 Hello, and welcome to this session in which we will discuss itemized deductions, and specifically, we will be discussing interest paid on mortgage and investments. In the prior session, we looked at medical and dental expense deduction that's completed in specific taxes. Real quick, what are itemized deductions? Itemized deductions are deductions from AGI. I know I keep repeating myself, but it's very important to understand on form 1040, we have a line, an important line called adjusted gross income. We have certain deduction that are for AGI. That comes before AGI, therefore reduce AGI. And we have certain deductions that are from AGI. And itemized deductions are from AGI. What are itemized deductions? Itemized deductions are personal expense and nature. They're non-trade business expenses. Personal expenses would also include employee and investment expense, which are suspended from the year 2018 to 2025. So this is this part here. It's under the miscellaneous expense part. This is suspended from 2018 to 2025. And that's why less and less people are using the standard deduction, not the itemized deductions. Remember, for the itemized deduction to make sense, they have to be greater than the standard deduction that's given by the government. A deduction given by the government. Well, since President Trump's tax law changes, they increased the standard deduction. Therefore, less people are taking the itemized deduction because they don't have enough of them to exceed the standard deduction. And they would only give you a benefit, a tax benefit, if the itemized deductions are greater than the standard deduction. Again, let's take a look at the form. We looked at medical and dental expenses that's done. Tax has paid done. In this session, we'll focus on interest you paid. And notice here, home mortgage interest and points. Home mortgage interest and points. Home mortgage interest not reported on form 1098, which is the banks gives you points not reported on form 1098 and investment interest. So simply put, it's going to be home mortgage interest and something called points. I'll show you what we'll talk about them basically form of interest and investment interest. Let's go ahead and get started. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions as well as exercises. Go ahead, start your free trial today. Now, before we proceed any further, I just want to let you know we have many types of interest. So I'm going to go over the types of interest that we have. We have personal interest. What is personal interest? Well, it's a personal. It's the word suggest. It's not business. What could be a personal interest? Credit cards, personal loan, car loan. Those are not deductible. There's nothing you can do with those. Then you might have interest on student loan. Student loan interest, kind of a personal interest, but it's deducted for adjusted gross income. And there's a separate session covering student loan interest. So student loan interest is a deduction for the individual. So it's kind of a personal interest, but we call it student loan because it's deductible. That's why we're separating it. And it's deductible for AGI, not from AGI. Now we covered this in a separate recording and it's subject to limits. Not everyone can take it. Once you exceed a certain number, you cannot take it. And you might be asking why student loan is treated differently. Well, because when you graduate, most likely you don't own a home yet. Most likely you don't pay interest on a mortgage yet. Therefore, the government wants to give you a deduction for the interest, but they don't want to include it on schedule A because you're not going to have a home mortgage. Because remember, to itemize you have to bunch things together. And if you're in your early 20s or mid 20s or late 20s, most likely you don't own a home yet. Therefore, you don't have a home mortgage interest. You don't have taxes. So what they're saying is we're going to give you this deduction separately. So that's why. And it's covered in a separate recording. Then we have home mortgage interest, which is, it's called acquisition debt. It's one you buy or improve a house. That's deductible from AGI subject to limit, which we will be discussing in this session. And there is investment interest, which is also deductible from AGI and we'll discuss in this session. Starting with qualified residence interest. When the law changed a little in 2017 Tax Law and Jobs Act, there was a lot of confusion about qualify residence interest. Simply put, a lot of confusion about home mortgage interest, whether it's deductible or not. Yes, it's still deductible. They changed the limits a little bit. Nevertheless, it's still deductible. So interest on qualified residence. What is qualified residence? Principal residence. Where do you live? Plus one other. Now the one other home, so you could have two homes that you can deduct interest on. The other home cannot be a rental. If it's a rental, then the interest is deducted on Schedule E. Is deductible if the debt is secured by these properties. In other words, you have the debt and the debt is a mortgage debt. And you could have two property, not the rental property. So the second one cannot be rental properties. Because if that's the case, that's totally separate. I mean, you could have two personal property and 10 rental. It doesn't matter. The rental are treated separately and those two properties can have their interest deducted. Now how much interest can be deducted? We'll see. According to the Tax Cuts and Jobs Act from 2018 to 2025, qualified residence interest only include interest on debt used to acquire, it means to buy and to make substantial improvements. Substantial improvement means what? Let's assume you want to add a room to your home or have a swimming pool or you have a major renovation. It does not include debt used to buy a car or go on vacation or take college courses. It doesn't include that. So the interest that's deductible related to either buying the house itself or making improvement to the house. And the reason I am emphasizing why you cannot use the debt for other reasons because in the past you would be able to take out money against your equity. What's equity? Let's assume you own a home for $600,000. This is the value of your home. And you have a mortgage against that home for $400,000. That's the debt. That's the mortgage. So the difference between the asset, the value of the asset. This is the asset. 