When the Tax Cuts and Jobs Act was passed in December 2017, it was widely reported that the deduction for home equity loan interest was going away in 2018. And to be fair, as the bill was written, that certainly appeared to be the case.
However, the IRS's interpretation is somewhat different, according to a recently released document by the agency. Many borrowers will be thrilled to learn that some home equity debt may qualify for the mortgage interest deduction after all. Here's a rundown of the IRS's guidelines for the home equity deduction going forward, and what it could mean to you.
One major tax change for some home equity borrowers
As part of the Tax Cuts and Jobs Act, the deduction for mortgage interest was modified. Now, borrowers can deduct interest paid on as much as $750,000 of "qualified residence loans." Previously, the deduction was available for as much as $1 million of mortgages and $100,000 of home equity debt. To meet the definition of a "qualified residence loan," the debt must be secured by the taxpayer's home (primary or second home), and must meet certain other requirements.
So, what does this mean for home equity borrowers? The new law suspends the deduction for interest paid on home equity loans and lines of credit from 2018 until 2026.
However, there is one big exception. If the proceeds from the loan are used to buy, build, or improve the home that secures the loan, they are still deductible as "qualified personal residence" loans. In other words, if you borrow against your main home to put in a swimming pool or redo your kitchen, the interest can potentially be deductible. On the other hand, if you borrow against your home equity to pay off credit card debt or take a family vacation, the deduction no longer applies.
What's more, the previous $100,000 home equity debt cap doesn't apply to loans that qualify. If you take out say, $200,000 in home equity debt to renovate your home, the interest can be deductible.
To clarify, the IRS provided a few examples to show how this could work. From the IRS's newsletter, here are three hypothetical scenarios and the tax implications of each:
- 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.
- Example 3: 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 $500,000 loan to purchase a vacation home. The loan is secured by the vacation home. Because the total amount of both mortgages exceeds $750,000, not all of the interest paid on the mortgages is deductible. A percentage of the total interest paid is deductible (see Publication 936).
What it could mean to you
Depending on the type of home equity loan you have, this could be bad news or good news.
If you have home equity debt that was obtained for purposes other than home improvements or other qualified purposes, your interest will no longer be deductible. It doesn't even matter if you have a pre-existing home equity loan taken before the new tax law passed. There is no "grandfathering in" for unqualified home equity debt.
On the other hand, if you do obtain home equity debt used for qualified purposes, not only do you still get to deduct the interest, but in many cases, the deduction could be even better. As long as your total qualified personal residence debt is within the $750,000 maximum, you can deduct all qualified home equity debt, even if it exceeds the previous $100,000 cap.
The new tax law is still a work in progress
This is a perfect example of how the new tax law is still a very fluid situation. When the Tax Cuts and Jobs Act was first signed into law, it was widely reported that the home equity deduction was gone in its entirety. Now that the IRS has had a chance to review and interpret that part of the tax bill, it turns out that the deduction was only removed in certain cases, and could actually be better than before for certain home equity borrowers.
We're still less than two months into 2018, so I wouldn't be surprised if the IRS interprets other parts of the new tax law in similarly clarifying ways.