Sweeping tax reform was signed into law by President Trump on December 22, 2017. Now that tax returns are being prepared for the 2018 year, individuals are more keenly feeling the impact of the “Tax Cuts and Job Act” (“TCJA”).
I’ve had numerous calls on two questions by Americans overseas who own a foreign residence. First, whether US persons living abroad having mortgage loans secured by their foreign residence can still deduct mortgage interest and second, whether they can deduct foreign real property taxes paid.
Briefly, yes, mortgage interest is still deductible under the new rules, but the deduction is more strictly curtailed. Sadly, under TCJA, foreign property taxes are no longer deductible at all.
If you are an employee living overseas and are being reimbursed by your employer through a housing allowance, all may not be lost, however. More on this later in the blog post. I carefully think through the tax rules and often come up with a sound workaround when things otherwise look bleak! Your tax advisor should be doing the same, if he or she is not, then it’s time reconsider advisors.
Here’s everything you need to know.
Mortgage Interest Deductions
Under pre-TCJA law, a taxpayer could take an itemized deduction for so-called “qualified residence interest”. Generally, this is interest paid on a mortgage secured by what the tax law calls a “qualified residence”. A “qualified residence” is a principal residence (e.g., the taxpayer’s primary home) and one other residence owned and used by the taxpayer as a residence (think, vacation home). These rules remain the same under the new law, and it does not matter whether the residence is located in the United States or overseas.
“Acquisition Indebtedness” versus “Home Equity Indebtedness”
Under the old law, two types of interest were deductible – interest paid on so-called “acquisition indebtedness” of up to $1 million ($500,000 in the case of a married individual filing a separate return), plus interest paid on so-called “home equity indebtedness” of up to $100,000. Simply put, “acquisition indebtedness” encompasses any type of loan so long as the loan was used to purchase, build, or “substantially improve” any “qualified residence” of the taxpayer.
“Home equity indebtedness” is different and is any indebtedness that does not already count as acquisition indebtedness so long as it’s secured by a “qualified residence”. While the debt must still be secured by a “qualified residence”, taxpayers were given complete discretion as to how the funds from the loan were to be used. Taxpayers could use the borrowed funds to finance a new car or pay tuition, or to pay off credit card debts. It did not matter the purpose to which the funds were put, the interest was still deductible.
TCJA’s New Rules
1. Mortgage Interest
The rules change the deductibility of “qualified residence” interest, at least temporarily. For tax years beginning after December 31, 2017 and before January 1, 2026, the deduction for interest on “home equity indebtedness” is completely suspended (i.e., there will be no deduction permitted), and the deduction for mortgage interest on “acquisition indebtedness” is limited to underlying indebtedness of up to $750,000 ($375,000 for married taxpayers filing separately). Unless extended by Congress, these provisions of the new law will “sunset” (i.e., expire) on January 1, 2026 and the old law will be reinstated at that time.
As detailed below, the Act “grandfathers” certain mortgage loans for “acquisition indebtedness” providing them the benefits of the old law:
The new lower limit does not apply to any “acquisition indebtedness” that was incurred prior to December 15, 2017. There is no similar protection for “home equity indebtedness”, irrespective of when the loan was taken out.
“Binding contract” exception. A taxpayer who had entered into a binding written contract before December 15, 2017 to close on the purchase of a principal residence before January 1, 2018, and who purchased such residence before April 1, 2018, shall be considered to incur “acquisition indebtedness” prior to December 15, 2017. Under this provision, the taxpayer will be allowed the prior-law $1 million limit.
Refinancing. The old law’s $1 million/$500,000 limitations continue to apply to taxpayers who refinance existing qualified residence indebtedness that was incurred before December 15, 2017, so long as the indebtedness resulting from the refinancing doesn’t exceed the amount of the refinanced indebtedness.
The IRS has issued some guidance on the new rules “Interest on Home Equity Loans Often Still Deductible Under New Law“.
As mentioned, TCJA has completely done away with the deduction for foreign property taxes. Let’s compare this scenario to when property taxes are paid to a US State with regard to a property within the State. These State property taxes remain deductible on the federal income tax return (subject to dollar limitations).
So, the American citizen owning his home and paying property taxes on it to the foreign country where he resides cannot deduct those property taxes on his US income tax return at all, whereas his counterpart living in the US may deduct property taxes paid on the State-side property. This TCJA provision has not gotten much press, but it certainly unfairly increases taxable income of the many US taxpayers owning foreign real property. This is but one of many examples illustrating how the US tax law discriminates against the US person living abroad. You can read of many more examples at my tax blog post here.
Posted: March 21, 2019