Word spread quickly in the days leading up to tax reform: The home mortgage interest deduction was on the chopping block. Ultimately, the deduction was spared, but the amount of home mortgage allowable for purposes of the deduction was limited to $750,000 for new mortgages. Existing mortgages were grandfathered, but that didn’t appear to be the case for home equity debt, raising some questions for taxpayers. Today, the Internal Revenue Service (IRS) finally issued guidance concerning deducting interest paid on home equity loans.
Under prior law, if you itemize your deductions, you could deduct qualifying mortgage interest for purchases of a home up to $1,000,000 plus an additional $100,000 for equity debt. The new law appeared to eliminate the deduction for interest on a home equity loan, home equity line of credit (HELOC) or second mortgage (sometimes called a “re-fi”) but some tax professionals, like me, argued that it was the substance of the loan, not the name, that mattered. Last month, the issue became a prominent topic of debate, inspiring lively Twitter threads like this one:
The IRS has now clarified that “despite newly-enacted restrictions on home mortgages, 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.” Specifically, the new law eliminates the deduction for interest paid on home equity loans and lines of credit (through 2026) “unless they are used to buy, build or substantially improve the taxpayer’s home that secures the loan.”
This is consistent with the language in the statute. The new law, at Section 11043, says:
“(i) IN GENERAL. In the case of taxable years beginning after December 31, 2017, and before January 1, 2026
(I) DISALLOWANCE OF HOME EQUITY INDEBTEDNESS INTEREST. Subparagraph (A)(ii) shall not apply.
(II) LIMITATION ON ACQUISITION INDEBTEDNESS. Subparagraph (B)(ii) shall be applied by substituting $750,000…
But you can’t stop there: Relying on captions is never a good idea. You have to keep reading. The new law allows taxpayers to continue to deduct “acquisition indebtedness.” And if you go back to the original statute, the bits that remain make clear that acquisition includes any indebtedness secured by the residence which is “incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer.” The law goes on to state that “[s]uch term also includes any indebtedness secured by such residence resulting from the refinancing of indebtedness meeting the requirements of the preceding sentence (or this sentence); but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.”
In other words, interest on a re-fi which is secured by your home (qualified residence) and which does not exceed the cost of your home and which is used to substantially improve your home will continue to be deductible so long as it meets the other criteria – like the new dollar limit.
The new law imposes a lower dollar limit on mortgages qualifying for the home mortgage interest deduction. Beginning in 2018, taxpayers may only deduct interest on $750,000 of new qualified residence loans ($375,000 for a married taxpayer filing separately). The limits apply to the combined amount of loans used to buy, build or substantially improve the taxpayer’s main home and second home.
The IRS even threw out a few examples:
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 which downloads as a PDF).
So, to recap, interest on that re-fi you were planning on using to re-roof your home? Deductible so long as you otherwise meet the criteria. Ditto for interest on a re-fi to build an addition.
But the re-fi you were planning on using to pay off those credit cards? Not deductible. Similarly, there’s no deduction for re-fi interest you were planning on using to pay for college, take a vacation, or finally master the sport of curling.