IRS Clarifies Home Equity Interest Deduction

February 22, 2018

An Information Release announced yesterday from the IRS provided clarification about a recent law change affecting the deductibility of interest on home equity debt.

The Tax Cuts and Jobs Act of 2017 (“the Act”), enacted on December 22, 2017, suspended the deduction for interest paid on “home equity indebtedness” incurred from 2018 until 2026. Many believed that the interest on home equity loans was now entirely non-deductible.

However, the IRS Release clarified the nature of the change: “Taxpayers can often still deduct interest on a home equity loan, home equity line of credit (HELOC) or second mortgage, regardless of how the loan is labelled.” The determining factor for deductibility is how the borrowed funds are spent.

“Home equity indebtedness” is distinguished from “acquisition indebtedness”, which remains deductible under the Act, subject to certain limitations. “Acquisition indebtedness” is defined as debt “incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer.” In other words, if debt is incurred to buy, build or substantially improve the taxpayer’s home that secures the loan, even if some form of home equity loan is utilized, the interest may still be deductible.

Keep in mind that there is a cap on the total amount of debt that can be considered for purposes of deducting interest on your home. For debt incurred after December 15, 2017, the cap is $750,000 or $375,000 for married taxpayers filing separately. For debt incurred on or before December 15, 2017, the limits are $1 million and $500,000, respectively, and these loans are grandfathered. Interest attributed to debt in excess of these limits is not deductible. Also, total indebtedness on a 1st and 2nd home is combined in considering these limitations, and that would include any home equity loans that are treated as “acquisition indebtedness.”

Following are two examples provided by the IRS that illustrate these rules:

“Example 1: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home with a fair market value of $800,000. In February 2018, the taxpayer takes out a $250,000 home equity loan to put an addition on the main home. Both loans are secured by the main home and the total does not exceed the cost of the home. Because the total amount of both loans does not exceed $750,000, all of the interest paid on the loans is deductible. However, if the taxpayer used the home equity loan proceeds for personal expenses, such as paying off student loans and credit cards, then the interest on the home equity loan would not be deductible.

“Example 2: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home. The loan is secured by the main home. In February 2018, the taxpayer takes out a $250,000 loan to purchase a vacation home. The loan is secured by the vacation home. Because the total amount of both mortgages does not exceed $750,000, all of the interest paid on both mortgages is deductible. However, if the taxpayer took out a $250,000 home equity loan on the main home to purchase the vacation home, then the interest on the home equity loan would not be deductible.”  This last point illustrates the requirement that the borrowed funds must be used to purchase, build or substantially improve the same home that secures the loan; debt secured by a different home does not qualify the interest for a deduction. (Source: IRS News Release 2018-32, 02/21/2018, underlines added for emphasis.)

In addition to the above opportunity, it’s worth noting that long-standing rules permit taxpayers to consider how borrowed funds were used in determining whether the associated interest might be deductible. These interest tracing rules are still in effect and could allow interest on home equity loans to be deductible, even beyond the considerations mentioned above. For example, interest incurred on funds borrowed via a home equity loan that are used to acquire a rental property or invest in a business may be treated as deductible interest under other provisions of the tax law.

In summary, there are instances when interest on home equity debt is still deductible. Keep this in mind when reflecting on the current debt you have outstanding as well as consideration of any additional home equity debt you might incur.

Need help interpreting the Tax Cuts And Jobs Act for you or your business?
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