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A quarter-century ago, only someone in desperate need of cash would take a second mortgage. Then Congress changed the tax rules, and today, millions of Americans have “home equity” lines.
Banks are losing $30 billion a year on these products, and untold thousands of families stand to lose their homes to foreclosure. Is this another example of a law’s unexpected consequences? Nope. This outgrowth of the Tax Reform Act of 1986 was perfectly foreseeable, and in fact, foreseen. But, then as now, Congress tended to tune out warnings that it preferred not to hear.
Prior to the tax reform, taxpayers could deduct nearly any sort of interest expense, including interest on credit card balances, automobile loans, and life insurance loans. After the tax reform, nearly all non-business interest expense was no longer deductible.
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But a few exceptions remained. The most important was (and is) that taxpayers still can deduct the interest on up to $1 million of mortgage debt incurred to buy or improve a principal residence or a vacation home. The real estate industry lobbied hard to keep this benefit in the law.
The tax reform law also preserved a benefit for second mortgages. Taxpayers are permitted to deduct interest payments on up to $100,000 of debt, regardless of the purpose for which the debt is incurred, so long as they put their home up as collateral. The Internal Revenue Service explains: “Generally, home mortgage interest is any interest you pay on a loan secured by your home (main home or a second home). The loan may be a mortgage to buy your home, a second mortgage, a line of credit, or a home equity loan.” So, even if you plan to use the money for a big screen TV or a vacation, if you borrow against your home, you can take the deduction.
In recent years, many home equity lines of credit have greatly exceeded the $100,000 cap. Interest on the excess debt is nondeductible. However, the government has no easy way to know the size of the loan on which the interest is being paid. Over more than two decades in the tax business, neither I nor any of my co-workers have ever been asked to demonstrate that the interest deductions claimed on a tax return are for a loan within the allowable limits. We follow the law anyway, but we can safely assume that many taxpayers do not, either out of ignorance or otherwise. In practice, therefore, taxpayers can end up taking deductions for interest expense on debt well above the limits.
September 2, 2010
