In the aftermath of the Tax Cuts and Jobs Act of 2017 (TCJA), home buyers may be disappointed by the diminishment of tax benefits that once subsidized homeownership. With a substantial increase in the standard deduction and sweeping changes to many individual income tax provisions, millions of taxpayers will no longer need to file an itemized return in 2018, meaning that millions of taxpayers will no longer benefit from the tax deductions previously taken by homeowners. According to the Joint Committee on Taxation, the number of taxpayers filing an itemized return in the 2018 tax season is expected to decline by 61.3% (“Tables Related to the Federal Tax System as in Effect 2017 Through 2026,” Apr. 24, 2018, http://bit.ly/2rZZuq5). In this current climate, it is more important than ever for tax professionals to be knowledgeable about potential tax savings.
This article summarizes the most common tax deductions for homeowners in the wake of the TCJA, and emphasizes planning opportunities. Specifically, it examines the deductibility of mortgage insurance, both currently and over time, to achieve minimum out-of-pocket expenses while producing maximum tax savings.
Tax Breaks for Homeowners
Despite a significant increase in the standard deduction under the TCJA, many taxpayers will continue to benefit from home-ownership and itemized deductions. Although taxpayers will likely see a decrease in total itemized deductions, several historically deductible tax items may continue to provide relief. As described below, home mortgage interest, state and local property taxes, and points paid at closing are all potentially viable deductions for homeowners in the 2019 filing season. The deductibility of mortgage insurance in the coming years, however, is uncertain, as this deduction must be extended by Congress. The challenge to tax professionals is to help clients make the best financial decision possible when structuring a home loan that includes mortgage insurance.
Mortgage interest deduction.
Under the TCJA, taxpayers can deduct mortgage interest paid on acquisition indebtedness up to $750,000 ($375,000 for married taxpayers filing a separate return). Home equity indebtedness remains deductible as well, provided the proceeds are used to buy, build, or substantially improve the taxpayer’s home that secures the loan (“Interest on Home Equity Loans Often Still Deductible Under New Law,” R-2018-32, Feb. 21, 2018, http://bit.ly/2A9nRGw), keeping in mind that the combined total of acquisition and home equity indebtedness may not exceed the $750,000/$375,000 limitation. Taxpayers can also continue to deduct mortgage interest on a second home as long as total home mortgage indebtedness on the two homes does not exceed $750,000. For homes purchased on or before December 15, 2017, the maximum amount that may be treated as acquisition debt remains $1 million ($500,000 if married filing separately) for any acquisition debt incurred with respect to the taxpayer’s principal residence [Internal Revenue Code (IRC) section 163(h)(3)(F)(i)(III)].
Beginning in 2018, taxpayers will be limited to a $10,000 itemized deduction for combined state and local taxes ($5,000 for married taxpayers filing a separate return). This deduction applies to state and local income taxes and property taxes. In states where taxpayers bear a high burden for both income and property taxes, such as New Jersey, Vermont, and Wisconsin, taxpayers will be hardest hit by this limitation.
Points paid at closing.
Points paid at closing, which are essentially prepaid interest, are generally deductible not in the year paid, but rather over the life of the home loan. Points paid at closing can be currently deductible, however, if the loan is used to purchase or improve the principal home and the home serves as collateral for the loan. Points at closing may also be deducted if the payment of points is typical in the area where the transaction takes place and the amount paid does not exceed what is typically charged. These types of points are often referred to as origination fees, loan discounts, or discount points.
Mortgage insurance deduction.
Another potential tax benefit for homeowners is primary mortgage insurance (PMI), required to protect the lender when a buyer is unwilling or unable to put down at least 20% of the purchase price. The Bipartisan Budget Act of 2018 extends the deductibility of PMI to include amounts paid before the end of 2017; however, Congress is still debating whether to extend the mortgage insurance deduction permanently or eliminate it (House Ways and Means Committee, Tax Subcommittee Hearing, March 14, 2018). Regardless, homebuyers will be faced with the decision of how to purchase PMI.
Homeownership after the TCJA
According to the U.S. Census Bureau, as of June 2018, sales of new single-family homes are up 14.1% compared to one year ago, and the median sales price for these homes is $313,000. Assuming an interest rate of 5% and a 5% down payment, mortgage interest alone on a home at this price would be $14,868. Add the cost of mortgage insurance, at an average rate of 1%, and a significant tax deduction is at stake. It is important for taxpayers to structure their loans to maximize cash flows and tax benefits.
In a traditional mortgage, borrowers have to make a down payment of 20% or more to avoid paying PMI. The cost of home mortgage insurance can be paid monthly, increasing the monthly mortgage payment, or in a lump sum, either by the borrower or the lender. There are many options for would-be homeowners that require a low down payment of just 3%–5%. Over the past three years, the median down payment for a first-time home buyer has been 6% (Ryan Derousseau, “Why You Shouldn’t Make a Big Down Payment On Your First Home,” Fortune, Sept. 20, 2017, http://bit.ly/2CrAuOB). According to the National Association of Realtors (2017 Profile of Home Buyers and Sellers, http://bit.ly/2SdkKnN), first-time home buyers who financed their home typically financed 95% of the purchase price.
