On February 21, 2018, the IRS released IR-2018-32 where it clarified that, in many cases, taxpayers can continue to deduct interest paid on home equity loans under the recently enacted Tax Cuts and Jobs Act (TCJA). If you have or are contemplating taking out a home equity loan or line of credit, read on to see how you may be affected by TCJA.
First, a Little Background:
TCJA did not change the rule that taxpayers may deduct interest on mortgage debt that is “acquisition debt.”
Acquisition debt means debt that is:
Secured by the taxpayer's principal or second home, and
Incurred in acquiring, constructing, or substantially improving the taxpayer's principal or second home.
Prior to TCJA, the maximum amount treated as acquisition debt for deducting interest was $1 million ($500,000 if married filing separately). This meant a taxpayer could deduct interest on no more than $1 million of acquisition debt. Taxpayers could also deduct interest on “home equity debt.”
Home equity debt, as defined for the mortgage interest deduction, meant debt that:
Was secured by the taxpayer's home, and
Wasn't incurred to acquire, construct, or substantially improve the home.
Prior to TCJA, the maximum amount home equity debt on which interest could be deducted; here, the limit was the lesser of $100,000 or the taxpayer's equity in the home ($50,000 if married taxpayer filing separately).
Under TCJA, for tax years beginning after December 31, 2017 and before January 1, 2026, the limit on acquisition debt is reduced to $750,000 ($375,000 if married filing separately). For these same tax years, there is no longer a deduction for interest on “home equity debt.” Eliminating the deduction for interest on home equity debt applies regardless of when the home equity debt was incurred.
However, the $1 million, pre-TCJA limit applies to acquisition debt incurred before December 15, 2017, and to debt arising from refinancing pre-December 15, 2017 acquisition debt, to the extent the debt resulting from the refinancing does not exceed the original debt amount. These loans will be what is often referred to as “grandfathered.”
In IR 2018-32, the IRS said that despite the newly enacted restrictions on home mortgages under TJCA, 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 TCJA suspends the deduction for interest paid on home equity loans and HELOCs, 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 (e.g., credit card debts) is not. For the interest to be deductible, the loan must be secured by the principal or second home, not exceed the cost of the homes, and meet other requirements.
The TCJA imposes a lower dollar limit on mortgages qualifying for the home mortgage interest deduction. The lower limits apply to the combined loans used to buy, build or substantially improve the taxpayer's main home and second home.
Let’s Look at a Few Examples:
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 of both loans does not exceed $750,000, all 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.
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 of both mortgages does not exceed $750,000, all 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.
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 of both mortgages exceeds $750,000, not all the interest paid on the mortgages is deductible. A pro-rata percentage of the total interest paid is deductible.
Tax Warrior Perspective
The IRS was wise to clarify this part of the TCJA quickly, so taxpayers can plan their affairs. Put simply, TCJA limited the interest that could be deductible by lowering the debt allowable from effectively $1.1 million to $750,000. This change will generate tax revenue to offset some of the, what we would call, generous corporate tax rate reductions. Simultaneously, TCJA took away the deduction for interest on home equity debt used for personal expenses, what some viewed as a tax loophole of sorts.
An important take away regarding these changes, is that more thought should go into the decision to refinance grandfathered debt. An analysis of the tax impact of the refinancing must now accompany the general economic analysis decision-making process.
2018 Tax Reform has changed the landscape of taxation. The hastily and poorly written law leaves many taxpayers and practitioners searching for guidance from the IRS. The guidance will be slow coming, but with mortgage debt, the IRS came through and provided much-needed clarity quickly.
If you need assistance determining the deductibility of your mortgage interest or with interpreting how the TCJA affects your business or personal tax situation, do not hesitate to contact The Tax Warriors®.