Under the new tax law, does it make sense to pay off one’s mortgage?

The Tax Cuts and Jobs Act of 2017 (TCJA) has changed the rules as to whether homeowners should pay off their existing home mortgage debt. This week’s column discusses these rule changes resulting from TCJA’s passage Among them are the doubling of the standard deduction and the limitation of the home equity loan and line of credit interest deduction.

The Tax Cuts and Jobs Act of 2017 (TCJA) has changed the rules as to whether individuals should pay off their existing home mortgages. This column discusses how TCJA changes the math for millions of Americans, especially married individuals as to whether they should pay off their mortgages - even if they took out a mortgage within the last five years.

According to Congress’ Joint Committee on Taxation, for 2017 32 million tax filers received a mortgage interest deduction on their Federal income tax returns. For 2018, that number will drop to 14 million. To understand why the number of Americans expected to receive a mortgage interest deduction will drop over 50 percent, it is important to review the key changes resulting from passage of TCJA and taking effect in 2018.

For many employees, two revisions resulting from TCJA’s passage will have the biggest impact on the mortgage interest deduction. The first revision is the doubling of the standard deduction to $12,000 for most single filers and $24,000 for most married couples filing jointly. As a result, millions of individual tax filers will no longer benefit from itemizing on their income taxes. Part of itemized deductions is mortgage interest.

The other change resulting from TCJA that will affect the mortgage interest deduction is the cap on the deduction of state and local income or sales taxes, personal property taxes, and real estate taxes to $10,000. Note that the $10,000 limitation is per tax return and not per person, whether the person files as single, head of household, or married filing joint or separate.

The doubling of the standard deduction and the $10,000 state and local tax deduction, known as the “SALT” deduction, will affect married individuals harder than single individuals. This is because a married couple during 2017 needed itemized deductions exceeding $12,700 in order to benefit from itemizing and filing Schedule A. Starting in 2018, the married couple’s itemized deduction, including SALT (limited to $10,000), mortgage interest, charitable contributions and medical expenses exceeding 7.5 percent of their adjusted gross income have to exceed $24,000. This means that assuming a married couple has a maximum SALT deduction of $10,000, the couple will need more than $14,000 in other allowed itemized deductions in order to benefit from itemizing and using Schedule A on their Federal income tax returns.

The new threshold is lower for those individuals who file as single, as each individual can also deduct SALT up to $10,000. With a standard deduction of $12,000, this means single filers only need more than $2,000 of mortgage interest, charitable contributions and the like in order to benefit from itemizing and filing Schedule A on their Federal income tax returns.

Other Mortgage Interest Limitations Under TCJA

As a result of the passage of the TCJA, new home purchasers can deduct the interest on total mortgage debt up to $750,000 for up to two homes. While this limit will not be an issue for most home buyers starting this year, some will be affected.

Those homeowners who took out mortgages prior to Dec. 14, 2017, are limited to $1 million of total mortgage debt on up to two homes. They can continue to deduct their mortgage interest.

The rules also changed for home equity loans and lines of credit. In order to deduct the interest on these loans, a homeowner must use the debt to buy, build or improve his or her primary residence. If the proceeds from the loan or line of credit are used for any other purpose such as paying college tuition, buying a car or paying credit card debt, the interest paid is not deductible.

For those homeowners who are in the middle or towards the end of their mortgage term with a decreasing mortgage interest deduction, a key question is whether they should pay off the mortgage. The answer depends on whether the after-tax return on an investment is higher than the homeowner’s mortgage rate. If it is, then it does not make sense to pay down the mortgage. Consider the following example:

Joseph has a mortgage rate of 3.5 percent and a $10,000 SALT limit under TCJA, it makes no sense for Joseph to itemize on his income taxes. He is better off using the standard deduction and therefore Joseph receives no mortgage interest deduction. Rather than paying off his mortgage, Joseph would be better off investing his money earning  at least 3.5 percent on an after-tax basis on some type of investment. He could perhaps invest in a stock index mutual fund yielding 6 to 8 percent on a before-tax basis  over a period of 10 to 15 years. But these is no guarantee Joseph could get this type of investment return.

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