When Congress passed the law formerly known as the Tax Cuts and Jobs Act (“TCJA”) in December 2017, most commentators thought that home equity loan interest was no longer deductible under any circumstances. However, a recent IRS notice clarified that in certain situations, the interest on home equity loans, home equity lines of credit and second mortgages in fact remains deductible. This new IRS announcement demonstrates that the TCJA requires time to shake out completely. In the meantime, we’ve highlighted examples from the IRS to show how the new TCJA rules on home equity loan interest can impact you.
How the New House Rules can Affect your Game Plan
The new law limits the amount of the mortgage interest deduction for taxpayers who itemize through 2025. Effective January 1, 2018, a taxpayer can deduct interest only on mortgage debt of $750,000 for a qualified residence1 – mortgage debt incurred before December 31, 2017 retains the $1 million limit. The congressional conference report on the law stated that it also suspends the deduction for interest on home equity debt, which was previously deductible up to $100,000 for qualifying debt regardless of how the loan proceeds were used. Moreover, the actual bill includes the section caption “DISALLOWANCE OF HOME EQUITY INDEBTEDNESS INTEREST.” As a result, many people believed the new law eliminated the home equity loan interest deduction.
On February 21, the IRS issued a release (IR 2018-32) clarifying that the law suspends the deduction only for interest on home equity loans and lines of credit that aren’t used to buy, build or substantially improve the taxpayer’s home that secures the loan. In other words, the interest isn’t deductible if the loan proceeds are used for certain personal expenses, but it is if the proceeds go toward, for example, a new roof on the home that secures the loan. The IRS further stated that the deduction limits apply to the combined amount of mortgage and home equity acquisition loans — home equity debt is no longer capped at $100,000 for purposes of the deduction.
Example 1: A taxpayer took out a $500,000 mortgage to buy a principal residence with a fair market value of $800,000 in January 2018. The loan is secured by the residence. In February, he/she takes out a $250,000 home equity loan to pay for an addition to the home. Both loans are secured by the principal residence, and the total doesn’t exceed the value of the home.
The taxpayer can deduct all of the interest on both loans because the total loan amount doesn’t exceed $750,000. If he/she used the home equity loan proceeds to pay off student loans and credit card bills, though, the interest on that loan wouldn’t be deductible.
Example 2: The taxpayer from the previous example takes out the same mortgage in January. In February, he/she also takes out a $250,000 loan to buy a vacation home, securing the loan with that home. Because the total amount of both mortgages doesn’t exceed $750,000, he/she can deduct all of the interest paid on both mortgages. But, if he/she took out a $250,000 home equity loan on the principal home to buy the second home, the interest on the home equity loan wouldn’t be deductible.
Example 3: In January 2018, a taxpayer took out a $500,000 mortgage to buy a principal home, secured by the home. In February, he/she takes out a $500,000 loan to buy a vacation home, securing the loan with that home. Because the total amount of both mortgages exceeds $750,000, he/she can deduct only a percentage of the total interest he/she pays on them.
For further guidance on how this new IRS rule on home equity loan interest deduction may impact your personal situation, please contact your Friedman LLP tax advisor.
1 For tax purposes, a qualified residence is the taxpayer’s principal residence and a second residence, which can be a house, condominium, cooperative, mobile home, house trailer or boat. The principal residence is where the taxpayer resides most of the time—the second residence is any other residence the taxpayer owns and treats as a second home. Taxpayers aren’t required to use the second home during the year to claim the deduction. If the second home is rented to others, though, the taxpayer also must use it as a home during the year for the greater of 14 days or 10% of the number of days it’s rented.