean we can avoid the need to pay New York City tax.

We are not alone in the desire to escape to the suburbs and the housing market is getting quite heated.  Prices are reasonably in line with historical rates, so I am not overly concerned about a bubble, but there is so much free cash floating around that cash purchases are becoming the norm.

In order to compete with the people who have enough cash readily available to purchase a home outright many people are stretching their resources and buying in cash with the goal of subsequently applying a Cash Out Mortgage to the property, thus dropping their equity levels down to something close to as if they had gone the mortgage route.  However, what many people fail to realize is that by doing this they are treated unfavorably by the IRS.

Mortgage and Home Equity Interest Deduction Rules

The IRS states that the interest on the first $1 Million of Acquisition Debt can be deducted, as can the interest on $100,000 of Equity Debt.  The problem, that I have seen many people make (including financial advisors) is that they interpret the rule to mean the first $1 Million of Mortgage Debt.

However, the key word is acquisition, if no acquisition occurs then it is an Equity debt transaction and only the $100,000 limit applies. What that would mean then, to the person who bought the house in Westchester for say. $500,000 in cash then cashed out $350,000 they could only deduct interest on $100,000, and the $250,000 balance of the mortgage would be non-deductible.

This applies to second mortgages and refinances that release equity also, for example:

Jim bought a property in 1998 for $200,000, with $40,000 downpayment and a mortgage note of $160,000.  In 2010 he decided to take advantage of the lower rates and refinance.  At the time of the refinance the property had appreciated in value to $500,000 and his mortgage balance had reduced to $100,000.

If Jim wanted to refinance into a new mortgage, and also borrow some money to pay for his sons college tuition, and buy a new car and therefore applied for a $300,000 loan he would have to first pay off the existing note, for $100,000 and then have a balance of $200,000 in equity.  Because there was only $100,000 of original Acquisition Debt on the property Jim would be able to deduct $100,000 for Mortgage Interest and Deduct $100,000 for Home Equity.

In another example, if Jim had no outstanding mortgage at the time of the second loan, he would be only able to deduct $100,000 for home equity debt and nothing for mortgage interest despite the loan being called a mortgage.

Datapoints

• Acquisition Debt limits can apply to the combined debt of your first two properties, a primary and a secondary home
• Acquisition Debt limits are $1M for joint or single filers, $500,000 for ‘married filing singly’ filers
• Equity Debt limits are $100,000 for joint or single filers, $50,000 for ‘married filing singly’ filers
• Deductions are limited to AGI, from $100,000 for joint filers and $50,000 for single filers they start to phase out.  Most disappear with salaries that are 10% higher than those levels.

Conclusion

Just because you have a debt that is called a mortgage, if the transaction did not include an acquisition event then your mortgage will be treated as an Home Equity loan for any amounts that are higher than the mortgage you refinanced.