There are many great reasons to be a home owner in the United States. These include: stability, wealth creation and the satisfaction of owning your own home. From a tax standpoint, one of the most compelling aspects of home ownership has to do with the mortgage interest deduction. Simply put, this part of the tax code (sec 164) allows taxpayers to deduct the interest on their mortgage up to a certain amount from their gross income.
One of the unique structures of an amortizing loan is how the interest and principal are spread out through the life of the loan. The first ten years of a 30-year mortgage loan is heavily weighted towards the interest payments, the final ten years is heavily weighted towards principal payments and the middle ten are a mix of the two. Since most of the first ten years of a mortgage’s life is spent funding interest, new homeowners have an incentive to deduct those interest payments from their gross income. This can be quite a tax saving and a compelling reason to own rather than to rent.
Under the previous tax code, a couple that filed jointly was able to deduct the interest on a loan up a $1,000,000. A single filer was able to deduct interest on a $500,000 loan. The changes that have gone into law in the new ‘Tax Cuts and Jobs Act’ lower the level of deduction on loans up to $750,000 for joint filers and $375,000 for single filers. However, if you had an existing loan less than $1,000,000 in the case of joint filers and less than $500,000 for single filers before the tax law was signed, then you will be grandfathered and allowed to continue deducting that interest. The total loan amounts can be split between the homeowner’s principal residence and a secondary residence as long as they don’t exceed $750,000 or $375,000 respectively. Another change from the previous code is that interest on home equity loans up to $100,000 can no longer be deducted. That has gone away and is no longer in effect.
So how will this affect the residential real estate market? First, it is important to note that 94% of all home loans in the US are for amounts less than $750,000. The areas with loans larger than $750,000 will be concentrated to a handful of states such as New York, New Jersey and California. A loan of $800,000 would typically represent a $1,000,000 sale price with a 80/20 loan-to-value (LTV) ratio. In some markets such as Manhattan that amount will currently buy a one-bedroom apartment. The question that must be considered, is whether someone with the means to purchase a $1,000,000 property will decide to “downgrade” to a $750,000 home because of the loss in the interest write off. While that scenario may occur, it is hard to believe it will be a wide-ranging phenomenon.