The Tax Cuts and Jobs Act of 2017 affected the tax deduction for interest paid on home equity debt beginning in 2018.  Under the previous law, you could deduct interest paid on a maximum of $100,000 in debt borrowed against home equity, no matter how the funds were used.  The old rule is scheduled to return in 2026.

The bad news is that you can no longer deduct interest on home equity loans or home equity lines of credit (HELOCs) if you use the money for college tuition, medical bills, credit card debt, etc.  The good news is that the IRS has announced “Interest on Home Equity Loans Often Still Deductible Under New Law” in a February 21, 2018 news release (IR 2018-32).

The book, not the cover

According to the IRS, even if a loan is labeled “home equity”, the interest may be deductible on your tax return.  The key is how the borrowed money is used.  In addition, the $100,000 ceiling doesn’t apply.

For home loan interest to be tax deductible, the taxpayer must use the funds to buy, build, or substantially improve your home.  Beginning in 2018, taxpayers may only deduct interest on $750,000 of such “qualified residence loans”, or $375,000 for a married taxpayer filing separately.

Those numbers apply to the total of a taxpayer’s home loans, but older loans up to $1 million and $500,000, respectively, may have fully deductible interest.  As in prior years, home loan interest on debt that exceeds the cost of the home is not eligible for an interest deduction (among other requirements).

Fine points

For home loans obtained in 2018 and future years, some tax rules are clear, while others are a bit more ambiguous.

Example 1:  Eve Harper takes out a loan from Main Street Bank to buy a home in July 2018.  In November 2018, Eve takes out a “home equity” loan from Broad Street Bank to purchase a car.  The interest on the second (home equity) loan is not tax deductible.

Example 2:  Same facts as example 1, except that Eve uses the Broad Street Bank loan to install central A/C, add a powder room, and upgrade plumbing throughout her new home.  The interest on both of the loans would now be deductible.

The tax treatment of interest on the loans in Examples 1-2 may seem straightforward, but the circumstances involving your loan may not be so clear cut.

Example 3:  Same facts as example 1, except that the Broad Street Bank loan is used to make a down payment on a mountain cabin, where Eve plans to go for vacations.  Interest on this $50,000 loan is deductible because the total of both loans does not exceed $750,000, and the $50,000 loan is secured by the cabin.  Indeed, Eve could get a loan up to $250,000 (for a $750,000 total of home loans) to buy the cabin and still deduct the interest, as long as this loan is secured by the cabin.

Example 4:  Same facts as example 3, except that the Broad Street Bank loan is secured by Eve’s main home, not by the cabin she is buying.  Now, the Broad Street Bank loan would be considered home equity debt no matter now much was borrowed, and no interest on that loan is deductibl.

Over the limit

What would happen if Eve gets a $500,000 loan in June to buy her main house and another $500,000 loan in November to buy a vacation home?  She would be over the $750,000 debt limit for deducting interest on 2018 home loans, so only a percentage of the interest paid would be tax deductible.

The bottom line is that if you intend to use a home equity loan to buy, build, or substantially improve a home, you should be careful about how the debt is secured.  Be prepared to show that the money really was used for qualified purposes.

Moreover, qualified home loans obtained on or before December 15, 2017, are grandfathered, with tax deductions allowed for interest up to $1 million or $500,000, as explained.  Some questions remain, though, about how refinancing those grandfathered loans will affect tax treatment.  If you are considering refinancing a home loan that’s now grandfathered, my office can provide the latest guidance on how your taxes might be affected.