An overview of the new tax law
Under the new tax law home equity loans and lines of credit are still deductible. Yet they are subject to certain conditions.
- The proceeds must be used to buy, build or substantially improve a home that is secured by the home equity line of credit (HELOC)
- The borrower cannot use the proceeds to pay off credit cards or pay for other personal expenses
- Married couples who incur mortgage interest on a residential mortgage that has a balance of $750,000 or less can fully deduct the mortgage interest on Schedule A. This includes interest incurred for both the primary mortgage and home equity line of credit. The single filer or a person filing as “married filing separately” will experience a $375,000 threshold before the mortgage interest incurred is limited on Schedule A.
Prior to this change in the tax laws, couples used to be able to deduct the mortgage interest expense for mortgages with balances up to $1,000,000. Single filers and taxpayers filing as married filing separately could incur a mortgage balance up to $500,000 before experiencing a limitation in the mortgage interest deduction associated to the mortgage. Furthermore, the HELOC used to be a separate calculation where married couples could have up to $100,000 in an additional HELOC before experiencing a limitation in the mortgage interest deduction. This has all changed with the new tax law.
It is worthy to note, the hidden liability for a divorcing party outlined below existed before the new tax law change. It is the amount of the hidden liability that changed as a result of the new tax law. Further context is provided below.
How does this new tax law impact parties going through a divorce?
As part of the negotiated financial settlement, let’s assume Spouse 1 keeps the home and assumes the full obligation of the associated 1st mortgage and HELOC too. When Spouse 1 was married to Spouse 2, Spouse 1 enjoyed a higher tax threshold up to $1,100,000 under the old tax law. Under the new tax law, as a result of getting a divorce, Spouse 1 will automatically drop to a much lower threshold of $375,000. Why? Assuming Spouse 1 does not remarry in the near term and is not restricted from getting married either in the divorce decree, then Spouse 1 will have a tax filing status of Single or Head of Household. In either situation, the mortgage interest that is eligible for deduction is directly tied to the mortgage balance outstanding which cannot exceed $375,000 as noted above.
This translates into approximately $15,000 of lost tax savings each year that may need to be incorporated into the overall financial settlement structure. The $15,000 is derived as follows:
Married couple threshold $ 750,000
Single or Head of household threshold $ 375,000
Difference $ 375,000
Effective tax rate 30%
Effective increase in taxes $ 112,500
Assumed interest rate 8.00%
Annual tax loss due to change in threshold $ 9,000
If the outstanding mortgage balance is not close to its maturity, then the amount of financial discourse between the two parties could multiply significantly.
Let’s use the $15,000 annual tax loss outlined above as the context. Why? This is the amount of money Spouse 1 (the newly divorced party) will have to pay to the federal government as a result of getting divorced every year. In our example let’s assume there are 15 years remaining to pay off the mortgage.
Annual tax loss due to change in threshold $ 9,000
# of years remaining on mortgage until it matures 15
Cumulative out of pocket $ 135,000
Over time, this translates into Spouse 1 who will now have to file as either Single or Head of Household to experience a hidden tax liability of $135,000.
You might ask how can Spouse 1 have Spouse 2 incorporate all or a portion of this into their mutually agreed upon financial settlement structure for their divorce? Here is some thinking behind this:
- Did Spouse 1 voluntarily file for the divorce?
- If yes, then Spouse 1 may not be able to request Spouse 2 to incorporate the additional tax burden into the financial structure
- If no, then Spouse 1 was placed into an involuntary position. Spouse 1 will now have to incur this unexpected financial burden over time
Furthermore, if the divorce decree restricts Spouse 1 from getting remarried to receive certain types of compensation, then Spouse 1 may inadvertently be required to incur this higher tax burden over time. Why? According to the divorce decree Spouse 1 would be restricted from enjoying a different tax filing status of married filing jointly (MFJ). MFJ would place Spouse 1 at a higher mortgage threshold. If Spouse 1 kept the house and associated mortgages Spouse 1 would not be able to reduce the future tax burden.
The question that arises is whether Spouse 1 incorporated the $135,000 hidden liability into the financial negotiation process prior to finalizing the settlement structure? Who identified the hidden liability? These situations come up all of the time. It is a matter of knowing where to look to uncover the issues.
It is worthy to note divorces can be complex negotiations with a lot of financial risk unknowingly placed on the table. Parties discover their risks months if not years later and have few options available to rectify the situation.
This new tax law around the mortgage interest deduction appears very innocent on the surface. When incorporated into a divorce process it adds another pawn on the divorce chess board that needs to be delicately managed as divorcing parties proceed through their divorce process.
About the Author
Larry Smith is a Founding Partner of Divorce Outcomes, a specialized professional services firm that manages all of the financial aspects in a divorce process. Since 2003 he has worked as a trusted financial advisor, financial advocate, divorce architect and technical financial expert; he is not an attorney. He is an alumni of KPMG and Andersen with expertise in technical accounting, forensics, sophisticated taxation, management consulting, risk management, advanced process engineering, business combinations, divorce management, multi-party negotiations, advanced quality analytics and cognitive performance technologies. Since 1986 Larry has been advising individuals and organizations about innovative financial solutions to resolve complex financial challenges that arise in life and in business.
For both personal and business divorces, Larry is considered an expert in divorce strategies, divorce process management, financial divorce architecture, financial risk management, taxation for divorces, financial divorce forensics, advanced divorce analytics, financial divorce negotiations and mediation, business valuations and sophisticated equity structures. He helps clients shape complex financial decisions, manage communication risks and ever-changing negotiating positions to strategically preserve or grow wealth from these types of transactions.
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About Divorce Outcomes
Divorce Outcomes is a specialty services firm that helps people both domestically and internationally manage all of the financial decisions that arise in their divorce process. We are not attorneys. We are financial experts who partner with our clients as their personal financial advocates. We help our clients manage their divorce process, uncover hidden financial risks, architect divorce solutions, manage ever-changing negotiating positions, communicate complex financial matters and close the divorce process as soon as possible with a goal to arrive at the best outcomes possible. Throughout the process we evaluate the current state of our clients’ financial lives with an objective to best reposition their future. We do not sell any products. We simply raise issues that are in our clients best interest. Our clients share with us we:
- unfold, analyze and repackage their financial life so they are well positioned after their divorce
- preserve the value of their business or marital estate
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- find ways to make our client, and at times both parties, money through the process
- design their divorce to work for them and their family’s life
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- reduce the total process time from start to close
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As we reach an agreed upon settlement structure, we help our clients identify a fitting attorney who can leverage the financial solution to draft and record the requisite legal documents. Where outcomes are at risk from a traditional process, we function as expert financial negotiators or financial mediators to turn around the situation and achieve our client’s desired outcomes.
Learn more about us at divorceoutcomes.com or review our blogs to gain a clearer understanding about our approach and how we maximize the financial outcomes for our clients.
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute formal advice or a recommended course of action as every person’s situation is unique and different. The information here is not intended to be, and should not be, relied upon by the recipient to make a decision without professional guidance.