Whittling away the mortgage deduction

Nation's Business, March, 1988 by Gerald W. Padwe

Whittling Away The Mortgage Deduction

Aside from life, liberty and the pursuit of happiness, the 20th century's great American promises have included a chicken in every pot, two cars in every garage and the absolute deductibility of the interest paid on home mortgages.

Congress made the latter less absolute as it left town last December 23, leaving us a Christmas present: the 1987 Omnibus Budget Reconciliation Act, designed to reduce the federal deficit. The act includes tax provisions intended to raise $9.4 billion in fiscal 1988 (and about $30 billion more in the next two fiscal years). Some of those tax provisions take the first nicks in what could eventually be a much more extensive effort to cut away the tax-favored status of home ownership.

Mortgage loans. Despite the 1986 Tax Reform Act's restrictions on deducting interest on consumer loans, it had preserved the complete deductibility of interest on a loan secured by the taxpayer's primary or secondary residence. There was, to be sure, a limitation: Deductibility was lost for interest on loan amounts above the cost of the home plus what had been paid for improvements. But now the 1987 law has gone significantly further, adding for the first time a limitation that is not governed by the actual value of the home: Interest is deductible only on mortgage loan amounts up to $1 million.

Home-equity loans. Under the 1987 law, as under the 1986 rules, a taxpayer can deduct interest on a mortgage loan completely (up to that $1 million ceiling), even if the proceeds of the loan are used for what otherwise would be nondeductible personal expenditures. This "loophole," combined with the 1986 limitations on personal-interest deductions, spawned a tremendous growth in home-equity loans. To prevent a potentially substantial revenue drain, the 1987 law provides that any home indebtedness other than a primary mortgage--generally, a second mortgage or a home-equity loan--will support an interest deduction only to the extent the loan does not exceed either the home's fair market value less the amount of the first mortgage, or $100,000, whichever figure is smaller.

Example: A primary or secondary residence has a total cost--original cost plus improvements--of $150,000. It is now worth $185,000, and there is a $120,000 mortgage on it. The taxpayer's interest deduction on a home-equity loan or second mortgage will be limited to the interest on $65,000, the difference between the fair market value and the mortgage loan.

For some, this change could actually introduce a bit more liberality into the law. The 1986 act limited home-equity loans to original cost plus improvements, unless the proceeds were used for qualified medical or education expenses, in which case the home-equity borrowing could be up to fair market value. With the 1987 changes, proceeds up to fair market value may be used for any personal purpose, as long as the $100,000 limitation is not exceeded.

Effective date. Loans taken out before Oct. 13, 1987, will be treated as qualifying mortgage indebtedness even when they exceed $1 million, but the loan amounts outstanding on that date will count against the new limitations if the homeowner takes out additional loans. In other words, a taxpayer whose pre-October 13 mortgage is for more than $1 million can still deduct all of the interest on that loan; but if he takes out a second mortgage, none of that interest will be deductible.

Photo: Thinking about a second mortgage to pay for home improvements? Congress has changed the rules on deducting interest on such loans.