Typically, homeowners will pay PMI monthly. The cost of PMI is typically between 0.3% and 1.5% of the loan balance annually, depending on the borrower’s credit score and other risk factors (Dori Zinn, “What Is PMI? Learn the Basics of Private Mortgage Insurance,” Bankrate.com, Sept. 11, 2018, http://bit.ly/2RgD2HO). For example, Henry and Harper, a married couple, purchase a new beach home with a purchase price of $425,000. They finance 95% of the loan, or $403,750. Given a 5% down payment, PMI on their loan will cost somewhere between $1,211 and $6,056 annually, depending on their credit score, loan term, and other risk factors. PMI could increase Henry and Harper’s mortgage payment by as much as $505 monthly unless they structure their loan in such a way as to save on the monthly PMI payment.
Paying for PMI monthly could be a costly choice for many taxpayers, particularly those with higher incomes. The reason for this is twofold. First, the tax deductibility of PMI for high-income taxpayers has traditionally been lost due to phaseouts. Although these phaseouts have not yet been established for 2018, the 2017 mortgage insurance deduction was phased out for taxpayers with AGI above $109,000 and $54,500 for married taxpayers filing a separate return. Second, unlike the mortgage interest deduction, which is effective until the end of 2025 (and likely beyond), the mortgage insurance deduction must be extended by Congress on a yearly basis. Although Congress allowed the deduction for amounts paid in 2017, deductibility of mortgage insurance for 2018 remains an open question. One way for taxpayers to overcome this uncertainty and ensure a greater mortgage interest deduction is to structure their home loans with lender-paid PMI.
Many banks will prepay the PMI for their customers in exchange for a slightly higher interest rate. Although lender-paid PMI loans carry a slightly higher interest rate, they do not have an additional monthly payment for mortgage insurance. Lender-paid PMI loans often produce a lower monthly cash outflow because the mortgage payment, even with its higher interest rate, is often smaller than the combination of a mortgage payment and mortgage insurance. In addition, because of the higher interest rate associated with a lender-paid PMI loan, taxpayers may benefit from a higher mortgage interest deduction. The difference in these loan options can be seen in the example below.
Consider Sawyer Davenport, a single taxpayer, who buys a house in 2018 for $380,000 (Exhibit 1). He finances 95% of the purchase price and must choose between two loans: one with a monthly PMI payment (Loan A) and one with lender-paid PMI (Loan B). Assume Loan B carries a higher interest rate (4.625% compared to 4.25% for Loan A) and that Loan A has a monthly PMI payment of $180.50 (based on PMI of 0.6%). Loan B offers an overall lower monthly cash out-flow ($1,856.04, compared to $1,956.40 for Loan A). Thus, the PMI premium drives up the cost of Sawyer’s monthly mortgage payment more than the higher interest rate.
Comparison of Monthly and Lender-Paid PMI
It is important to note that under Loan A, when Sawyer has paid his mortgage down to 80% of the original appraised value of his home, he can request to have his PMI cancelled. If he makes his mortgage payments regularly, with no additional principal payments, he can request the PMI reduction after approximately eight years, dropping his monthly mortgage payment to $1,775.90. With the lender-paid PMI (Loan B), Sawyer’s mortgage payments will remain constant for the life of the loan. If Congress elects not to extend the mortgage insurance deduction for 2018, the monthly PMI payments will provide no tax benefit under Loan A; however, the mortgage interest on Loan B will remain fully deductible, assuming Sawyer has sufficient deductions to warrant filing an itemized return.
Over the life of a home mortgage loan, the lender-paid PMI (Loan B) will result in higher total interest costs; however, given that many homeowners sell their homes before they reach the 80% threshold needed to cancel PMI, a higher cash flow in the early years of the home loan may make financial sense. According to the National Association of Realtors’s 2018 Homebuyer and Seller Generational Trends Report (http://bit.ly/2ELlsFQ), 50% of all home sellers stayed in their home for 10 years or less. Younger taxpayers, those 37 and under, often sold their home within the first six years (see Exhibit 2). For these taxpayers, a slightly higher interest rate with no monthly PMI payment is probably a much more favorable option.
Actual Tenure in Previous Home (Percentage Distribution)
Not a Clear-Cut Decision
Simple heuristics may not always lead to optimal advice. Choosing a higher interest rate over a lower one may seem counterintuitive, but considering the tentative nature of the home mortgage insurance deduction, the likelihood of a 10-years-orless loan life, and initially higher cash flows, an option with a slightly higher interest rate may often produce a better financial outcome. Although the number of taxpayers who itemize is expected to decline significantly, more than 13.8 million taxpayers will continue to benefit from the mortgage interest deduction (Joint Committee on Taxation). Proper financial planning regarding mortgage structure may increase taxpayer cash flows while simultaneously increasing the home mortgage interest deduction, resulting in significant tax savings for millions of homeowners.