Just when you thought it was safe to exploit the Tax Reform Act of 1986, our friends in Congress may be changing the rules again.
Trying to raise tax revenue to cut the federal budget deficit, lawmakers have proposed a number of tax law revisions that would reduce the attractiveness of several popular investments and tax strategies, particularly home mortgage refinancings and home equity loans, real estate and bond swaps, and certain types of limited partnerships.
These proposals, contained in one or both of the tax-increase bills passed by the House and the Senate Finance Committee last month, will be considered along with other revenue-raising measures for inclusion in a final deficit reduction bill to be formulated by House and Senate tax-writing committees. The impetus for such a bill gained strength Friday, when President Reagan and congressional leaders endorsed a $9-billion tax increase as part of a plan to reduce the deficit by $30 billion this year.
If enacted, the changes could affect thousands of homeowners and investors--particularly in California, where real estate values are higher than in the nation as a whole. Already, the threat that these proposals may be enacted has prompted some taxpayers to postpone refinancings and asset swaps, experts say.
"It doesn't pay to be a fool and rush in when they could change the ground rules," said David A. Berenson, national director of tax policy for the accounting firm of Ernst & Whinney. "You have enough time before year-end to make your transactions. I wouldn't rush now."
Here's how the proposals affecting home loans, swaps and limited partnerships will work:
Home Mortgage Refinancings
Tax reform has spawned a boom in home equity loans and mortgage refinancings. Taxpayers are using these loans to pay down credit card debts or other non-mortgage borrowing, on which deductibility is being phased out under tax reform.
A provision in the House bill approved Oct. 29 would limit the deductibility of interest on refinancings and home equity loans when they are used for purposes other than paying for the home or home improvements. That limit is $100,000 or the fair market value of the home, whichever is less.
Current law limits the amount of such borrowing eligible for full deductions to the purchase price of the home plus the value of home improvements, unless the excess is used for educational or medical expenses.
How will the proposed change work? Assume that you spent $300,000 to buy and improve your home and have a $175,000 mortgage balance on it. Under current law, you could take out a home equity loan or refinancing for the $125,000 difference and all its interest would be fully deductible, even if you used some of the money to buy such non-housing items as stocks or a new car.
But under the House provision, only $100,000 of the $125,000 will be eligible for full interest deductions. The deductibility of interest on the remaining $25,000 will depend on what the proceeds are used for. If it is used for home improvements, it may be fully deductible.
"This provision is very significant, particularly in California" because of the state's expensive homes, Ernst & Whinney's Berenson said. Homeowners with large equity in their homes will be limited in how much they can borrow on a fully deductible basis against that equity, experts say.
However, homeowners who bought their homes many years ago at less than $100,000 may be able to borrow more on a fully deductible basis. A homeowner who paid only $25,000 for his home--now worth more than $100,000--could borrow as much as $100,000 on it on a fully deductible basis. Under current law, he could only borrow up to $25,000, unless he used the loan for medical bills or tuition.
The House proposal also would curb other tax benefits related to mortgage borrowing. It would limit to $1 million the maximum amount of mortgage loans on which interest could be fully deducted. It would also drop the special exemption for education or medical expenditures. And it would eliminate boats and mobile homes from qualifying as second residences that are eligible for full interest deductions.
Loans in place on or before Oct. 13 would not be affected.
William G. Brennan, editor of Brennan Reports, a Valley Forge, Pa., tax-advisory newsletter, contends that there is a good chance these limits will be enacted. The boom in those loans makes them a convenient target, with the potential for raising millions in new tax revenue, he said. Also, the limits are likely to affect only the wealthiest homeowners, making the proposals politically palatable.
What if you just want to refinance the existing balance of your mortgage to get a lower interest rate? As long as you are not taking cash out to use for non-mortgage expenditures, interest would be still fully deductible under the House plan, Brennan said.
Real Estate Swaps