Are Home Equity Loans Still Deductible After Tax Reform?

Can you still deduct interest on home equity loans after tax reform? Find out the new rules here for deducting interest on home equity loans.Image source:  Getty Images

Home equity loans and home equity lines of credit both make it possible for you to borrow against the equity of your home. You can use the money you borrow from your home for many purposes, including to finance home improvement projects or to repay debt you owe.

Because home equity loans involve borrowing against your home, many people who take out these loans wonder whether they can deduct interest paid, since mortgage interest is generally tax deductible. The answer is: it depends.

The rules have changed slightly as a result of the passage of the Tax Cuts and Jobs Act in 2017, so taxpayers need to know the situations when it's permissible to take a deduction for interest paid on either a home equity loan or home equity line of credit.

You can find out here whether interest is tax deductible on your loan or not, as the answer depends upon the specifics of your situation.

Can you still deduct interest on home equity loans after tax reform?

The Tax Cuts and Jobs Act of 2017 imposed new limits on the deductibility of interest on home equity loans and home equity lines of credit. The deduction is now limited to circumstances where the money obtained from the loan is used to build a home; buy a home; or substantially improve the home that is securing the loan.

This means if you take out a home equity loan or home equity line of credit to help you to remodel that house or add an addition, the interest on the loan should be tax deductible. If you take a home equity loan to help you cover costs of purchasing the home you're borrowing against, you can also deduct interest.

However, if you take out a home equity loan to pay off your debt or to fund a vacation, you aren't permitted to deduct interest paid on the money borrowed.

In order for you to be eligible to take out a home equity loan or line of credit and to claim a tax deduction for interest paid on that loan, the loan also must meet certain other requirements. For example, it must be the main home or second home of the taxpayer who is claiming the deduction, and the loan must not exceed the cost of the home.

There is a dollar amount limit for deductions

The Tax Cuts and Jobs Act also imposed stricter limits on the total amount of mortgage debt a taxpayer can have and still deduct the full amount of interest.

Thanks to tax reform, taxpayers are permitted to deduct interest only on qualified residence loans of up to $750,000 or $375,000 if filing taxes as married filing separately. This $750,000 or $375,000 loan limit is a combined limit for all of the loans used to build, buy, or substantially improve a first home and a second home belonging to the taxpayer.

Under the limits before tax reform, taxpayers could deduct interest on mortgage loans of up to $1 million and could also deduct interest on qualifying home equity loan debt of up to $100,000 or up to $50,000 if married filing separately.

You could take this additional $100,000 deduction on your home equity loan no matter what you used the proceeds for in most cases, although the rules differed under alternative minimum tax (AMT) calculations.

You have to itemize to deduct home equity loan interest

In order to deduct interest on mortgages or home equity loans, you need to itemize your deductions when you file your tax return.

Itemizing deductions may not make sense for many people anymore, thanks to the fact that tax reform significantly increased the standard deduction. In 2017, the standard deduction for single taxpayers or for married couples filing separate returns was $6,350. For married couples filing jointly, the standard deduction was $12,700 and for heads of household, the standard deduction was $9,350.

Thanks to tax reform, the new standard deduction is $12,000 for singles and married filing separately, $24,000 for married couples filing jointly, and $18,000 for heads of household.

Since the standard deduction was nearly doubled, you'll need to determine if it makes sense to still itemize to claim your deduction for mortgage interest and home equity loan debt.

Unless the total value of the deductions you're eligible to claim if you itemize exceeds $12,000, $18,000, or $24,000, it no longer makes sense to itemize as you could reduce your taxable income further by opting for the standard deduction instead.

How long are the new rules in effect?

Many of the changes made by tax reform, including doubling the standard deduction and the new restrictions on deductions for home equity debt, are in place only for a limited period of time. The new $750,000 cap on the mortgage interest deduction is also limited in time.

These relevant changes made by tax reform will be in effect for tax year 2018 through tax year 2025. For the 2026 tax year, the old laws on home equity loans from before tax reform will once again be in place -- unless further modifications are made in the interim.

Not being able to deduct interest makes taking a loan more expensive

Home equity loans cost less than many other types of loans, because they're a secured loan so less risky to lenders. The interest charged on a home equity loan, for example, can be substantially lower than the interest rate on a personal loan or a credit card.

However, one big benefit in the past was being able to deduct interest on a home equity loan. Now that you can't do that unless you're using the loan to pay to buy or improve your home, using a home equity loan or line of credit to pay off existing debts becomes less attractive.

A deduction on interest is valuable. If took a $20,000 home equity loan at 5.65% and paid it off over four years, you'd pay around $2,392 in interest over the four years. If you were in the 22% tax bracket, the interest deduction would've saved you a total of $526 in federal taxes.

Be aware of the updated tax rules

It's important to understand updated tax rules, both when you tap into the equity in your home and when you file your taxes. Tax reform made major changes to the rules for home equity loans and lines of credit, and now you know how those changes could affect the potential cost of your loan as well as how much you might owe to the IRS.  

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