Prior to the Tax Cuts and Jobs Act (TCJA), taxpayers were permitted to deduct interest on home equity debt. That was true specifically for those debts which were secured by the taxpayer’s home and were not an "acquisition indebtedness" (such as those incurred acquiring, constructing or improving a home).
Through Code §163(h)(3)(F), the TCJA eliminated the deduction for interest on home equity debt for tax years beginning after December 31, 2017 and before January 1, 2026. This was applicable regardless of when the home equity debt had occurred.
Through Informational Release IR 2018-32, the IRS clarifies that, although restricted by the TCJA, taxpayers can still deduct interest on many home equity loans, home equity lines of credit, or second mortgages. The IRS states that TCJA suspends the deduction for interest paid on home equity loans and lines of credit when they are used for something other than the purchase of, building of or substantial improvement of that taxpayers home that secures the loan.
This Informational Release also clarifies the new dollar limitations on total qualified residence loans for those taxpayers considering taking out a mortgage. The TCJA imposes a lower dollar limit on mortgages qualifying for the home mortgage interest deduction. For tax years after December 31, 2017, taxpayers may only deduct interest on $750,000 of qualified residence loans. These are down from the prior limits of $1 million, or $500,000 for a married taxpayer filing a separate return. The limits apply to the combined amount of loans used to buy, build or substantially improve the taxpayer's main home, as well as a second home.
In order to qualify for this deduction, the home equity loan must be considered “acquisition indebtedness,” which is essential debt secured by a home and used to acquire, construct, or substantially improve the home. If the home equity line qualifies as acquisition indebtedness, the interest should be deductible, subject to the new principal balance limitations ($750,000 for debts incurred after December 15, 2017). If the principal balance of the mortgage and the equity line combined is in excess of this limitation, the interest deduction will be limited.
The following examples illustrate these updates.
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 and both loans are secured 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 loan and/or credit card debt, 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 and the loan is secured. In February 2018, the taxpayer takes out a $250,000 loan to purchase a vacation home and the loan is secured. 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 and the loan is secured. In February 2018, the taxpayer takes out a $500,000 loan to purchase a vacation home and the loan is secured. Because the total amount of both mortgages exceeds $750,000, not all of the interest paid on the mortgages is deductible.
For questions on this or any other provision of the Tax Cuts and Jobs Act please contact a member of the HBK Tax Advisory Group.