One casualty of the new tax law was thought to be the deduction for interest paid on home equity loans. The language of the bill was vague, and the conference report simply states, “…the Conference agreement suspends the deduction for interest on home equity indebtedness.” Now, in a surprise move, the IRS has advised that many taxpayers can continue to deduct their home equity interest.
The IRS’s interpretation of the new law is that it allows the deduction of interest on loans used to buy, build, or substantially improve a taxpayer’s home, regardless of how the loan is labelled. The key is what the loan is used for, not what it is called.
Under the new law, for example, interest on a home equity loan used to build an addition to an existing home is deductible, while interest on the same loan used to pay for a car is not. The loan must be secured by the taxpayer’s main home or second home and may not exceed the cost of the home. Also, the home equity loan and any other qualified indebtedness cannot exceed the new dollar limits.
Beginning in 2018, taxpayers may only deduct interest on $750,000 of qualified residence loans. The previous limitations were $1 million for an acquisition mortgage and $100,000 for a home equity loan. The new limit applies to the combined amount of any loans used to buy, build or substantially improve the taxpayer’s main home and a second home.
The examples below illustrate how these limitations work.
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 home. Both loans are secured by the main 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 credit cards, the interest on that 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 $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 interest on up to $750,000 of debt would be deductible.
Interestingly, it appears that the IRS actually broadened the language in the Act with its interpretation of the deduction limitations, which is unusual, but a welcome change for homeowners.