It’s no secret that Americans are obsessed with real estate. Real estate ownership is the cornerstone of the American Dream. So much so that Congress decided to encourage real estate ownership as a way to build financial security through direct spending and income tax incentives.
On Dec. 22, 2017, President Trump signed into law the most sweeping tax legislation since 1986. Let’s summarize some of the changes most relevant to homeowners.
Note that many of the changes discussed below are scheduled to sunset on Dec. 31, 2025, meaning the prior law will come back into effect. Unless otherwise noted below, assume that all changes under the Act will sunset.
Mortgage Interest Deduction
Under prior law, an individual taxpayer could deduct interest on up to $1 million of “acquisition indebtedness” (debt incurred in acquiring, constructing or substantially improving a principal or second home) secured by a taxpayer’s principal residence or second home. A taxpayer could also deduct interest on an additional $100,000 of home equity indebtedness secured by a residence regardless of how those borrowed funds were used. Those two limits essentially meant that homeowners could deduct interest on debt of up to $1.1 million secured by a principal or second residence.
The Act limited the mortgage interest deduction for new mortgages originating after 2017.2 The IRC now provides that taxpayers may deduct interest on up to $750,000 of acquisition indebtedness secured by the taxpayer’s principal or second home. However, existing mortgages and refinances of existing mortgages are grandfathered up to the prior $1 million limit. Interest on home equity loans is no longer deductible unless the proceeds of such loans are invested in improving the home. The total amount of acquisition indebtedness and home equity indebtedness is subject to an overall limit of $750,000.
This change primarily affects taxpayers who acquire new residences after 2017, the purchase of which is financed by a mortgage in excess of $750,000. It also affects taxpayers who have outstanding home equity loans or who were planning to borrow against the equity in their homes for purposes other than home improvement.
Personal Casualty Loss Deduction
Under prior law, a taxpayer could deduct personal casualty or theft losses (that is, losses to personal or real property) if the losses arose from fire, storm, shipwreck or other casualty or theft. The losses were only deductible to the extent that they exceeded $100 per casualty and the aggregate of net casualty and theft losses exceeded 10 percent of the taxpayer’s adjusted gross income.
Under the Act, casualty losses are only deductible if the loss is attributable to a disaster declared by the President under the Robert T. Stafford Disaster Relief and Emergency Assistance Act (the Stafford Act). Events that may be classified as disasters under the Stafford Act are limited to natural catastrophes and fires, floods or explosions within the United States that the President determines cause damage sufficient and severe enough that federal relief is warranted. This change doesn’t apply to property used in a trade or business. Because the deductibility of casualty losses has been severely limited for personal use property, you may consider reviewing your client’s property and casualty insurance to determine whether he has sufficient coverage.
Property Taxes
Under prior law, individuals could fully deduct state, local and foreign real property taxes on Schedule A of Form 1040. This was an itemized deduction, meaning that it would only benefit the taxpayer if her total itemized deductions exceeded her standard deduction.
Under the Act, the total amount that may be claimed as an itemized deduction for state and local taxes (SALT) including property tax, is $10,000. Furthermore, the deduction may not be claimed for foreign property taxes. This limitation doesn’t apply to property tax attributable to real property used in a trade or business or held for investment purposes.
Several states have adopted proposals to alleviate the impact of the $10,000 cap on the federal income tax deduction for SALT. Under those proposals, taxpayers would be permitted to make charitable contributions to state and local government funds (intended to be deductible for federal income tax purposes) in exchange for state and/or local tax credits. In response to the states’ proposals, the Treasury Department issued proposed regulations to clarify that when a taxpayer receives a quid pro quo, such as a state or local tax credit, in exchange for a charitable contribution, the charitable income tax deduction must be reduced by the amount of the tax credit.
The cap on deductibility of SALT may not have significant impact on many taxpayers’ bottom lines for two reasons: First, the standard deduction has doubled under the Act, so fewer taxpayers will be claiming itemized deductions. Second, the deduction for SALT is only available when calculating a taxpayer’s liability under the regular tax regime, but not under the alternative minimum tax (AMT). The AMT requires the taxpayer to calculate her liability twice, first using the regular income tax rules and then under the AMT rules. The taxpayer then has to pay the higher amount of tax. Under prior law, this meant that taking a property tax deduction for regular income tax purposes (along with other deductions that are allowed for regular income tax purposes but not for AMT purposes) resulted in many taxpayers owing AMT and thereby reducing the effect of such deductions. Under the Act, fewer taxpayers will owe AMT because the AMT exemption increased significantly, and the exemption phases out at much higher income tax levels.
IRC Section 1031 Exchanges
Generally speaking, an exchange of property is a taxable event. However, IRC Section 1031 provides that no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for like-kind property. This permits taxpayers to defer gain recognition, or potentially eliminate capital gains, if exchanged property is held until the taxpayer’s death, at which time a step-up in cost basis may be available.4
Under prior law, almost any type of property used in a trade or business or for investment, other than inventory, stocks, bonds, notes or other securities, could be exchanged for like-kind property. The Act eliminated like-kind exchanges for all property other than real property.
If your client is a homeowner, you should help her determine whether any of the changes to the IRC impact negatively (and how you may help the client mitigate that impact) or provide an opportunity for your client to reduce her income tax liability.
This is an adapted version of the author's original article in the December 2018 issue of Trusts & Estates.
—UBS Financial Services Inc., a subsidiary of UBS AG Member FINRA/SIPC., its affiliates and its employees (including Financial Advisors) do not provide tax or legal advice. The views and the opinions expressed in this article are those of the author and do not necessarily represent or reflect the views of UBS Financial Services Inc. or its affiliates.