Changes made by the Tax Cuts and Jobs Act (TCJA) are raising many questions among taxpayers and tax professionals due to the complexities and incomplete guidance of the new law. One of the more puzzling is whether interest paid on home equity loans (HELOAN), lines of credit (HELOC), and second mortgages is still deductible.
Out With the Old
Prior to the TCJA, taxpayers claiming itemized deductions were able to deduct interest on home equity loan balances up to $100,000 ($50,000 for married filing separate) – regardless of how the loan proceeds were used (e.g., general living expenses, education, paying off other debts, buying a car, taking a vacation, investment/business, or home improvement). This was in addition to the [primary] home mortgage interest deduction.
In With the New
For years 2018-2026, the TCJA now restricts the deduction for home mortgage interest to loans where the proceeds were only “used to buy, build, or substantially improve the taxpayer’s home that secures the loan.” Proceeds used for anything else will not qualify specifically for the home mortgage interest deduction. If some of the proceeds do qualify as defined above, they will need to be segregated out from the non-allowed items and interest will need to be calculated separate to allow for the deduction.
The home mortgage interest deduction is still in effect; however, the limits have been lowered. Starting in 2018, taxpayers may only deduct interest on up to $750,000 of qualified residence loans (down from $1 million), or if married filing separate, the limit is up to $375,000 (down from $500,000). These limits are applicable to the combined amount of loans used to buy, build, or substantially improve the taxpayer’s main home and second home. There are grandfathered provisions that allow existing home acquisition loans to continue to be deductible up to the $1,000,000 limitation. Caution: the grandfathered loan provisions do not apply to home equity loans.
Just because your loan is labeled a home equity loan, home equity line of credit, or second mortgage doesn’t in itself mean the interest is not a deductible expense. Although TCJA removed the deduction for home equity loans as described above, it did not change other provisions of the tax code where a deduction for interest on a home equity loan may be available. TCJA did not change the opportunities available under the interest tracing rules where loan proceeds are used for business or investment purposes. The tracing rules include a provision that will generally allow a loan advance to be traced to transactions occurring 30 days before or after the advance. Consider the situation where proceeds from a home equity loan are used to purchase a business or investment property, or are contributed to your business or rental LLC for operating capital. In such cases, a portion of the interest expense may be deductible as business or investment interest expense.
Some Examples to Provide Perspective
- In February 2018, John and Jane Doe buy a home (principal residence) and take out a $400,000 mortgage against it to purchase the home. The home is valued at $850,000. In May of 2018, they then take out a $200,000 home equity loan against the home to build an addition. Together, the total loan balance is $600,000, which is not more than the value of the home, AND is less than the $750,000 of total combined qualified loans, so all interest paid on both loans is deductible home mortgage interest.
NOTE: If John and Jane split their $200,000 home equity proceeds and used $150,000 of it for an addition and $50,000 for other personal purposes, such as purchasing a car, only the interest on the $150,000 used for the home addition would be allowable for deduction under the TCJA.
- In July of 2018, Mark and Mary Doe buy a home (principal residence) and take out a $500,000 mortgage against it to purchase it. In the fall of 2018, they purchase a vacation home and take out a $250,000 loan against the vacation home to acquire it. Both homes have separate mortgages against them and both qualify for the interest deduction as they are less than the $750,000 of total combined qualified loans.
NOTE: If Mark and Mary used equity in their principal residence to take out a second loan against it to purchase the vacation home, they would NOT be able to use the interest from the second loan because it was not used “to buy, build, or substantially improve the home that secures the loan.”
- In February of 2018, Carl and Carol Doe buy a home (principal residence) and take out a $500,000 mortgage against it to purchase it. In March of 2018, they buy a vacation home and take out a $300,000 loan against it to purchase it. Both homes have separate mortgages used to acquire them; however, because the total combined amount of qualified loans is $800,000, which exceeds the new $750,000 limit, only a percentage of the total interest paid will be deductible.
NOTE: If Carl and Carol take out a $100,000 home equity loan and can appropriately trace the use of these proceeds to their business this loan would not be deductible as home mortgage interest but alternatively could qualify has a business interest expense deduction.
Besides these highlights, there may be other factors impacting the deductibility of interest expense in your particular situation. The new provisions are complicated and depending on your circumstances there are opportunities that should be discussed with a tax professional.
We can help clarify your tax situation and plan for future opportunity. Call your local Dalby Wendland professional today.
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