600 and the liability is the 400. What's left is equity. It means you have $200,000 in equity in your home. In the past, you would be able to go to the bank and take a loan against the equity. And when you take the loan, you can do whatever you want with it. You can buy a car, go on vacation, whatever you want to do. It's personal use. Therefore, if you take the loan out and use it for personal use, then you cannot deduct the interest. Now, for that incurred on or before December 15, 2017, simply put, pre-tax cuts and jobs act of 2017. Before that, interest paid on total acquisition debt of $1 million, qualify as deductible residence interest. Simply put, you could have a loan up to $1 million and deduct the interest on that loan if it's $500,000 for married filing separately. Before the tax cuts and jobs act. So what did the tax cuts and jobs act change? All what the tax cuts and jobs act change is the amount is not a million. The amount is 750. So before pre-tax cuts and jobs act, you could have a loan up to $1 million and deduct the interest on that loan or loans as long as they are for the acquisition or the improvement of the house post tax cuts and jobs act. You could only have loans up to $750 and deduct the interest on that. You could have a loan, $20 million home mortgage loan. That's not a problem. The interest that you can deduct is $750 and a million. So the amount changed and there was a big confusion that this deduction is going away. Well, they took away another deduction, which is what? If you used it for personal use, they took it away and they lowered the amount a little. Now, no worries. After 2025, they will go back to the $1 million regardless of when the amount was borrowed. Let's talk about something called home equity loan, which is kind of I explained it, but I want to also make sure I re-emphasize the point. Prior to 2018 and after 2025, qualified residents are also include interest on home equity loans. What is home equity loans? Home equity loans are loans secured by qualified residents. Why is it called home equity loans? Because you have a loan against the mortgage, against the value of your home. So basically we're looking at a second mortgage. So you took a first loan, a first mortgage, then you have some equity, you took a second mortgage. Interest is deductible on loans only if used to improve personal residency. This is what we need to know. Not personal purpose. I know I'm repeating myself. I have to because to make the point. So home equity loan or a second mortgage, they are deductible if they are used to improve the home. Obviously to buy the home, usually you only need one mortgage. Who knows? Maybe sometime you need two, but usually banks, you need only one mortgage, which is first mortgage. Just want to emphasize this. Home equity loan, basically what it is, or sometimes they call it home equity line of credit. What does that mean? It means you remember the example I gave you 400,000 minus 600,000 minus 400,000 gave you an equity of 200,000. Now you don't have to take this money out, but you could have what's called a home line of credit. Home line of credit. It means the bank says anytime you need money, you can go and tap, take this money out. It's available to you. It's like a credit card, but the loan, this line of credit is against your home. So it's like a second mortgage, but you can, you only have a mortgage when you use the money. Again, that's still available as long as you use the money for qualified residents. The loan is backed by a qualified residents and it's used for improve the personal residents. Remember, all the loans together, they cannot be more than 750. They can be more than 750, but you can only deduct the interest component based on 750. Let's take a look at an example. John owns a personal residence with a fair market value of 800,000 and a mortgage of 550. Well, this means the equity is 250,000. So John went to the bank and borrowed 100,000. That's secured by a second mortgage or a home equity loan to renovate his kitchen. Is this deductible? Yes. Well, yes, it is because it's against using his home as a collateral and it's used to renovate the kitchen and the amount of all the loans, 500,000 plus 100,000 does not exceed 750 or the value of his residence. The reason they have the value of the residence because sometimes that doesn't usually happen anymore. Back in the past, even if your home was worth 800,000, some lenders will give you more than 800,000 on your home, which is risky. It means they're giving you more debt than the value of your home. If you borrow more debt than the value of your home, it's basically a form of speculation. However, if John used this home equity loan proceeds to purchase a new car and a boat, the home equity loan would not be deductible. Let's talk about points. As you saw on schedule A, there's something called points. What are points? Points paid as a fee for borrowing money are considered deductible. So what you do is this. When you take out a mortgage, sometimes the bank tells you, look, if you pay points, I'm going to tell you what they are, we will lower your interest rate. It's basically you pay money up front to lower the interest rate. Well, when you pay money to borrow money, that's interest, but they call it point. To qualify as deductible interest, points cannot be classified as a service charge. But you have to make sure they classify whatever you paid when you paid that when you bought your interest. Basically, let's assume the bank says your interest on this loan is 5%. You would say, look, can I buy the points? Can I basically deduct 1% to make it 4%? And the bank would say, yes, if you pay us $5,000 now, basically, you're buying the points. You're buying the points to lower the interest. Basically, every time you spend money to borrow money, it's interest, but they call it point. That's what points are. And you have to make sure it's a classify as a service and not a service charge. Service charge because when you take out a loan, the bank will charge you many different things, many different service charges. That's how they make money. If you're paying for points, make sure it has points so it's deductible. In most cases, points must be