IRS clarifies interest on home equity loans can still be deductible

In an Information Release, IRS has announced that in many cases, taxpayers can continue to deduct interest paid on home equity loans under the recently enacted Tax Cuts and Jobs Act.

Taxpayers may deduct interest on mortgage debt that is “acquisition debt.” Acquisition debt means debt that is: (1) secured by the taxpayer’s principal home and/or a second home, and (2) incurred in acquiring, constructing, or substantially improving the home. This rule hasn’t been changed by the Tax Cuts and Jobs Act.

Under pre-Tax Cuts and Jobs Act law, the maximum amount that was treated as acquisition debt for the purpose of deducting interest was $1 million ($500,000 for marrieds filing separately). Under the Tax Cuts and Jobs Act, for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, the limit on acquisition debt is reduced to $750,000 ($375,000 for a married taxpayer filing separately).

Under the Tax Cuts and Jobs Act, for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, there is no longer a deduction for interest on “home equity debt.” The elimination of the deduction for interest on home equity debt applies regardless of when the home equity debt was incurred.

IRS said that despite the newly-enacted restrictions on home mortgages under the Tax Cuts and Jobs Act, 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 IRS clarified that the Tax Cuts and Jobs Act suspends the deduction for interest paid on home equity loans and lines of credit, unless they are used to buy, build or substantially improve the taxpayer’s home that secures the loan.

For example, interest on a home equity loan used to build an addition to an existing home is typically deductible, while interest on the same loan used to pay personal living expenses—such as credit card debts—is not. As under pre-Tax Cuts and Jobs Act law, for the interest to be deductible, the loan must be secured by the taxpayer’s main home or second home (known as a qualified residence), not exceed the cost of the home and meet other requirements.

Illustration 1: In January 2018, John takes out a $500,000 mortgage to purchase a main home with a fair market value of $800,000. In February 2018, he 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 John 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.

Illustration 2: In January 2018, Mary takes out a $500,000 mortgage to purchase a main home. The loan is secured by the main home. In February 2018, she 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 Mary 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.

Illustration 3: In January 2018, Bob takes out a $500,000 mortgage to purchase a main home. The loan is secured by the main home. In February 2018, he 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. Only a percentage of the total interest paid is deductible.