Homeowners are harmed by changes in tax code

Real Estate Weekly, April 24, 2002 by Neil Binder

While homeowners indifferently enjoy the benefits of tax-deductible interest associated with the mortgage on their home, many do not realize the array of limitations and other landmines that Congress has subtly added to the tax code in order to chip away at this sacred cow. The worse part of this new trend limiting the tax benefits of homeowners is that many people don't even know about it until it's too late. The interest deductions are lost, the refinancing is in place or the new home has been purchased. As such, I thought it might be useful to consider one element of this controversy--the limitations associated with refinancing of a primary residence.

Section 163 of the Internal Revenue Code limits the ability of taxpayers to enjoy a tax deduction of the interest on their primary residence. Currently, a taxpayer is entitled to a deduction equal to the acquisition financing on the home with a limit of $1 million. However, in the event of a refinancing of this mortgage, the permissible deductible interest only applies to the actual mortgage balance being refinanced. Any excess mortgage proceeds are not deductible except for an additional equity credit line of $100,000. (An exception would be if the refinanced proceeds were used to make capital improvements on the home, in which case that portion of the refinance proceeds used for that purpose would be permissible and the basis of the home would be increased.)

Let me clarify the problem by an example: Mr. and Mrs. Jones buy a home for $200,000 and obtain a 30-year self-liquidating mortgage in the original amount of $150,000 in 1990. In the year 2002, Mr. Jones decides to refinance when the balance of the original loan has reduced to $100,000. The Jones's home has appreciated to a value of $700,000 and they are able to now obtain a loan of $500,000. However, the interest on this loan is only deductible under IRC 163 to the extent of $250,000, consisting of replacement of the existing loan of $150,000 and the addition of an equity line add-on of $100,000. A deduction for the interest applying to-the mortgage principal in excess of this amount is not permitted.

Where this becomes particularly bizarre may be seen through the following: Instead of refinancing their home, Mr. and Mrs. Jones decide to sell it and buy the one right next door, which is exactly like theirs. They sell their home for $700,000 and acquire the neighbors' for the same amount. In this case, however, all the $500,000 profit on the sale of their home is exempt from tax. They use $200,000 of these sale proceeds to acquire the new home and obtain a mortgage of $500,000 from the bank. Since the mortgage is for the original acquisition of the new property, the full amount of the interest is deductible.

Let me give you another even more bizarre event: Mr. and Mrs. Jones sell the home they have lived in since 1990 and decide to retire to Florida. Since they are now senior citizens with limited income, they elect to buy their Florida home with no mortgage, all cash, so that their monthly expenses are reduced.

Six months after they arrive, Mr. Jones has a heart attack and must be hospitalized. As a result, the Jones's need money and decide to get a mortgage on their Florida home. However, none of the interest on this mortgage is deductible. This is because Section 163 permits only a 90-day window after the acquisition of a home to acquire a mortgage. Since this 90-day period has elapsed, the Jones's would not qualify.

Most senior citizens have lived in their current residences for an extended length of time. They are unlike younger families who have a recurring tendency to buy and sell, thereby enjoying the profit exemption and higher interest deduction on each succeeding step in developing their home wealth. In many instances, senior citizens' homes represent one of the remaining significant assets they can rely upon to garner economic resources for their retirement. But under the current law, they are entitled to a meager deduction if they wish to access this wealth. Obviously this is not good tax policy. There is no economic logic; but rather, there is inequity in application and substantial noncompliance. A homeowner should get the same break on refinancing a home as a new purchaser.