capitalized and spread out over the loan's duration. However, when points are paid for acquiring or improving a personal residence can be fully deducted in the year they were paid. Again, that's the only reason they can be deducted. If when acquiring or improving a personal residence, then you can deduct them. Forget about capitalizing them because you're not going to capitalize them for personal loans. That's all what it is. Points paid for refinancing, notice here, if you're doing refinancing, those must be capitalized over the life of the loan. But if you're acquiring or improving a personal residence, it's deductible. Now, what does it mean refinancing? Refinancing means right now your mortgage is 8%. Your mortgage, 8%. And the overall interest rate dropped to 5%. You'd say, you know what? I can refinance. I can replace my old loan, my old 8% loan with a new loan of 5%. That's called refinancing. You're not buying the home. You are simply reducing your debt. You're reducing the cost of your debt. That's what refinancing is. If you incur points on refinancing, then you have to amortize them. Now, why don't you want to amortize them? Because to amortize them, it means you're taking a smaller amount every year. And remember, for the itemized deduction to make sense, they have to be large to be greater than the standard deduction. When you itemize them, they're not as beneficial as taking them all at once when you acquire or improve a personal residence. Let's take a look at an example. John purchased his residence many years ago, obtaining a 30-year mortgage at an annual interest rate of 7%. And the current year, he decided to lower his mortgage since the interest rate is down and lower it by 2 points, that's 5%. So he's going to go through a refinancing process. And through this process, he incurred 3,200 in points because he wanted to. Part of the deal was you pay 3,200. It will help you reduce your points. Now, the 3,200, which is treated as a prepayment of interest, which is interest, needs to be capitalized and spread out over the remaining life of the loan. So this 3,200, you'll have whatever the remaining life of the loan is, you divide it by that, and this is how much interest you can take per year. Sometime when you have a loan, you might incur a prepayment penalty. What's a prepayment penalty? It's basically you want to pay off the loan, but the lender says, if you want to pay it off, you're going to have to pay a little bit extra. It's a penalty, prepayment penalty. When a mortgage loan is fully paid off before its term, which means early, somehow you have money, you want to pay off the loan, the lending institution might impose a prepayment penalty. You always want to be aware of this when you take out a loan. Is there a prepayment penalty? Because at some point, you might have the money and you want to pay off the loan. This penalty typically a percentage of the remaining balance. So if your remaining balance is 100,000, they would say the prepayment interest is 1 or 2%, which is $3,000 if it's 2%. Interest is interest deductible? Yes, it falls under the same rule of deductibility of other types of interest, depending what loan are you paying. If you're paying a personal loan, you cannot use it. If you're paying a qualified residence, you can use it. It's just basically interest on the mortgage. If you're paying it for investment interest, we're going to see what you can do next with investment interest. Let's talk about investment interest. What is investment interest? Investment interest when you borrow money to do what? To invest in stocks, to invest in bonds, to make an investment. So now you're taking out money and sometimes those are called margin loans, the technical word. You're taking out money to do what? To invest. Taxpayer at Congress has placed restriction on the deductibility of interest on loan taken to acquire or hold investments. Because if not, people will take a lot of risk if they can deduct all this interest. How much can you deduct of this investment interest? The deduction of investment interest is limited to the net investment income for the year and only can be claimed if the taxpayer itemized the deduction. So the first thing you do is you want to itemize the deduction. That's one. Two, how much can you deduct? Well, you have to look at your investment income, net investment income. So if you have expense of 10,000 and you have net investment income of 3,000, so this is the income and this is the expense, you're only limited to 3,000. So you can bring your net investment income to zero and 7,000 will be what? Unused. Now, if you incurred interest expense to buy tax exempt securities, tax exempt securities are municipal bonds. Municipal bonds, remember, they are not taxable. If the bonds are not taxable, well, guess what? The expense is not deductible. No deduction for interest expense incurred to buy tax exempt securities. An example of them is municipal bond. And we talked about those when we talked about tax income exempt, which is income exclusion. One of it is interest on municipal bond. You need to know this inside out. Example, Jane borrowed $10,000 from a bank to invest in stock. She pays an annual interest of 8% on this loan and earns $1,000 in dividend. This is investment income. Her net investment income is $1,000. So the maximum amount of investment interest she can deduct is also 1,000. This means she can deduct the interest she paid on the loan up to how much? $1,000. Now, bear in mind, it's important to note that Jane can only claim this deduction if she itemized her deduction. It means she prepared schedule A. If she chooses the standard deduction, forget it. She cannot have that $1,000. Also, she incurred it. She's not itemizing. She cannot take it. So what we did in this session, we looked at interest paid. And the next session will be charitable contribution. So the next session on the itemized deduction will be charitable contribution. Once again, schedule A itemized deductions are very important. They are deducted from AGI. Okay, and there's a bunch of them, and they only make sense. When you add them all up, make sense means they are beneficial to you and they are greater than your standard deduction. So they compete with the standard deduction. Good luck. Study hard. For now, go to Farhat Lectures, work MCQs, and stay safe.