Word spread quickly in the days leading up to tax reform: the mortgage interest deduction on housing was about to fall. In the end, the deduction was saved, but the residential mortgage amount eligible for the deduction was limited to $750,000 for new mortgages. Existing mortgages were grandfathered, but this did not appear to be the case for home equity debt, raising some questions for taxpayers. Today, the Internal Revenue Service (IRS) finally issued guidelines regarding the deduction of interest paid on home equity loans.
Under the previous law, if you itemized your deductions, you could deduct eligible mortgage interest for home purchases up to $1,000,000 plus an additional $100,000 for equity debt. The new law appeared to eliminate the interest deduction on a home equity loan, home equity line of credit (HELOC), or second mortgage (sometimes called a “re-fi”), but some tax experts, like me, argued that it was the substance of the loan, not the name, that mattered. In the past month, the issue has become a prominent topic of debate, inspiring lively Twitter threads like this one:
The IRS has now clarified that “despite newly enacted restrictions on home mortgages, taxpayers can often still deduct interest on a home equity loan, home equity line of credit (HELOC), or second mortgage, regardless of or how the loan is labelled”. Specifically, the new law eliminates the deduction of interest paid on home loans and lines of credit (until 2026) “unless they are used to purchase, build or substantially improve the home of the taxpayer who secures the ready”.
This is consistent with the wording of the act. The new law, in article 11043, says:
“(i) GENERALLY. For taxation years beginning after December 31, 2017 and before January 1, 2026
(I) REJECTION OF INTEREST ON DEBT ON CAPITALITY. Subparagraph (A)(ii) does not apply.
(II) LIMITATION OF ACQUISITION INDEBTEDNESS. Subparagraph (B)(ii) will apply replacing $750,000…
But you can’t stop there: relying on subtitles is never a good idea. You must continue reading. The new law allows taxpayers to continue to deduct “acquisition indebtedness”. And if you go back to the original law, what remains makes it clear that acquisition includes any residence-secured debt that is “incurred in the acquisition, construction, or substantial improvement of any qualifying residence of the taxpayer “. The law goes on to state that “[s]this term also includes any debt secured by this residence resulting from the refinancing of debt meeting the requirements of the preceding sentence (or this sentence); but only to the extent that the amount of debt resulting from such refinancing does not exceed the amount of debt refinanced.”
In other words, interest on a re-fi that is secured by your home (qualified residence) and that does not exceed the cost of your home and that is used to significantly improve your home will continue to be deductible as long as it meets other criteria – like the new dollar limit.
The new law imposes a lower dollar limit on mortgages eligible for the mortgage interest deduction. As of 2018, taxpayers can only deduct interest on $750,000 of qualifying new home loans ($375,000 for a married taxpayer filing separately). Limits apply to combined loan amount used to purchase, build or substantially improve the taxpayer’s principal residence and secondary residence.
The IRS even threw out a few examples:
Example 1: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a principal residence with a fair market value of $800,000. In February 2018, the taxpayer takes out a $250,000 home equity loan to add an addition to the principal residence. Both loans are secured by the principal residence and the total does not exceed the cost of the home. Since the total amount of the two loans does not exceed $750,000, all interest paid on the loans is deductible. However, if the taxpayer used the proceeds of the home equity loan for personal expenses, such as paying off student loans and credit cards, 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 principal residence. The loan is secured by the principal residence. In February 2018, the taxpayer takes out a loan of $250,000 to buy a second home. The loan is secured by the vacation home. Since the total amount of the two mortgages does not exceed $750,000, all interest paid on the two mortgages is deductible. However, if the taxpayer took out a $250,000 home equity loan on the principal residence to purchase the vacation home, 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 principal residence. The loan is secured by the principal residence. In February 2018, the taxpayer takes out a loan of $500,000 to buy a second home. The loan is secured by the vacation home. Since the total amount of the two mortgages exceeds $750,000, any interest paid on the mortgages is not deductible. A percentage of the total interest paid is deductible (see Publication 936 downloadable in pdf format).
So, to recap, the interest on that renovation you were planning on using to re-roof your house? Deductible as long as you otherwise meet the criteria. Ditto for interest on a re-fi to build an addition.
But the re-fi you intended to use to pay off those credit cards? Not deductible. Similarly, there is no deduction for re-fi interest you intended to use to pay for your education, take a vacation, or finally master the sport of curling.
- To see what your Schedule A might look like for the 2018 tax year, click here.
- For more general information on tax reform, including new tax rates and standard deductions for 2018, click here.
- For more information on these new holdback tables for 2018, click here.